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|Subject: The Mortgage Mess||Date: 3/7/2009 4:35 PM|
|Author: junkman02||Number: 26238 of 36082|
The following is just a portion of John Mauldin's weekly newsletter, “Thought from the Front Line.” To read his entire newsletter, you'll have to register at his website ( linked following). Registration is free, and the whole letter is worth reading. In fact, the snippets I quote are probably even misleading, because they've been taken out of context. My reason for quoting them is to engage your interest enough to want to follow up.
In the beginning there were ratings agencies, and they rated corporate bonds from the very highest of credit quality (AAA) down to junk (CCC).
Now AAA means that the chances of losing money are very, very low. With each level of increased incremental risk comes a lower rating. If a corporate bond was at risk for losing just one dollar, it was rated all the way down to junk. And that was fine. Everybody knew the rules of the game.
But then investment banks asked the agencies to rate a large group of home mortgages in a pool known as a Residential Mortgage Backed Security (RMBS). The investment bank would divide the pool (the RMBS) into various tranches. The highest-rated tranche would be given a rating of AAA. Let's say that the AAA tranche was 92% of the loan pool. The AAA tranche would get the first 92% of all monies coming into the pool before the other investors were paid (again, really oversimplified, but that is the net effect). That would mean that the pool could have 16% of the home loans default and lose 50% of their value before the AAA tranche would lose even one dollar.
We all know now, though, that some of those AAA-rated tranches are in fact going to lose money. And the rating agencies are now writing down the ratings on the former AAA tranches.
I am not talking about the exotic CDOs and CDO squareds, or some of the truly toxic securitized assets which are going to zero. What I am writing about today are plain vanilla mortgages grouped together in securitized pools.
Toward the end of his letter, he makes this suggestion:
Let's move away from using standard bond ratings for multi-obligor securities. Why not rate a bond by the percentage of capital likely to be returned? Let's call it the Impairment Factor, or I-Factor. If a bond is likely to lose 10% of its capital, then it would have an I-Factor of 10%. An I-Factor of 0% would mean the bond should see all its capital returned, and an I-Factor of 100% would mean that all the money will be lost.
That is a point I've argued for years. Default rates are a concern to FI investors, but what really matters is recovery rate. Estimating those rates can be done even by small investors. But it's an area within deep-value investing better left to specialists, not “average” bond investors. But if the rating agencies were forced to re-evaluate how bonds are rated, small investors would benefit. This is part of the reason I've been hammering on yield-curves so hard. Understanding them is a step toward understanding market-implied ratings, which, in turn, shed light on the inadequacies of rating-house ratings.
Meanwhile, he argues: ....we are giving banks [lots of] taxpayer money while forcing them to sell assets that might be worth $.95 cents on the dollar in a less-stressed world. We are shoveling money in the front door while it is being pushed out the back door to my friends at the hedge funds.
To his credit, he deplores the situation and would like to see it fixed. The reason is simple. In the long run, such stupidity benefits no one. Rigged markets blow up, making it impossible for anyone, honest players or not, to make money. And any money manager, any investor or trader, who knows that he or she is any good, also knows that they are good enough that they don't have to cheat to make money. They can their hold in a fair game.
What Maudlin would like to see is a fair game. Unfortunately, the current policy makers --and Mauldin names them-- don't understand markets well enough to fix the problems and create that fair game.
"This cycle needs to be broken. Mary Schapiro? Tim Geithner? Are you listening?"
And let's add President Obama, Ben Bernanke, Barney Frank, Chris Dodd, and Larry Summers to the list of those who should be listening. I know that some of my readers will have access to these people. See if you can get them to focus on this problem, and let's move on to the next problem -- housing.
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