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The Subprime Mortgage Market, Bear Sterns, Federal Reserve, and Jim Cramer Meltdown Simultaneously

August 12th, 2007 · 1 Comment

The recent subprime mortgage meltdown and subsequent meltdown of a Bear Stearns hedge fund that invested heavily in subprime mortgage securities has caused quite a bit of heartache in global capital markets, leaving all three major broad market indexes in the U.S. down for the month of July. Usually, the markets close up on a monthly basis, as the markets tend to grow in general. But speaking of meltdowns, check out Jim Cramer absolutely freaking out two minutes into this video while discussing Bear Stearns CFO Sam Molinaro’s statement that this was the “worst credit market in 22 years”. Onto the screaming:

Jim, I like your show, so I hope you don’t have a heart attack on air. But if you don’t understand what Bear is doing by issuing bad news, you just really don’t understand the game. But I doubt that, since you yourself have been accused of floating rumors with the intent of affecting the price of your positions — Time magazine reported that you gamed Maria Bartiromo by feeding her rumors which she would repeat them on air. Bear is releasing bad news because they understand that news affects the market, and volatility is preferable to illiquid stagnation.

The banks that securitized subprime loans saw this coming a mile away. That’s why they securitized the debt: it passes the risk on to someone else. But instead of a massive meltdown where a couple big players would have lost it all, a lot of people — the bond holders — are losing a little alot of times. The price of risk is changing and liquidity is drying up because investors are convinced a bear market is coming or is happening now, and is here to stay.

Coincidentally, while prices are dropping now, earlier this month an almost unnoticed decision was made by the SEC: elimination of the uptick rule. I believe this, plus recent bad news, is contributing to bear raids across the board by the big players. Most of the global financial companies that created the subprime mess also have equity trading desks that likely moved, or were ready to move, to short the market — seeing the correction coming, knowing that their peers would have to release bad news in the short term because of the mortgage crisis, and knowing small investors would be even more worried with all the bad news coming out. The net result is a self fulfilling prophecy. They release bad news while they are short the market. The market dips. When stock prices dip low enough, traders cover their shorts at a profit. Then, with prices down, they start going long again, bringing the support back in and bringing the price back up, again at a profit. The cycle will continue; this is not the coming of a new great depression.

Right now, you’ve got bad borrowers and bad lenders being ousted simultaneously. The borrowers will lose their homes, and the fund managers that lost money in this mess will probably lose their jobs. But don’t think the banks are really in trouble for one second; to even suggest that is to balk at the entire concept of the Federal Reserve system, which coincidentally bailed out the banks this Friday with $36 billion. There is a great video about exactly how ridiculous the concept of the Federal Reserve system is, but it’s a bit over the top, so make sure to wear your tin-foil hat if you watch that. But Republican Presidential candidate Ron Paul explained the problem with the Federal Reserve eloquently in the video below, seven months ago. And sure enough, when the markets caught on to the subprime bubble, the Federal Reserve decided this week to issue $36 billion in new money! Money created from thin air — thanks to the Federal Reserve — just as is discussed in this video.

But this all is to say the problem with the mortgage meltdown is not real. It’s real, and it’s screwing up the plans for mortgage backed security issuers across the board. Hedge funds are especially screwed, since they often employed leverage to realize more gains while the party lasted. But now the mortgage backed bonds they held are nearly worthless in many cases, so some hedge funds are on the verge of bankruptcy. But even money market funds, which are traditionally considered to be as safe as a checking account, have lost up to 20% of their value overnight in some limited cases as a result of the subprime crisis. As an aside, I’ve yet to see a money market fund that beats the high-yield, FDIC insured savings accounts being offered online these days. Sure, you can only withdraw six times a month, but you can always batch the withdrawals to one per week and still have two withdrawals per month in reserve. I am genuinely interested to know what benefit people see in a money market vs. any other equally liquid instrument or account. Feel free to comment below.

But now that the house of cards is falling, people are wondering who to hold accountable. It’s hard to say who to arrest and who to bail out. All the Fed can do is throw money at the banks, which they did. But what are the banks going to do with that money? It’s not like they can keep these subprime funds floating. Who’s going to buy them? That game is over.

The real culprit in all of this mess was neither the mortgagees, mortgagors, or the banks that thought it a good idea to securitize something as inherently insecure as mortgages. The real culprit here are the ratings agencies. If a CDO, CLO, or MBS was AAA secure, why would it pay over than 100 bp more than a Treasury? Tranching and credit enhancement made that rating possible — but AAA? Come on! The underlying SPVs were sitting on everything between junk to investment grade.

It’s like buying regular vs. premium gasoline from the same pump hose — don’t you ever at least wonder if you’re getting what you pay for? S&P, a division of McGraw-Hill — the same people that likely brought you textbooks in high school — and Moody’s should have had the foresight to rate these more responsibly. Though, I am not quite sure what benefit they had in this, or if they truly just assumed that the default rates on loans to people with poor credit would ever exceed 10%.

On that note, not all CDOs are as poorly structured as most subprime MBS were. One of the first CDO offerings ever, a credit-card backed security for $2 billion of JC Penney’s private issue credit card debt in the 1970s was scrutinized for just that reason — ratings agencies wanted to see something to demonstrate that cardholder default rates would not exceed some threshold in their model. Kuhn Loeb was able to show that JC Penney survived the great depression with only a 10% or so default rate on their credit accounts. And so the rating agencies gave the senior tranche a AAA rating. In that case, the paper held up over time. Now that these MBS aren’t holding up, their buyers are in for a world of hurt.

But for the record, I don’t necessarily think it was a bad thing for mortgagees to give enticing terms or for banks to try and securitize them. The idea actually really wasn’t that bad: part of the American dream is owning a home, so securitization enables creditors to put more people in homes. But creditors got carried away by cheap money supply in the early 2000s. Cheap money to banks is like crack to junkies. It makes them do dumb things, like fail to do due diligence on undocumented loans.

So where do we go from here? Down for a little while, most likely. I think we have 6 to 12 months left before the housing bubble is totally bottomed. This will continue as teaser rates on mortgages from the early 2000s reset to their standard, much higher rates, and raise mortgage payments substantially for home buyers. When things turn around, I don’t see a huge rally, but I do see a recovery. The downturn last week created some real bargains if you trade on fundamentals like P/E, or especially yield. Combine that with a weak dollar, and you have a very favorable environment for foreign investors. The money will come back; it’s just a matter of time. That is, unless you’re a mortgage lender, homebuilder, or leveraged hedge fund. Then you might have to be a bit more patient.

Think about this the next time you hear: “Bad credit? No credit? No problem!

Tags: Business · Government & Politics · My Thoughts

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