Monday, December 24, 2007

The Credit Crisis - Subprime Mortgages & Various Idiots

Here is an Article that really educates and also pinpoints the root of the problems we are facing. It looks like the real villains have a Wall Street work address.

The Credit Crisis - Subprime Mortgages & Various Idiots
December 7, 2007 by Richard Whitworth, Morsystems CEO

We are in a credit crisis brought on by a lack of confidence – so what’s next?
The crisis has exploded beyond Wall Street, driving the Dollar to record lows - and now, it appears to be sending the prices of commodities, especially oil, to historic new highs. The results could be extremely destructive for the economy in general. The subprime crisis and the ripple effect in commodity and foreign exchange markets raise the odds of a recession.

Estimates from various sources show that the subprime mess will ultimately cause $250 to $500 billion of losses. It is inevitable that more players will have to revalue at least a portion of assets that are presently held. Another important point - the majority of these Collateralized Debt Obligation or “CDO” assets do not reside in institutions, they are scattered through various pension funds, insurance portfolios, hedge funds, etc. Those losses haven’t even been addressed yet.

The banks are not forthcoming with any detailed information on their true positions, making it difficult for anyone to assess what the future really holds. Uncertainty is holding the financial and real estate markets in a huge vacuum, where it is difficult to function normally.

So let’s see if we can get a clearer picture of the players, and the mistakes made by some of the most powerful institutions in America. How did the banks begin purchasing huge amounts of high-risk mortgage debt and Bonds that most investors and analysts thought the firms were selling to their customers?

Instruments of Doom: First on the list of instruments involved; the Collateralized Debt obligation, or CDO, a type of investment vehicle that buys and sell Bonds. Wall Street banks typically do not actually operate CDO’s; instead, they create CDO’s for their clients, take a fee, and then move on.

This is the main point of departure AND the critical mistake made by the Wall Street banks – greed and fear set in, and they began to change their normal mode of operation – they became huge investors in the funds they generated. A very risky move – more on this as we move ahead.

Here's how a typical CDO backed by subprime mortgages worked. The game begins when a client comes to a Wall Street bank and requests financing for a CDO that will hold, for example, $2 Billion worth of Bonds backed by subprime mortgages. The banks also created a variety of Bonds backed by the interest and principal payments the CDO collects. Wait – there’s more…the bankers also create tranches of securities with different interest rates and levels of risk.

The banks then peddle their wares to hedge funds, pension funds, Money Market funds and other investors. The appeal to investors is simple: The CDO’s pay better rates than corporate issues with identical credit ratings – which brings me to the rating agencies.

Here’s another genius move made by the banks – many of those instruments offered in essence guaranteed returns. The refund policies, technically known as “liquidity puts,” were crucial. Those guarantees allowed the credit rating agencies to bless the investments with AAA ratings. An example of the idiocy of this particular move: The two now defunct Bear Sterns hedge funds relied on guarantees from Citi to raise $10 billion from money-market investors for three CDOs, well derrr!!

The rating agencies may be the main culprit in the game. They were extremely lax in their initial ratings on subprime mortgages – none of those offerings EVER deserved an AAA rating. Never mind that now with the cat out of the bag, they are still slow to downgrade subprime paper and securitizations.

This should not be a surprise to anyone, because the ratings agencies also prosper from the rising tide of credit issuances. Moody's, Fitch, & S&P literally ignored the erosion in the credit quality of the offerings and they basically elected to give the issuers the ratings they asked for. Amazing that issues that were rated AAA just months ago are now being re-written at junk bond status. Sadly – the rating agencies are great at passing the buck when things go wrong and they will probably sneak by any SEC scrutiny.

Back to the Banks…as the fees kept rising through the good times, the banks got greedy, they began buying big chunks of AAA paper themselves, loading the debt onto their own books. Even when the markets began to sour – foreclosures, home prices dropping, etc. the banks continued on their buying binge – all of a sudden they found that they needed to feed those CDO’s in order to keep the game alive. That was the kiss of death for Merrill’s CEO, Stanley O’Neal and for Citi’s CEO Charles Prince.

Wall Street banks are now holding tens of Billions in risky securities on their own books. And at this point in the game, it is difficult to assign an actual value to them. The banks are changing their estimates of the value of these assets as frequently as they change their underwear.

The SEC is on the attack, requesting real numbers and information from Merrill and other banks on what they knew at the time they were telling investors and the public that all was wonderful and they were in control of the situation.

Bottom line - the subprime story is far from over…and it will likely take a few years for the whole thing to shake out.

Sadly, this is Richard Whitworth’s last economic report that you’ll receive, he was in a fatal motorcycle accident 12-8-07. Since he nearly finished this report the night before, we needed to share it with you. Thank-you for your support,

The Whitworth family business at where his dream lives on for
Richard Whitworth, CEO, MorSystems