Why Sub Par Bets Not Sub Prime Loans Sank Wall Street

Serious investors can find significant advantages in understanding what has just occurred in these times of manufactured financial uncertainty.

Wall Street investment bank management, quantitative analysts (quants) and risk managers nearly succeeded in hijacking the world economies with their latest attempts at financial engineering. Mortgage Backed Securities and Collateralized Debt Obligations risk trading are the fruits of exuberant financial engineering.

These financial innovators took mortgages and commercial debt instruments, securitized, commoditized, and then divided these into two components, principal and interest. They sold these two components separately, as investments with separate risks and differing yields generating exorbitant fees for exuberant bets.

These principal, interest and risk derivatives are valued on specific yield performance. In the case of a principal bet and a mortgagee or borrower pays back their loans early or out of the normal actuarial ranges, it is bad for the spread investor who is betting on the greatest yield. Prepayment penalties are an attempt to hedge against early payback for these investors.

Making Markets

You getting all this? Don’t worry, you’re not meant to.

What these financial engineering geniuses did not plan on was the same trading system failures, but with a different twist, that bit their creators back in the 1980s. The automated trading systems these people depend on trading trip wires when certain parameters are exceeded. These trading limits or suspension assume the quants anticipated all out of range trading scenarios. When known and understood, these safeguards are built into programmed trading environments. Their early absence lead to Black Monday, The Long Term Capital Management and Asian Crises and other marginally connected and serialized market events. (For a great technical read, “A Demon of Our Own Design” by Robert Bookstaber.)

When these complex financial schemes succeed for their creators, the result is like furtive teen sex and cheap liquor. Some is never enough. Egos (individual and corporate) fueled with mind altering successes and bonuses, run wild.

In MBSs and CDOs, the whiz kids of Wall Street found yet another commodity and investment risk hedge game, though this time these layered secondary, tertiary and trading markets were based on basic residential and commercial loan paper. They turned the security of a homebuyer’s castle into an internationally traded commodity.

Mark to Who’s Market

The media has been predicting the deflation of a real estate bubble for years. They alleged that the market was unsustainable. This, of course is true of overbuilt markets with modest economies. When there are no people to buy or rent what is available, residential property remains empty and sits unproductively on someone’s books.

The media has been trumpeting the growing gaps between demand and supply, pricing and affordability. Yet production builders kept churning out houses far exceeding reasonable demand in dumb locations. With fewer buyers, no matter what the sale price is, the market sets the price. New builds and re-sales are down at about a cumulative 40 percent year-over-year. Prices have not followed as 2006 national average appreciation was “down” to 3.6 percent. Mid 2007, these average price numbers are beginning to wilt slightly. Particularly hard hit are mid to marginal markets.

Now Wall St needs to make someone accountable for their excesses, and speculative investors, unworthy borrowers, slick and unethical loan sellers are easy targets. In this environment wise eyes and analytical investors win.

Pick your markets

A good buy in a bad neighborhood is never a bargain. This is also true of mediocre or distant neighborhoods that are highly sensitive to employment, reserve savings and budget sensitivity. These remote sale statistics have forced average appreciation numbers down and even negative in many overstocked segments.

And, the media wants the world to know they were finally right. The problem is people with money to invest in funds have read these stories and analyses and have concluded that real estate paper may not be the place to invest. Investors of this caliber are provided with the right to call their investments at any time.

Collateral Damage & Direct Action

The result was a run on investment bank funds that had been investing in MBSs and CDOs. These investments were necessary to fund mortgages. This tightened up in most mortgage segments well beyond subprime. This reaction however is not based on mortgage delinquency requiring the start of foreclosure processes was at 0.66 percent of all mortgages (August 30/07.)

With a lack of funds to lend as mortgages, real estate sales that were already slow became slower still. The reality is there is a pent up demand for housing. The current uncertainty that undermines homebuyers’ confidence needs to be addressed. An increase in housing activity will restore consumer and industry confidence but, alas, will probably never quiet the media and their need for shocking headlines.

Jumbo loans are available, Alt A loans are back but both require the borrower meet stricter underwriting. Hard money is easily available. As a sophisticated investor you need funds to keep your deal flow active. This is readily available.

The real estate business is showing signs of life despite the latest reports. Remember these reports and stories are written on trailing data. This was the closings of August and September deals when the Funding Fright was in full cry.

God Bless, Good Investing and ignore the real estate headlines local newspaper

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