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Minyan Mailbag: Subprime Mortgage Pools

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The subprime mortgage pools are a symptom of a much much larger credit boom that has infected the entire credit spectrum, low quality to high.

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Professor Succo and Reamer,

I discussed your article with a hedge fund manager who, in turn, discussed it with a Wall Street type who, as he says, "drinks the cool aid." I thought that you would find his "riskless" answer interesting...

The fact that his guy is using the ABX HE (a synthetic) to suggest bond funds are mis-marking their portfolio is absurd. He never tells you that the ABX HE is NOT the cash market where bonds are actually traded. The cash market will NOT wait for the rating agencies, I assure you. And, he only shows you the BBB- traunch. He also only uses the 2007 vintage. >90% of all sub prime RMBS are A or higher. Intellectually, not very honest research.

I have zero residential exposure long. So I have no beef here. This dude is heavily short the ABX HE 2007 BBB- and is trying to push research supporting his position. I happen to agree with his position except that it's very crowded and risky now. Subprime is mess. But it's a mile deep and a half inch wide. If you want to pour short capital into the singular ABX HE 2-7 BBB - you have lots of company.

Also remember that "HE" stands for Home Equity. These are "zero down" mimics. They reflect <2% of all RMBS outstanding.

-Minyan Bob


Minyan Bob,

The response you received from the trader has one correct fact in that ABX indices are synthetic and not the 'actual' cash markets for the underlying securities that they represent. However, this is a moot point entirely.

The ABX indices are put together by Markit, a firm that has 16 of the worlds largest credit dealers (J.P. Morgan (JPM), CSFB, Goldman (GS), Morgan (MS), Citi (C), Bear (BSC), Bank of America (BAC) etc...) as partners in the development and tracking of asset-backed securities. Prior to Markit, institutional investors, like ourselves, that wanted to determine the level at which one of these instruments were trading, would usually have to call a trading desk somewhere and get the last price. Providing this type of transparency to aggregate ABX prices has obvious benefits that needn't be laid out. These ABX indices are representative, or else the largest dealers in the world wouldn't participate in providing the data, nor would they use the data to understand how to hedge their own books.

The cash market may or may not wait for the agencies: these instruments are not stocks. They are pools of cash flows. If an institutional investor were to decide he was keeping these instruments for the entirety of the instruments particular duration, he need never mark them to market at all. Thanks to the opaque magic of accounting for these instruments, if they suffered no rating agency downgrade, investors would have an even stronger argument not to mark them to market (even if the ABX indices said they were worth much less). Thus, the ratings agencies DO play a pivotal role in the buying, selling, holding, and marking process for these particular instruments. Some funds may mark them to market, others may not, but to suggest the ratings agencies don't play a role in that decision making process is not to understand the structure of these pools, the accounting rules in place to measure them, nor the incentives in place for managers and ratings agencies alike to sit on their hands.

As for intellectual honesty, the facts speak for themselves. Every one of the 2006 and 2007 tranches Markit tracks is down from their December 2006 levels. Every one: A, AA, AAA, BBB. Of course, some are down huge, others are down nominally, but they ALL reacted to the changing cash flow dynamics of these pools thanks to the implosion of the housing bubble. As for the assertion that ">90% of all sub prime RMBS are A or higher," this is entirely true, but again, irrelevant. According to Moody's (they are using the 2006 issuance for mortgages but the numbers travel well to other years): 80.8% of all sub prime mortgages by dollar volume are AAA, 9.6% are AA, 5% are A, while the remaining 4.6% are Baa and Ba.

But according to Moody's itself, the representative total pool losses by rating are: Aaa 26-30%; Aa 18-21%; A 13-15%; Baa 10-11%; and Ba 7-8%. Further, the CDS market – which are packaged/cobbled from these mortgages – can be infinite; financial engineers can (and have, given the demand for high yielding securities) create any number of securities off of the low quality subprime mortgage pools. Lastly, the problems are not just confined to sub prime obviously. Alt-A pools from 01- 06 are showing serious delinquencies and historic cumulative losses – and they are doing that when home prices are barely down, when rates have only recently gone sharply higher and when employment (if you actually believe the BLS) is at/near historic lows. In other words, these are GOOD times for the performance of mortgage pools and, voila, they aren't performing well. What happens when a recession takes hold more firmly (as it inevitably will)?

On the accusation that we are merely 'talking our book': we are not short any of the ABX indices or, for that matter, do we travel in these circles from a trading standpoint at all. We are simply trying to understand the credit market dynamics of these instruments because we have believed for the past two years that the credit bust we see coming will originate from these murky waters. The troubles that the Bear Stearns hedge fund has had over the last two weeks speaks directly to this risk. The ''fat tail'' potential in this area, given the amount of leverage utilized in this sector, is enormous. Who's to say if the trade is crowded or not? Since crowded can't be quantified, we prefer to stay away from conjecture and merely focus on the facts. We find that the very entities exposed to losses in credit derivatives are buying more assets to "prop" up prices is extremely disturbing.

The subprime mortgage pools are a symptom of a much much larger credit boom that has infected the entire credit spectrum, low quality to high. To assume that somehow credit problems in one of the largest ($6 trln in securitized mortgages) markets on the planet won't impact the rest of the credit universe, or asset prices in general, is the stance that all these entities are taking, including your trader friend.

This is our main point: although Wall Street will try and try to talk the market into believing that stance, it isn't.

-John Succo and Scott Reamer

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