Just How Sub Is Subprime?

	Monday, March 19, 2007

By JACQUELINE DOHERTY BULLS LIKE TO ARGUE THAT THE SUBPRIME mortgage market represents only 15% of the total mortgage market, implying that the damage wreaked by delinquent borrowers is limited. But that doesn't account for the trillions of dollars of securities that are based directly and indirectly on subprime mortgages. There are subprime residential mortgage-backed securities (RMBS), derivatives on subprime RMBS, collateralized debt obligations (CDOs) that buy subprime RMBS and/or the derivatives on the RMBS. With exposure spread through so many financial products, it may take awhile for the full extent of the problems arising from the Subprime Bust of '07 to surface. Specialty finance companies that focused on lending to folks with poor credit in the late 1980s would make a loan and hold it on their books. The problem: An individual's mortgage -- especially one in the subprime category -- has a rating of BBB or lower. So the volume of mortgages was limited by financial institutions' capital requirements, balance sheets and willingness to take on credit risk, explains Joseph Mason, associate professor of finance at Drexel University LeBow College of Business. Financial wizards created subprime mortgage-backed securities in the 1990s. The financial institution could sell a group of subprime mortgages to a trust. The trust finances the purchase by selling debt and a bit of equity. But about 80% or more of the debt the trust sells is AAA rated because it has first call on the payments from the mortgages. If there's money left over, then the lower-rated debt gets paid and finally the equity gets paid -- a bit like a waterfall. The key: finding investors to buy the 20% of lower-rated debt and equity sold by the trust. For the right price, there was a small group of buyers, like insurance companies or Wall Street dealers, willing to take on the risk. About four years ago, the rating agencies allowed collateralized debt vehicles to buy RMBS exclusively. They soon became big buyers of the risky, lower-rated parts. But in recent years a new buyer -- created by Wall Street -- emerged: CDOs, collateralized debt obligations. CDOs are actively managed, but are otherwise similar to a mortgage-backed security. CDOs buy fixed-income assets and sell primarily AAA-rated debt because the cash flows from the assets are prioritized to repay the AAA debt first and the lower-rated debt and equity afterwards. About four years ago, the rating agencies allowed the CDOs to buy RMBS exclusively, and they've subsequently become voracious buyers of the lower-rated portions. The sale of CDOs investing in subprime residential mortgage-backed securities rose from $9.9 billion in 2001 to $114 billion last year, according to Deutsche Bank. Wall Street has also created credit-default swaps on the subprime RMBS and the ABX indexes that track them. Because the ABX-related derivatives trade over-the-counter no one is quite sure of daily volume, but estimates put it at $200 million to $2 billion a day, with hedge funds big players. Now the delinquencies on subprime mortgages are rising faster and higher than forecast by the Wall Street and rating-agency models. If the CDOs don't perform as expected, investors may no longer be willing to invest in CDOs that buy subprime RMBS. And if subprime RMBS CDOs go away -- or more likely shrink in volume dramatically -- the biggest buyer of lower-rated subprime RMBS debt goes away. That means higher interest rates and less credit availability for borrowers. Below is a snapshot of the sub-prime market, its growth, players and key developments.