September 27, 2007

Doesn't Qualify Gets Converted to Quality - How the Worst Form of Debt Became Elevated to the Highest Credit Rating

The process of upgrading subprime mortgages begins with rolling large numbers of individual loans into multibillion-dollar packages. Allowances were made for a certain percentage of defaults, and for recovery rates on default that recognized that the value of the collateral would fall short of the defaulted loan amount.

The part of the process that is less well understood, and is quite complicated, is that those mortgage packages were further broken down to create tiers of risk within each package. That is, one investor would assume the liability in the case of losses beyond some trigger level up to a limit. That investor would get a higher rate of return. A second lender would assume the contingent liability up to the next benchmark.

The highest level credit rating was given to that portion of the package that was insulated by the liabilities assumed by the lower level investors. The portion of the mortgage package given the AAA rating would only incur losses to the extent that overall losses in the package exceeded the liabilities assumed by the lower level investors.

Two highly respected debt rating agencies worked closely with the mortgage industry to structure deals in a way that allowed them to provide their highest rating to certain portions of the mortgage portfolios.

The rating agencies, which were paid substantial fees for rating these mortgage packages, were seen by some investors as having been too close to the action to be objective. Whether that potential conflict of interest impacted their objectivity remains to be seen. More likely, the deals were simply too clever to be understood on a cursory review by the investing public.

While the default rates on subprime mortgages have been higher than expected, it appears that the default rates would have to go substantially higher to impact the AAA portion of the mortgage packages.

Unfortunately, the perception has become more important than the reality. Holders of subprime mortgage portfolios have been embarrassed out of wanting to own them, but it is hard to find other investors willing to buy anything even remotely connected to subprime mortgages.

If sub junk mortgages could be dressed up as high-quality investments, what other surprises might be lurking in the insane complexity of the modern financial markets? Many investors decided to sell first and ask later.

What’s Next?

It is difficult to say how long it will be before North American investors, including the financial institutions, regain confidence in the debt markets. Confidence appears to be returning quickly, judging by recent market action. While there are bargains to be had, the turmoil may not be over. With the present high-strung mood, even a hint of further trouble could see investors again run for cover.

Economic growth continues in most parts of the world, highlighted by strong growth in Asia. Importantly, let us remember that the market turmoil is driven primarily by perceptions, rather than having a fundamental basis. For that reason, it is likely that the world will shrug off this latest crisis – as it has shrugged off similar crises over the years.

In summary, the current credit situation represents an extremely serious disruption to the financial system, especially in the United States. However, looking closely at the situation, it is highly unlikely that the markets will further deteriorate.

At this time, many investors are too shell-shocked to take decisive action. It will be some time (perhaps weeks?) before the markets regain a solid footing. In the meantime, there is an opportunity to acquire good companies at attractive prices.

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