Lehman

[PLATO]

Originally posted by notyoueither
How is the mortgage backed security worthless?

If the homeowner defaults, you take the property back and sell it, through the courts.

There is fundamental value there.

Unless, are you saying that the holder of the mortgage has a mortgage on the mortgage? Then let the middlemen take the bath and let the ultimate owners of the asset realise the value. Too simple, yes?

Well the truth is that you are both right. There are many different types of layered risk in the market. While a lot of MBS are very highly leveraged, there are a lot more that are not. Continually, people tend to forget that actual foreclosures are way less than 1%. The real problem is that to cover the difference in expected losses of around .43% and actual losses of around .71% there is a reduction to the income stream (actual real losses are less due to recoveries). Couple this with defaults and the income stream is further diluted (defaults are at near record levels...these are mortgages that are 30-120 days delinquent. A notice of default is usually issued to a borrower at the 90 day delinquent point and formally starts the foreclosure process). This pushes yields down to very poor levels. With some MBS approaching 30% default rates, these are where the highly leveraged investor is taking a real bath. Most are not...they are just "at risk".

[notyoueither]

I don't know exactly why, but this song came to mind today.

[notyoueither]

Originally posted by PLATO


Well the truth is that you are both right. There are many different types of layered risk in the market. While a lot of MBS are very highly leveraged, there are a lot more that are not. Continually, people tend to forget that actual foreclosures are way less than 1%. The real problem is that to cover the difference in expected losses of around .43% and actual losses of around .71% there is a reduction to the income stream (actual real losses are less due to recoveries). Couple this with defaults and the income stream is further diluted (defaults are at near record levels...these are mortgages that are 30-120 days delinquent. A notice of default is usually issued to a borrower at the 90 day delinquent point and formally starts the foreclosure process). This pushes yields down to very poor levels. With some MBS approaching 30% default rates, these are where the highly leveraged investor is taking a real bath. Most are not...they are just "at risk".

What I am missing is.... how do you leverage these mortgages?

You mean to say that someone borrowed ~90% of the value of the mortgages, and turned around and sold them along with the obligation without paying off the lenders?

In other words, there was an industry in selling second hand crap (2nd mortgages, in essense) to a ready market of buyers for second hand crap that was large enough to endanger the international banking system?

**** the 10% morons! Give the real property back to the real owners, ie the ones who put up the cash. Do it by act of Congress, then don't worry, be happy.

[DanS]

Originally posted by notyoueither
How is the mortgage backed security worthless?

If the homeowner defaults, you take the property back and sell it, through the courts.

There is fundamental value there.

Unless, are you saying that the holder of the mortgage has a mortgage on the mortgage? Then let the middlemen take the bath and let the ultimate owners of the asset realise the value. Too simple, yes?

Yes, essentially the holder of the mortgage has a mortgage on these assets (which are bundled mortgages). The middlemen, as you describe them -- those who hold these toxic mortgage-backed securities -- are the AIGs, Lehmans, and Merrills of the world.

As Plato says, the large majority of mortgage-backed securities are boring, non-leveraged types. Those are high quality assets. Fannie Mae and Freddie Mac deal in this boring stuff, mostly. However, there's also some toxic stuff, which is causing the problems.

[DanS]

Big news just across the wire...

NEW YORK--(BUSINESS WIRE)--The Goldman Sachs Group, Inc. (NYSE: GS) announced today that it has reached an agreement to sell $5 billion of perpetual preferred stock to Berkshire Hathaway, Inc. in a private offering. The preferred stock has a dividend of 10 percent and is callable at any time at a 10 percent premium. In conjunction with this offering, Berkshire Hathaway will also receive warrants to purchase $5 billion of common stock with a strike price of $115 per share, which are exercisable at any time for a five year term.

In addition, Goldman Sachs is raising at least $2.5 billion in common equity in a public offering.

[DanS]

And the credit markets have seized up again. 3-month treasuries are only yielding 0.07%.

[Vanguard]

Originally posted by notyoueither


What I am missing is.... how do you leverage these mortgages?

You mean to say that someone borrowed ~90% of the value of the mortgages, and turned around and sold them along with the obligation without paying off the lenders?

In other words, there was an industry in selling second hand crap (2nd mortgages, in essense) to a ready market of buyers for second hand crap that was large enough to endanger the international banking system?

**** the 10% morons! Give the real property back to the real owners, ie the ones who put up the cash. Do it by act of Congress, then don't worry, be happy.

Remember that the bank that wrote the mortgage had to borrow money to pay the builder of the house. That costs them money in interest.

If the homeowner stops making payments and the bank takes the property back, then, sure, they only have a small loss due to interest--- if the house can be sold for the same price as they originally lent.

But if the value of the house has declined, say 10%, then they are out 10% of the total amount they lent. If they only make 5% of the value of each mortgage they write, then each default and decline in value wipes out all their profits from two other mortgages.

And if the value of the house declines 20%, it would wipe out the profit from 4 other mortgages. Get much of this and your interest payments become larger than the amount you make on mortgages. At that point the entire amount you invested in becoming a mortgage lender is lost.

[Dinner]

Originally posted by DanS
Sure. Let's pretend that the leverage on a mortgage-backed security is 10-1, meaning that I put in 10% cash, borrow 90% from the money markets, and buy mortgages with the proceeds. If the underlying mortgages decline by 10% or more in value, the mortgage-backed security is worthless.

When Plato says that even foreclosed houses sell for a high portion of the borrowed price, he is of course correct. But that doesn't mean that particular mortgage-backed securities are anything but worthless, given the leverage baked in to some of them and the suspect quality of the underlying mortgages.

Although this is an artificially simple example, this is basically how it works.

I've heard that a lot of the investment banks actually leveraged things 30 to 1 if you can believe it.

[Vanguard]

Of course, back when houses were appreciating 10% per year, you literally could not lose money on mortgages. Even if the homeowner defaulted, you would simply take the home back and lose nothing on the transaction---- the appreciation on the house would make up all your losses on foreclosure and resale.

Under those conditions you would obviously want to leverage yourself as much as possible---- the more you borrowed the more you earned. It didn't matter who you loaned to or what their risks of default were----- you could always get the house back at a profit.

The important thing back then was making sure you wrote more and more mortgages, regardless of cost.

[PLATO]

Originally posted by Vanguard
Of course, back when houses were appreciating 10% per year, you literally could not lose money on mortgages. Even if the homeowner defaulted, you would simply take the home back and lose nothing on the transaction---- the appreciation on the house would make up all your losses on foreclosure and resale.

Under those conditions you would obviously want to leverage yourself as much as possible---- the more you borrowed the more you earned. It didn't matter who you loaned to or what their risks of default were----- you could always get the house back at a profit.

The important thing back then was making sure you wrote more and more mortgages, regardless of cost.

You have no idea how many meetings I went to where "Pump up the Volume" was literally screamed.

What you have outlined is exactly what happened in several companies that were considered to be the "big" players in subprime.

The secondary market at that time was buying floods of this paper and could not get enough of it. Not only were they heavily leveraging it at times, but the were paying $1.07 on the dollar to aquire this type debt.

I remember looking at some packages out of California's Napa County where appreciation rates were 8% per month!

People were buying speculative housing at 100% with seller's paying closing costs (not 1 penny out of pocket), getting 60 days until the first payment on their loan, and selling for 16-17% profit before they paid a penny! Houses were going on the market there and would have half a dozen firm offers, all over the asking price, by the end of the day.

I can remember thinking that these companies were in big trouble when the appreciation stopped...but no one knew how bad it would really get. Off balance sheet CDOs, multi-layered credit default swaps, rating agencies paying lip service, investors not doing any research on what they were buying. These were the problems that threw the industry over the edge.

It is not so much that a lot of this paper is leveraged. Most of the leveraged positions have been hedged with credit default swaps...and then those positions have been hedged with credit default swaps...and so on. This is one of the real problems we are facing. No one knows how much is out there in credit default swaps...there is no clearing house or any records of this stuff except the agreements themselves. Part of what is causing Treasury's urgency...Lehman's $600 billion in debt was something the government and the markets figured that they could stand...what they didn't realize was the nearly $1.7 trillion in credit default swaps tied to that debt and the effect that is going to have on other institutions.

[PLATO]

Originally posted by Vanguard
Of course, back when houses were appreciating 10% per year, you literally could not lose money on mortgages. Even if the homeowner defaulted, you would simply take the home back and lose nothing on the transaction---- the appreciation on the house would make up all your losses on foreclosure and resale.

Under those conditions you would obviously want to leverage yourself as much as possible---- the more you borrowed the more you earned. It didn't matter who you loaned to or what their risks of default were----- you could always get the house back at a profit.

The important thing back then was making sure you wrote more and more mortgages, regardless of cost.

You have no idea how many meetings I went to where "Pump up the Volume" was literally screamed.

What you have outlined is exactly what happened in several companies that were considered to be the "big" players in subprime.

The secondary market at that time was buying floods of this paper and could not get enough of it. Not only were they heavily leveraging it at times, but the were paying $1.07 on the dollar to aquire this type debt.

I remember looking at some packages out of California's Napa County where appreciation rates were 8% per month!

People were buying speculative housing at 100% with seller's paying closing costs (not 1 penny out of pocket), getting 60 days until the first payment on their loan, and selling for 16-17% profit before they paid a penny! Houses were going on the market there and would have half a dozen firm offers, all over the asking price, by the end of the day.

I can remember thinking that these companies were in big trouble when the appreciation stopped...but no one knew how bad it would really get. Off balance sheet CDOs, multi-layered credit default swaps, rating agencies paying lip service, investors not doing any research on what they were buying. These were the problems that threw the industry over the edge.

It is not so much that a lot of this paper is leveraged. Most of the leveraged positions have been hedged with credit default swaps...and then those positions have been hedged with credit default swaps...and so on. This is one of the real problems we are facing. No one knows how much is out there in credit default swaps...there is no clearing house or any records of this stuff except the agreements themselves. Part of what is causing Treasury's urgency...Lehman's $600 billion in debt was something the government and the markets figured that they could stand...what they didn't realize was the nearly $1.7 trillion in credit default swaps tied to that debt and the effect that is going to have on other institutions.

[DanS]

After some time thinking about this, Paulson's plan is really distasteful. He doesn't want to provide funds to these banks at punitive rates, but that's precisely what he should be doing. Strip those fvckers bare.

[Vanguard]

Or at least get equity.

[Kidlicious]

No, DanS is right. They should have to pay for this.

[PLATO]

No. That would be not real smart. Take institutions that have nearly failed and have our economy in their hands and take punitive action on them. It may be hard to understand, but punishing these banks right now would be the same as punishing ourselves.

Now...if they wanted to force them into repurchase agreements based on balance sheet strength and earnings that carried a punitive rate, then I could go for that. It is just not smart to try to put more pressure on the system right now.