How (not) to fix the subprime mortgage collapse

"...Every year new investment products are created that are entirely unsuitable. Professional funds then group-blunder into the worst, wholly ignorant of the underlying risk..."

BEN BERNANKE told politicians in Washington this week that the collapse of subprime mortgage companies had been "contained".

Perhaps Dr. Ben was just thinking of Fremont delaying its fourth-quarter results...or New Century Financial (NEW) having to restate its earnings for the first nine months of last year.

Yes, that little nugget of news knocked NEW's stock 30% lower in one session last month. But the damage was still "contained", right? It's not like Bernanke had to revise GDP thirty per cent lower as a result.

And maybe the Fed chairman was just thinking of out-and-out mortgage lenders going bankrupt, like Ownit or MLN...rather than pan-global investment banks such as Merrill Lynch spending $1.3 billion to keep First Franklin running...or Credit Suisse funding the defunct ResMAE...or Bear Stearns picking up Encore in what ML-Implode.com calls a "firesale".

As always, however, the market's way ahead of the Fed. Stock in Merrill Lynch (MER) has dropped 15% from its top of January. Morgan Stanley (MS) has fallen almost 13%, as has Citigroup (C). Goldman Sachs (GS) is off nearly 10% for the last week alone - and not only because no one wants to own investment banks when investors take a bath on Chinese equity funds.

In the bond market too, Wall Street's biggest and best are being marked down. The price of credit-default swaps, the insurance contracts used to protect investors against non-paying bonds, have leapt on their debt. Since the start of January, for example, the cost of CDS insurance on Goldman's debt has risen by 52%.

The bond market thinks Goldman's debt just got riskier, in other words. In fact, "their own traders are valuing the three biggest securities firms as barely more creditworthy than junk bonds," says Shannon D. Harrington for Bloomberg.

"Prices for credit-default swaps linked to the bonds of the New York investment banks this week traded at levels that equate to debt ratings of Baa2, according to Moody's Investors Service. For Goldman, Morgan Stanley and Merrill Lynch & Co., that's five levels below the actual Aa3 rating on their senior unsecured notes and two steps above non-investment grade, or junk."

Why are the investment bankers so nervous about their own debt? Both Wall Street and the City of London earned record sums in the last 12 months. But at the top of the credit cycle - and with global asset values tumbling as the flood of easy money dries up thanks to rising rates in Japan, higher real rates in the US, and the threat of rising rates in Switzerland - the biggest security firms are starting to look awfully insecure. They just happened to make a lot of money selling mortgage-backed securities, too. Yet the risk of mortgage default only got shared, rather than passed along.

In the United Kingdom for instance, 125% mortgages lent at 7 times income for 50 years were packaged and sold - retail - to house-hungry consumers now struggling to make interest-only payments each month. Then the City of London bundled that risk along with yet more subprime debt and sold it again - wholesale - to pension and insurance funds.

Double the fun, in other words - plus a high-risk investment for unwitting pension savers, and "negative equity" for the homeowner without house prices needing to drop.

Trouble is, the investment banks also kept back a little of these asset-backed insecurities for themselves, too. At Bear Stearns, says CreditSights in New York, MBS junk equals some 13% of the firm's "tangible equity". Lehman holds 11% of its worth in such bonds. Goldman, Merrills and Morgans won't say - and they declined to talk to Bloomberg about it this week. But CreditSights reckons their exposure sits in the "low- to mid-teens."

Containing the subprime collapse, in short, might take more than simply talking down the risk before a Treasury committee. And looking for research on how to fix the US real estate market, Dr. Bernanke could do worse than ask his friend (and fellow academic) Mervyn King at the Bank of England to show him what happened the last time British house prices collapsed.

The wipe-out in residential real estate prices that hit the United Kingdom in late 1989 took 7 years to reach rock-bottom. Judged against inflation, it destroyed one third of the "wealth" built up by the preceding bubble. Even with real interest rates slashed to half their bubble-top levels, home-buyers in the class of '89 had to wait 12 years to get even.

But luckily for them, real interest rates have only continued to sink since then. No prizes for guessing that house prices have more than doubled in the last 5 years.

Back on Wall Street, and "these guys have made a lot of money securitizing mortgages over the years in a mortgage boom time," notes Richard Hofmann, a bond analyst at CreditSights. For mortgage boom time, read "cheap money".

"The question now," Hofmann goes on, "is what is the exposure to credit risk and what are the potential revenue headwinds if they're not able to keep that securitization machine humming along."

But keeping revenues "humming" with fresh issues of asset-backed securities (ABS) might prove the least of Wall Street's worries. Put the thought of Thursday's insider-dealing arrests to one side. It's the pile of asset-backed insecurities that will cause sleepless nights in Manhattan this weekend. For as any parent knows, giving measles to all the kids at kindergarten won't cure your children's rash. But it might lose them a few friends in the play ground.

And the trouble caused by junk-rated mortgage bonds is beginning to show up like angry red spots on a class of pre-schoolers.

"Every year new investment products are created which are unsuitable," as Bedlam Asset Management says in its latest annual report, although "unsuitable" hardly says it for subprime-backed mortgage bonds. Something had to give as real estate prices shot higher and fresh meat for the mortgage grinder grew harder to come by. That something was credit quality, plus all semblance of responsible lending.

"Professional investors group-blunder into funds whilst wholly ignorant of the underlying investments," Bedlam goes on. But everyone who's ever bought a house understands the housing market - including Wall Street's finest.

Cheap money makes real estate look cheap on the monthly repayments. The extra demand it unleashes then pushes the total price higher - and to keep the bubble inflating, new ways of making cheap money look cheaper have to be created.

Now the air's gushing out of the subprime market, there's only way Bernanke can plug his finger in the hole and stem the defaults. Just like he said back in 2002, cheap money dropped out of a helicopter can fix pretty much any problem in the financial economy - short-term at least.

Creeping back down from 5.25%, Dr. Ben's got room for 17 baby-steps on the Fed funds rate before he hits the "emergency" low of 2003. Choosing that path would prove a disaster for the Dollar, of course, as well as putting the US real estate market onto the same cyclical merry-go-round that British homeowners have enjoyed/suffered since the '70s.

It would also prove a good time to own gold.

Adrian Ash

City correspondent for The Daily Reckoning in London and a regular contributor to MoneyWeek magazine, Adrian Ash is head of research at www.BullionVault.com

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