Bear Stearns - Please Pass the Risk

By: Andy_Sutton

I have sat here completely agog and amazed at the shenanigans going on within the financial community. Last week some hedge funds associated with Bear Stearns got themselves in trouble on risky subprime mortgage debt. Surprise Surprise. People with common sense have been forecasting this mess for a while now. My point in writing on this is to illustrate the moral hazard that is created when this type of stuff goes on and it is this moral hazard that can get Mr. and Mrs. Main Street into big trouble.

In days where sanity dominated a mortgage worked something like this: You would go to the local bank and apply for a mortgage. The bank would do their due diligence ad nauseum. They would generally require significant down payments, credit checks, pay stubs, bank statements, tax returns and all sorts of other documentation. The bank did this because they planned on holding the note for the full duration and they actually cared whether the mortgage was repaid or not! This practice is not that ancient. My first house was purchased in 1998 and the documentation required was substantial. The company held the mortgage until the property was sold. They did their due diligence because they wanted to make sure that we made the payments.

Fast forward to today. Anyone who has a mailbox knows what I'm talking about here. Everyone and their brother wants to push a mortgage. No credit? No problem! No down payment? No problem! No job? No problem! No documentation loans, cash-out refinancing, reverse amortization, zero-interest and sometimes many combinations of the above have created a situation where someone with marginal income, no down payment and lousy credit can get a mortgage to buy a $300K house. What do you think the chances of this very marginal buyer actually making good on that loan for the full 30 years are? You got it - slim and none and slim is packing his bags; he's outta here.

Why do banks do this? Why don't they care if the payments aren't made? They'll lose money if that happens right? Wrong. This is where the real fun starts. When these loans are made, the originators (the banks that originally sold the loan) rarely keep them. You may write your check to them every month, but your debt is gone; probably before the ink is dry on the deed. Your loans is pooled together with many other loans and then sliced up into what are called tranches. Some of the tranches contain good loans, others contain foul effluvium, reeking of subprime, subprime and more subprime.

However, thanks to the complicity of the various rating companies, this foul mess somehow gets an investment grade credit rating and may be sold to pretty much anyone. Only the very worst of it gets a junk rating, and sometimes they take the worst, combine it with someone else's worst, and slap an investment-grade rating on that too. On and on the game goes. The point is that your originator has passed the risk on to someone else. Maybe that someone is a hedge fund or maybe it is your pension plan. Maybe it is your college 529 fund. Maybe it is your 401/IRA. The point is the originator no longer has any risk.

This is where the moral hazard comes in. If the originator has nothing to lose, what point is there in exercising due diligence? Who cares? Just sell as many mortgages as you can. This is the environment that has been created, not out of stupidity, but out of greed. Pure unadulterated greed.

Payday might be in the offing though as more and more of this debt begins to go sour. The fly in the ointment is in how this debt is valued. The models that were used to value the debt take into account a certain rate of delinquencies, defaults, and foreclosures. So what happens when the foreclosures soar as they have been? Certainly the debt still can't be worth what they thought it was. There is the problem. If the debt is repriced to reflect current conditions, given the leverage involved, I think we would see a massive collapse of some of the bigger banks. The banks simply cannot allow this debt to be repriced. This is why you hear calls for a 'gentle unwinding' of positions. In other words; they're caught and they need help to get their hands out of the proverbial cookie jar. This deal could get awfully interesting in a hurry.

Anytime these reckless practices flourish, it spells danger for consumers at best, absolute ruin at worst. Only time will tell how many good and decent people were suckered into the mortgage industry's version of the 'American Dream' during this latest phony boom. Time may finally give us the total damage in dollar terms, but there is no way to calculate the human cost; the ruined lives, marriages, and families. I can only hope that we learn our lessons well and always exercise due diligence even when it appears as though we don't have to.

By Andy Sutton
http://www.my2centsonline.com

Andy Sutton holds a MBA with Honors in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics. He currently provides financial planning services to a growing book of clients using a conservative approach aimed at accumulating high quality, income producing assets while providing protection against a falling dollar.

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