Facing the Reality of the Subprime Mess

07/18/2007 12:00 am EST

Focus:

Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

Richard Lehmann, president of Income Securities Advisor, says defaults on subprime mortgage loans have just begun and their impact will be far wider than many expect. 

You have no doubt read much about subprime mortgages (a.k.a. liar loans) and wish the subject would go away.

I'm afraid, however, that the subject will continue to plague us for some time to come, since some $515 billion of mortgages are due to reset over the next 12 months from a 0% to 3% teaser interest rate to north of 6%. Next year, another $680 billion will reset, of which 70% are subprime. The defaults have just begun.

To date we see interest rates rising on below-investment-grade debt. This comes about because common sense is starting to flow back into the heads of fund managers whose principal problem over the last year or so was finding an outlet for the glut of funds coming under their management.

Nothing makes such managers more careless than easy money. Nothing makes them overreact quicker than facing significant losses. The reason no one can quantify the extent of the problem is that these mortgages have been packaged into securities called collateralized debt obligations (CDOs) or Collateralized Mortgage Obligations (CMOs), which don't really trade, so there is no real market value.

In the case of Bear Stearns' hedge funds, this valuation problem was overcome by use of a financial model. Like all such models, it shone brightest in the eyes of its creators. When reality set in and no buyers could be found for their holdings, the entire market overreacted. (Bear Stearns disclosed Tuesday that the two troubled funds were practically worthless-Editor.)

Now the question becomes, how many other hedge funds are in trouble-funds without a deep-pocketed sponsor to bail out their overleveraged portfolios? History says this situation creates an atmosphere where recession is likely. Pundits who want to see the good times roll on say, "this time it's different." We'll know who's right before year end.

Individual investors have already seen the value of any real estate investment trust (REIT) holdings decline due to this problem. Further erosion can be expected soon in any financial institution paper you hold. But the greatest impact will probably come from a general drying up of credit leading to the start of a default wave. All the signs are already there, and the Bear Stearns debacle may have been the spark that sets it off.

Although default waves are traditionally set off by banks withholding credit to below-investment-grade companies because the economy goes south, "this time may be different."

Too much new high-yield paper is sitting on the sidelines from takeover deals done in the last few months. Market participants know that a default wave is overdue and has only been delayed by the ready availability of capital. Once fear overtakes availability as the driving force, things go bad very, very fast.

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