S.O.S. Sorting Out Subprime - Page 3 of 7

S.O.S. Sorting Out Subprime

others to issue securities against it,” says Dr. Andrew Brimmer of Brimmer & Co. in Washington, D.C., and a member of the black enterprise Board of Economists. “Many of those securitized mortgages were rated AAA and AA by the rating agencies.” These newly created bonds, called collateralized mortgage obligations (CMOs), are backed by the income stream from the bundled mortgages. Generally, bonds that are backed by debt instruments, including _mortgages, are referred to as collateralized debt obligations (CDOs). It was the meltdown of subprime mortgages and the CDOs that they backed that _rendered two Bear Stearns _billion-dollar hedge funds nearly worthless in July.

As institutional investors sought to maximize their returns through these mortgage-backed securities, somehow the riskiness of lending to borrowers with less-than-stellar credit was downplayed. “Once some organizations started to have problems, all of Wall Street has said, ‘Whoa, wait a minute. What have we been doing for the last couple of years?'” says Bostic, a former senior economist for the Federal Reserve Board of Governors. He says the liquidity crunch came about as a result of institutions “taking a step back” and assessing the risks they’re taking on. Still, for some it was too late. According to Bloomberg’s Subprime Scorecard, more than 100 mortgage companies have ceased operations or sought buyers since the start of last year.

Indeed, it was the rising liquidity crunch that led the Fed to inject billions of dollars into the financial markets through a series of repurchase agreements in August. In a repurchase, the Fed buys securities from dealers, who then deposit the proceeds into commercial banks. This rais
es the amount of money in the banking system. Ultimately, when the securities mature, they are returned to the dealers, who in turn repay the Fed.

“The Fed took action because the commercial paper market seized,” says Cyril Theccanat, managing director of investment management at Smith Graham & Co. Investment Advisors L.P. in Houston (No. 8 on the be asset managers list with $2.3 billion in assets under management). “They were very concerned that there would be a spillover effect in the real economy.” Commercial paper—including CMOs—is short-term debt, with a maturity of 270 days or less, that is primarily used by corporations to finance inventory or manage working capital. “If _corporations are unable to fund themselves in the short-term market, then that is going to have negative implications from the standpoint of capital spending and job growth,” he says.

The Ripple Effect
Subprime loans account for 23% of the mortgage market. Of those loans, the Center for Responsible Lending forecasts that one out of five originated in 2005 and 2006 will end in foreclosure. So far, the delinquencies are concentrated. The Mortgage Bankers Association reported that in the second quarter, the increase in foreclosure filings in four states—Arizona, California, Florida, and Nevada—was largely responsible for an overall rise in the national delinquency rate, which grew to 5.12% of all loans outstanding. In a release, the association’s chief economist said that were it not for the increases in