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So why did the subprime mess occur? Because many people were overstating their incomes to qualify for mortgages that they couldn’t afford. And how did they get away with this? Because many lenders didn’t bother to verify the borrowers’ income when they could have easily done so.
While many in the lending industry have stated that they were duped by fraud, it turns out that most suffered from their own complacency. According to this New York Times article, A Road Not Taken by Lenders, at least 90% of the borrowers had to sign an IRS Form 4506T, allowing the lenders to verify the income of the borrowers with the Internal Revenue Service, but many lenders did not bother to check, even for stated income loans where the borrower did not have to provide any documentation proving income—hence, the alias for stated income loans, liar loans.
Lenders gave 2 reasons for not submitting the 4506T form: too costly and too time-consuming. The verification cost $20 and takes about 1 business day, so the lenders’ reasons aren’t credible. Why wouldn’t a lender spend $20—a cost that would be passed to the borrower anyway—to secure a loan in the hundreds of thousands of dollars?
Because the lenders intended to sell the loans—and the risk of default—to investment banks to securitize and sell to investors in the form of mortgage-backed securities, CDOs, and SIVs. Meanwhile the lenders make money from upfront fees, such as loan origination fees, points, and servicing fees, and the more loans they make, the more money they make.
Structured investment vehicles (SIVs) and securities arbitrage conduits make money by selling asset-backed commercial paper (ABCP), and using the proceeds to buy, among other assets, mortgage-backed securities (MBSs), profiting from the difference between the high interest rate received on the longer-term MBSs, and the lower interest rate paid on the commercial paper. However, commercial paper has a maximum maturity of 270 days, far less than most MBSs, so the SIVs have to sell more commercial paper to pay for the ones maturing. When the MBSs get downgraded because of their load of subprime mortgages, SIVs relying on MBSs get downgraded because of its riskier assets. Thus, even without defaults, it has to pay a higher interest rate for its commercial paper, thus, eliminating its profits or even suffering losses. In extreme cases, it cannot even sell its commercial paper, forcing it to restructure or to turn to its sponsoring bank for financing. For instance, Axon Financial, Cheyne SIV, and OTTIMO Funding Ltd. were recently downgraded and forced to restructure because of their inability to sell their commercial paper in the money market.
Many funds are heavily invested in SIVs because they offered higher returns, and seemed very safe, but as more MBSs and other derivatives based on subprime mortgages get downgraded, the funds suffer as the SIVs suffer losses, prompting massive withdrawals from the funds by investors.
Florida freezes $15 billion fund as subprime crisis hits
Montana Fund Sees $247 Million Withdrawals
The credit ratings of certain collateralized debt obligations (CDO) will soon be downgraded in light of the increasing delinquency rate of subprime mortgages. About 40% of CDOs consists of residential mortgage-backed securities (MBS), and ¾ of that consists of subprime loans and home-equity loans, which have a lower lien status. Predictions are being made that CDOs will experience significant losses if home prices continue to depreciate, which is expected to continue at least until 2008.
Much of the subprime trouble was caused by mortgage fraud and falsifications in credit reports. Thus, credit scores, loan-to-value ratios, and ownership status have become less reliable as indicators of creditworthiness, so S&P, which rates much of the CDO issues, is changing its methodology. One change is that higher-rated tranches will need greater credit enhancement to prevent being downgraded if lower tranches in the same issue are downgraded.
A CDO issue divides its MBSs into different tranches, or classes, with different risk profiles. Lower credit-rated mortgages compose the lower tranches, which gives a higher credit quality to the upper tranches. However, all tranches must be sold, or the CDO cannot be issued. Thus, the lower credit ratings of the lower tranches may decrease the number of CDOs that can be sold, which, in turn, will decrease the number of mortgages that can be sold, which will increase mortgage rates for all borrowers.
Apparently, there is so much money in the fixed-income market, that yields are declining significantly more than the risk, which could be creating a private equity debt bubble.
Debt markets for private equity have become riskier because:
Why are lenders loosening underwriting standards to make more loans? Because the loans can be securitized, and the risks can be passed onto investors. Commercial mortgages are securitized into commercial mortgage-backed securities (CMBS), and divided into tranches of varying risk, which are then sold to investors. This is how the subprime mortgage market ballooned into the leviathan that it is today—banks securitized the debt and sold it to investors, thereby transferring the risk as well, which freed up more capital to lend even more. With so much money to lend, lenders marketed to borrowers with greater credit risk or lent money to pay bubble-inflated real estate prices, thus creating the current real estate bubble, with the inevitable decline in home prices, and, of course, greatly increased foreclosure rates.
CMBS issues in the last quarter of 2006 were nearly double the previous quarter, and continues to grow. Because of increased competition, underwriting standards have deteriorated, and riskier deals are being made, including interest-only loans, and even negative amortization loans. Although default rates have been low recently, this is bound to change. Thus, buyers of junk-grade bonds should beware.
The New York Stock Exchange Group, Inc. has received approval to list bond issues of all NYSE-listed companies on its exchange. The SEC has granted the NYSE an exemption to the rule that required that each bond be registered before it could be listed on an exchange. Exchange-listed bonds would have the more competitive bid/ask pricing system over the usual best-efforts approach where a bond broker would call 3 dealers to get the best price among them, even when there could be thousands of other dealers in the bonds—at least a few of whom would almost certainly have better prices. An exchange-listed bond price would aggregate all prices available for the bond into the best ask/bid price in the same way that stocks and options are listed.
The NYSE Group is also currently seeking SEC approval for a new fixed-income trading exchange that will be called NYSE Bonds.
Shariah is the law of Islam and it bans usury and interest payments—consequently, it also bans bonds. So that Muslim countries can benefit from international investment, and so international investors can invest in projects in Muslim countries, variations of the typical bond have been financially engineered to work somewhat like bonds, but still be compliant with Shariah—thus, they are called Islamic bonds.
One such structured product is the lease-back, or ijarah, structure. If a company wanted to raise money to build a plant, for instance, using this method, it would set up a special entity specifically for this project that would buy the plant. Investors would lend money to the special entity, in return for lease payments, in lieu of interest, for the term of the deal. At the end of the term, the principal is returned to investors, and the project becomes the property of the company.
Another way to avoid paying interest, at least in name, is to form a joint venture called a musharakah. The joint venture partners buy Islamic bonds and receive a percentage of profits over the term of the loan.
Malaysia has used the deferred payment sale principle of bai' bithaman ajil. A bank buys an asset on behalf of a customer, then sells it back later for a profit. However, bai' bithaman ajil, is not acceptable to the Middle East, which has a different interpretation of Shariah, so Malaysia has been promoting financial structures that are globally compliant and can be included in the global Shariah stock indexes. Standardization also helps to reduce the cost of developing and marketing Islamic bonds.
To gauge the safety of Islamic bonds, the Islamic International Rating Agency has developed the credit-rating Shariah Quality Ratings.
Catastrophe bonds (frequently shortened to cats), first marketed in the 1990’s in response to Hurricane Andrew and the earthquake in Northridge, California, are issued by insurance companies to cover catastrophes such as windstorms in Europe and earthquakes in Japan, but the majority cover hurricanes in the United States. It is a means by which insurance companies can transfer their risk. Reinsurance is not readily available for such disasters, and, in the event of a disaster, insurance companies get their money faster from catastrophe bonds than they do from reinsurance. Another advantage of bonds over reinsurance is that the issuer can get coverage over several years.
The risks of catastrophe bonds are hard to assess because their ratings are often based on a model portfolio rather than actual risks, which, in any case, is very difficult to forecast.
Catastrophe bonds are attractive to investors because, since it is possible to lose the entire principal from a disaster, they pay very high yields, and they don’t correlate with stocks or even with other bonds, thereby providing diversification.
Unit investment trusts are fixed portfolios of a particular asset class that were created to hold a particular class of securities, such as bonds, or to effect some particular investment strategy. They are like closed-end mutual funds, and registered under the Investment Company Act of 1940, but their holdings are published and cannot be changed. The majority of UITs held municipal bonds, but equity UITs that hold stocks and other securities are becoming more numerous.
They have a maturity date. In a bond fund, the maturity date is the date the bonds mature. Equity UITs have a specified maturity date that is determined by the strategy being pursued. For instance, there are UITs that use the Dogs of the Dow strategy, which is to buy the highest yielding stocks of the Dow Jones Industrial Average, and hold them for 1 year. Then sell them, and buy the stocks with the current highest yield, which involves rolling 1 UIT into another. Defined Asset Funds (also, Equity Investor Funds) are another of example of UITs—offered by Merrill Lynch, Salomon Smith Barney, Prudential Securities, Morgan Stanley, and UBS/Paine Webber Defined Asset—that invest in a particular class of securities, such as blue chips, REITs, or utilities. Sometimes the securities are screened from a particular index in the hopes of outperforming the index. Some UITs have specialized holdings, such as companies that are likely to be acquired, or that focus on renewable energy, or they might hold a particular type of security, such as preferred stock.
Investors in the unit investment trusts have an undivided interest in the principal and income of the portfolio, and can redeem their shares to the issuer for their net asset value.
The disadvantages of unit investment trusts are the high fees and the complete lack of any real performance history.
UITs are usually sold by brokerages, which charge a commission. There is often a front load and a back load, as well as ongoing management fees. Some UITs also charge 12b-1 fees to market their shares.
Because of the funds short lifespans, the funds' issuers frequently use back tests to substitute for actual performance history, which uses historical data to arrive at a performance value. Thus, the issuers argue that if the UIT had existed in the past, this is how it would have performed. The problem with this misleading yardstick is that, as oft been said with investment strategies, the past is no indicator of future performance, and, often, the composition of the UIT is selected so that a high performance record can be constructed. Even the beginning and end dates for the historical record are selected to maximize the historical gains.
Leveraged buyouts, which are becoming increasingly common nowadays and which use the cash flow of the target company to pay off debt obtained to buy the company, frequently destroys the credit rating of the target company, hurting current bondholders. Subsequently, many bond indentures are including covenants which protect bondholders in such scenarios. The most common provision is a change-of-control provision that allows current bondholders to get par value for the bonds from the company when there is a change of control. Although covenants are common in junk bonds, they are relatively rare in investment grade issues, where the credit degradation can be greatest.
Moody's, one of the nationally recognized statistical rating organizations (NRSRO), will assign ratings of CQ-1 for the best protection to CQ-3 for the lowest protection to nonfinancial corporate issuers with a credit rating of Ba to Baa. The rating will include an overall assessment of the covenant protection as well as analysts' commentary.
Kentucky's Court of Appeals has ruled—and the Kentucky Supreme Court has declined to review it—that a state cannot tax the interest on out-of-state municipal bonds any differently than in-state issued bonds because it violates the U.S. Constitution's Commerce Clause. The state's taxing authorities say that it will reduce the ability of the state and its municipalities to raise money for public interests, but I don't see how that would necessarily follow. In fact, it might lower their costs because there would be a larger market for their bonds.
A standard indenture requirement is that bond issuers must send quarterly and annual reports to bondholders by a specified time, about when it files those reports with the SEC. Most companies have 60 days after the missed deadline to file the reports. Failure to do so is a technical default.
Now that bonds prices are lower because of higher interest rates, a quick profit can be made by buying bonds at a discount, forcing a default which forces the company to pay par value for the bonds immediately, or pay a fee or offer better terms to bondholders as compensation.
So called vulture investors are using this method to take advantage of companies caught up in the options backdating scandals, which has caused their bond prices to drop in the secondary market.
Recently, private equity firms and management companies have been buying companies through leveraged buyouts (LBOs), which uses the acquired company's cash flow to pay debt used to acquire the company. This can cause the credit rating of the company to drop to junk status and the prices of its bonds to drop. As a consequence, many companies have added a change of control covenant that either limits the amount of additional debt that the company can take on, or the company must buy back the bonds, sometimes at a slight premium, when a change of control occurs. Some companies add a put option to its bonds so that bondholders can sell the bond back to the company at par value before maturity. For instance, Expedia recently sold 12-year bonds with a put option that allowed bondholders to turn in the bond after 7 years for par value.
I just received an email advertisement from my bank today for rising rate CDs. Right now, my bank is paying 3.42% up to 4% ($50,000 to $99,999 investment required for top rates) for a 12-month CD. The interest rate will be adjusted once during the 12-month term if rates continue to rise.
But why buy a rising rate CD when you can buy 4-week T-Bills that are paying about 4.5%? With the Treasury's new website http://treasurydirect.gov, you can open an account on their website, and buy a 4-week T-Bill with money drawn directly from your checking account. When the T-Bill matures 4 weeks later, the money is directly deposited back into your checking account. How easy is that? Furthermore, 4-week T-Bills are auctioned every Tuesday, and issued 2 days later, on Thursday—that's when your checking account will actually be debited for the purchase. That means that while interest rates are rising, you can could be earning the latest high interest rate available. Note that although T-Bills are auctioned, as a small investor who isn't buying more than $5,000,000 worth of T-Bills, you will get an average of the auction price, which right now is about 4.5%. And since the government has recently just increased the debt ceiling to $9 trillion, Uncle Sam is going to continue to need your money. Furthermore, unlike most CDs, you don't have to tie up your money for a whole year. In fact, a good strategy would be to stagger your T-Bill purchases, buying some every week, which means that some will mature every week, so if you need the money, you won't have to wait too long. This is a good way to save the money for emergencies, like if you lose your job, for instance. In most cases, you won't need all of the money right way, so the serial maturation of T-Bills is an excellent way to receive income right when you need it.
Now for a few basic facts.
It is easy to open an account at http://treasurydirect.gov, and everything is explained there—including a very good flash presentation.
The U.S. government debt is, to a large extent, financed by foreigners, so you can help your country by buying T-Bills, so that the interest, which is paid by the taxpayer, goes back to the taxpayer.
So, what is the amount of interest generated by a $9,000,000,000,000 debt. Well, here's an approximation:
4.5% x $9,000,000,000,000 = $405,000,000,000!
That's almost one-half of a TRILLION DOLLARS EVERY YEAR! Just in interest! Imagine the goods and services the government can provide with that much money.
In the past, mostly wealthy individuals, institutions, and foreign governments bought U.S. Treasuries. Now the rest of us can buy them, too. The fact is, the government can greatly increase the amount bought by U.S. citizens, thereby returning that interest to the people that pay it. Because U.S. Treasuries are now book entries—everything is electronically stored and transacted—there is no need to require a minimum purchase of $1,000 or in multiples of $1,000. Even maturity terms and dates can become more flexible. This would allow many more people to invest in U.S. Treasuries, and thereby, not only keeping the money in the country, but helping to lower the interest rate that the government pays by increasing the potential pool of investors.
Here's an interesting study, published in a letter to the SEC, by Fitch Rating, one of the 3 nationally recognized statistical rating organizations (NRSRO) selected by the Securities and Exchange Commission in 1975, the other two being Standard & Poor and Moody. These NRSROs rate corporate debt. Fitch ratings range from AAA for best quality down to D, a corporation in default. (All 3 rating systems are similar, but the rating codes vary slightly.) Ratings BBB or above is considered investment quality. Rating BB and B are considered speculative, and CCC, CC, and C ratings are considered a strong risk for default. (For a detailed explanation of Fitch's rating system, see CA Credit Rating - Fitch Definitions.)
Most long-term corporate debt is issued as bonds, and the lower the credit rating, the higher the interest rate paid by the bond. Thus, higher interest rates are paid for the increased commensurate risk. But, as you can see in the chart below, the increase in default rates increases only slightly for BB and B rated companies, and then increases dramatically for CCC, CC, and C rated companies. Thus, by buying B rated bonds, you can earn a significant interest rate without much of an increase in the probability of losing your investment.
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