Friday, June 22, 2007

More on Bear Stearns Fallout

From Bloomberg:

``The demise of two Bear Stearns managed Leveraged Mortgage Funds could be the tipping point of a broader fallout from subprime mortgage credit deterioration that would lead to cascading de-leveraging and ultimately ending with higher rates to new mortgage borrowers,'' New York-based analysts at Bank of America Corp. including Robert Lacoursiere wrote in a report published today.

Let's translate this sentence.

Mortgage securities 101: Loan originators sell the vast majority of their mortgage loans to firms that securitize loans. This means that securities firms take similar mortgages (same coupon, length to maturity etc...) and place them in giant pools of mortgages. By giant, we're talking $10 million minimum and usually quite a bit larger.

This pooling of assets is assumed to diversify the risk. Suppose there is a pool of $100 million mortgages. Out of this pool of $100 million, there is one loan worth $100,000 that is delinquent. Because this $100,000 loan is so small in relation to the $50 million pool (it is .01%), this one loan's underperformance won't effect the overall performance of the entire pool.

However, let's say there are 10, $100,000 loans that are delinquent. Now about 1% of the entire pool of mortgages are underperforming. This means we could start to have a problem with the entire pool of mortgages.

There is no universal point at which an amount of underperforming loans automatically impact the performance of the overall pool of mortgages. Each mortgage pool is unique onto itself.

Let's extrapolate this information to the bigger picture.

Delinquencies are increasing. As a result, there are more loans in mortgage pools that are underperforming. That means a larger number of mortgage pools may be experiencing problems. This is what the paragraph is talking about. The possibility that the number of underperforming/delinquent loans is starting to impact the entire industry is increasing. Bond 101: increasing risk = increasing interest rates. If someone is going to lend a high credit risk borrower money, the lender will ask for more interest as compensation for the increased risk.