For me, the real issue is the rating agencies and the way they look at pools of loans. It seems to make sense that pooling together loans should reduce the risk, like the idea that my stock portfolio endures less volatility (and theoretically risk) as I diversify.
So, they take a bunch of subprime mortgages, slap them together and create a AAA or AA rated MBS. Sounds great, except that what you are really holding is a piece of a bunch of similar loans that are not anywhere near AAA status on their own. The fact that you hold many loans is supposed to mean you are diversified, but I don't believe that is necessarily the case.
What happens when general economic conditions begin to cause defaults rather than individual circumstances? What if loan A isn't defaulting because borrower A just got fired for showing up late to work? What if borrower A got fired because he works for a plastics company that needs to cut costs to cope with rising oil prices? Meanwhile, borrower B can't make the payment because he worked in the homebuilding industry and the burst bubble (read: higher interest rates) cost him his job. Now loan C defaults because borrower C has a long commute and the price at the pump doesn't permit her to make the payment on a mortgage that seemed well within the budget four years ago? Then loan D defaults when the ARM (that he never actually understood) resets. When you are talking about subprime loans, rising energy prices and interest rates will affect all borrowers, and given their financial wherewithal, even small shifts can bring on a rash of defaults.
In my opinion, a bunch of subprime debt pooled together is not AAA. It is still subprime, or pretty close to it. It is like holding a "diversified" stock portfolio of 10 stocks: American Airlines, Airtran Holdings, JetBlue Airways, Continental Airlines, etc. Sure you own several stocks, but you haven't achieved any actual diversification. I look at subprime debt the same way because the borrowers are all in a situation where slight shifts in the economy can have a big impact on their bottom line. They may not be living paycheck to paycheck, but they can't afford to be out of work for very long or to see oil prices, interest rates, food prices, etc. all rising at the same time.
This is not to say I don't recognize the many useful properties of loan pooling, but I feel it has limitations. Slicing and dicing loans to create made to order securities is fantastic, but when you order subprime loans, that is what you get. I don't go to McDonalds expecting filet mignon.
I would love to hear other people's thoughts on this, especially if anyone would like to make the case that in fact the sum total of a bunch of subprime loans is significantly less risky than the loans are by themselves.
Edited 1 time(s). Last edit at Thursday, July 19, 2007 at 07:22PM by tobias.