Sub Prime Sludge and Solutions


Sub Prime what? A year ago I think this would have been the response most Americans would have given you if you brought up the potential problem. Nowadays everyone is an amateur economist with all the investigation and research going on by the average American.

Before looking at the solutions for the Sub Prime bust, you have to understand what has happened and why. From about 1995-2005 interest rates fell, creating more capital which found it's way into the housing industry. People figured out with the lower rates they could buy a house, maybe even more than one. As prices for real estate began to rise so did the equity and so did the collateral for creating more debt. Thus creating a "bubble."

Enter, "Financial Engineering." Banks, hedge funds, and insurance companies thought they could make a quick buck off this insanity and everyone would be happy. They figured they could transform these rather risky low quality loans in top of the line AAA securities. Now, some of these types of loans did not even require a small down payment. Nothing, zero, nada.

Individual mortgages, thousands of them, were wrapped up into groups called residential mortgage-backed security , or RMBS's. Large Wall Street banks such as, Bear Stearns, would buy the low quality loans from a mortgage broker. Concept was that unlike a regular bond, which was paid by a single corporation, RMBS securities were organized by risk called "tranches." Thousands of homeowners were paying the interest and the principal on these tranches. Most believed this bundle approach was less risky to own because the risk was spread around to so many people at different risk categories rather than just one entity. Well, everything was just fine until the summer of 2006. People for some reason started defaulting on these loans at a greater rate than expected. The big jump in subprime defaults led to the first hedge-fund blowups.

Now, the "liquidation" problem. As the market started collapsing the huge securities ratings were starting to be lowered. This in turn caused hedge fund liquidation. The amount of buyers for the mortgage backed securities dried up quicker than Joan Rivers. With no one their to buy sub prime mortgage brokers were left holding the bag and quickly started dropping like flies. This problem has catapulted all the way to the top, like Bear Stearns.

The solution? On March 13th the President's Working Group on Financial Markets offered some corrective actions.

Improved Credit Ratings

The report calls for credit rating agencies to improve the way in which
they "grade" securities. Currently, both traditional securities and structured credit products are graded the same way. Structured credit products are
sophisticated and often highly complex packages that include such ingredients as tranches (pieces) of mortgages representing a specific level of repayment risk. They are designed to meet specific investor needs. [1]

This is simple plain common sense. This will attempt to make credit rating agencies much more vitreous. Since most of the risk assessment of the mortgage packages was faulty, the actual risk was underestimated, and the models used to rate them were not disclosed, investors were not able to appraise them properly. These recommendations seek to correct this flaw by disclosing the methodology and assumptions about the credit rating process and encourages reviews of these assumptions. Investors would be kept in the loop about how far these agencies looked into these new credit products and how they attained their ratings.

Improving Mortgage Origination

One factor in the current upheaval is that mortgages were made to homebuyers who normally would not qualify for them and were presented as being of much higher quality than they actually were. While much attention has focused on underwriting problems in the subprime market, the fact is that credit standards were relaxed for most classes of loans with the result that home purchasers found themselves in mortgages that were inappropriate for their financial circumstances, and underwriters of mortgage-backed securities purchased mortgages that were far riskier than they seemed. [1]

To avoid this in the future better standards for underwriting these loans should be implemented. Unfortunately, they also recommend better state and federal regulation of underwriters. This is an unfortunate situation, but had these mortgage companies not acted so irresponsibly, there would be no need for government regulation. According to the Heritage Institute, enforcing licensing requirements on unsupervised mortgage brokers would greatly improve the quality of the mortgages that they create.

Improved Risk Management and Regulation

The report also addresses poor risk management practices within
financial institutions that both purchased and originated sophisticated
mortgage-related investments. One of the more disturbing revelations of the subprime crisis is that major financial institutions are unable to estimate their actual exposure to losses resulting from these types of securities accurately. The causes of this range from improper understanding of the actual risk associated with individual investments to the inability to aggregate the holdings of various investments properly across all of a firm's business lines. As a result, financial institutions have found themselves far more exposed to risk and potential liquidity problems than expected, especially as credit conditions have deteriorated.

One of the major problems with this whole scenario was the in-ability of these banks hedge funds, etc. to be able to know exactly how much risk they were going to be exposing themselves to. There was little to no understanding of how this undertaking might end up. The supposed protection of wrapping up so many individuals into one package, the RMBS, has been their undoing. So, to compensate this stupidity the government will require firms to have better management information systems so this information will be readily available. Also, they recommend firms meet liquidity and capital standards so that they can even weather the worst of times.

Final thought, from Bear Stearns, all the way down to the individual home buyer, everyone acted irresponsibly, hindsight is always 20/20. The banks thought they were smarter than the system and home owners were offered something they could not turn down, but couldn't afford. Problem is a loan is loan and someone will always expect you to pay it back, whether you can afford to or not.


[1] Preventing the Next Subprime Crisis



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