Subprime De-mystified

By Kunal Jaggi (References: The Economist, BusinessWeek, Investors Business Daily and personal web research)

If you have been following the news at all, you have probably at least once come across a news item on 'the credit crunch due to subprime meltdown and how it's going to cause a major economic recession'. After having followed it for about a month, here's my take.

First of all, a subprime loan is one that is offered to individuals who under the usual circumstances of bank scrutiny, don't qualify as good candidates for loans due to poor credit, lack of collateral or a stable source of income. In other words if mommy and daddy are bailing you out every time your credit card bill arrives, better pull up your socks. In the last couple of years, due to robust economic conditions and availability of capital, some banks issued plenty of subprime loans. In order to entice consumers, many of these loans were offered at zero percent financing deals for the first year or two and then variable (typically high) interest rates. Now this is the killer - I saw an interview with a woman who lost her second home after Countrwide Financial informed her after the first 2 years that her interest rate was going to be 11 %.

Mortgages can be thought of as a stream of future cash flows that are bought, sold, stripped, tranched and securitized in the secondary mortgage market. There are four main participants in this market - the mortgage originator (banks, mortgage banks and mortgage brokers), the aggregator, the securities dealer and the investor. In this scenario, big brokerage firms and banks bought these mortgage loans from the mortgage issues and used them to form Mortgaged Backed Securities (an asset that uses the mortgage loans as collateral). In the last couple of years, banks and Wall Street firms have then used MBS's to structure collateralized debt obligations (CDO) and collateralized mortgage obligations (CMO), those sexy words you've been hearing on CNBC all day .

In essence, they basically bundled together risky assets (which are ultimately dependent on consumers paying their mortgages) into financial structures that offer returns higher than corporate bonds through diversification to suit potential investors. The riskiest assets earn the highest return but take the first hit from any default in the underlying asset. These investments, like any other corporate bonds, have to be given a rating by the bond-rating agencies (Moody's, Fitch ratings, S&P) before they can be sold off to any investors. Without the agencies' stamp of approval, may big investors like pension funds and university endowments wouldn't be allowed to buy these CDO's and the market wouldn't exist. Now here's the biggest problem - these bond rating agencies are paid by the very same firms that issue these CDO's and not the investors who buy them.

Al Gore once said - "It's impossible for someone to understand something, if their very liveliehood depends on them not understanding it. " Rating agencies also help the issuing banks by telling them what they need to do to garner the highest AAA rating, which is a prerequisite for a Goldman hedge fund to touch the bond. The result has been that everyone has had a financial incentive to keep issuing these risky CDO's, without due diligence. It comes as no surprise that many of the 'AAA' rated bonds have defaulted. And when quantitative hedge funds made highly leveraged bets on these CDO's without incorporating the variable of greed and Wall Street shenanigans in their mathematical models, well they lost some money. Maybe a lot.

With that said, the S&P and Dow have lost a lot of money, markets have been heading south and many people are screaming about a recession. Suddenly the ridiculous private equity buyouts have vanished and people have realized that sometimes the complex financial derivatives that Wall Street dishes out are, well too complex. The truth is not even Alan Greenspan knows the entirety of the losses since the risk was spread amongst so many players. European banks have been said to be worse hit since many of them invested in American subprime CDO's due to slower domestic markets.

I think this is a great time to buy solid (good balance sheets and plenty of Free Cash Flow) high-growth stocks (tech, safe banks not exposed to subprime, pharma) since everyone is jumping the boat to steady stocks and US treasuries. Several leading economists have mentioned that most of the key performance indicator's of the economy are positive - Q2 GDP growth rate higher, a weaker US dollar increasing American exports and most sound businesses have financed their capital expenditures through retained earnings and cash flow. Just because a big investment bank fires workers doesnt mean overall unemployment is rising. The market often over-reacts and in my opinion there is going to be a jumbo boxing day sale soon. Walmart (WMT), Wachovia(WB), Bank of America (BAC) (2 banks not involved in subprime) are already trading close to their 52 week lows - more on that later.

By the way, notice that Countywide Financial (CFC), whose stock took a 51% hit is currently 95 % institution owned. Sniff sniff, anyone smell a big bad wolf ?

Opinion influenced by - The Economist (Banks in trouble, The Game is up, August 18th issue), Business Week (Let the blame begin), Bloomberg TV and my own head.