- So you make a bunch of loans, homeless people in the park will do.
- Then you take those loans and you sell them to another company.
- That company takes those loans, puts them all in a pile with other loans, and resells pieces of them as bonds to investors.
- They also make sure the bond-rating agencies rate the bonds highly by threatening to withhold their business.
- Investors, largely hedge funds and off-balance sheet entities tied to banks, borrow money from Japan at a low interest rate, snap up the bonds and make a big, risk-free profit on the difference between the bonds high return and the low cost of borrowing the money.
Its all a beautiful, cant-lose situations where everyone gets rich on fees and buys a new yacht. Until someone realizes that the homeless guy has never made a payment...
Last week we saw a correction in stock markets around the world and a reaction by the Federal banks of many nations because of the so-called "sub-prime mortgage" problem. The Dow dropped 1,000 points -- is it time to jump back in the market and snap up the cheaper stocks? Or is it best to wait? That's a tough call.
This whole mess is bigger and more complicated than a lot of people want to let on. What makes things worse is the lack of transparency and the slow-motion nature of the problem.
The guys at step #1 and maybe #3 knew the risks of those borrowers but those risks got lost by steps #4 and #5. (The greater fool theory hard at work.) Not only do investors who own these mortgage-backed bonds not know what their true risk is many of these investors do not even have to disclose how many of these bonds they own. The accounting rules for hedge funds and other investing companies are very different from banks or public corporations.
The worst may be over already, making this a good time to buy.
Or not.
The mortgagees themselves, the 2/28 and 3/27 loans, are a slow motion problem. People may be able to make their payments for months or even years before problems. Similarly, the investors who own these bonds are likely to keep them hidden as long as they can and hope for the best.
One can expect more "surprise" announcements over time as the mortgage defaults grow and at the end of accounting periods, like Q3 and Q4, when companies are forced to declare returns to their investors and the government. Right now its hard to know anything for sure and that creates the fear and doubt that hurts markets and creates volatility.
