Subprime “Bookies” May End Up Like The Ending of The Last Sopranos’ Episode

by Brian Brady

Commercial Real Estate Finance Expert
Structured Debt and Equity
Licensed Real Estate Broker in AL, CA, and FL

Author website

I wrote a tongue-in-cheek post about the subprime loans’ collapse about three months ago. I wanted to show the history of securitization of home loans and explain that many of these defaults may actually be “buried” in mortgage pools. I pontificated that the expected debacle from the collapse may not be as bad as we think. Hmmm…maybe I’m wrong?

Bloomberg.com reports today that hedge funds are petitioning the Securities and Exchange Commission to be vigilant of mortgage pool manipulation. Simply put, mortgage pool manipulation is “burying the bad loans in the back of the breadbox”. Issuers of mortgage bonds have a responsibility to comb through the mortgage pool and extract the loans that were in default, especially those that are in default do to fraud or botched underwriting. It is a requirement because mortgage investors hedge their credit risk in the derivatives market.

Derivatives are volatile financial instruments designed for hedging purposes. They are the “afterbirth” of the carving up of whole loans in a mortgage pool. Let me try to explain a bit further. Mortgage bond issuers sometimes extract different characteristics of a mortgage pool and sell them to different investors with varying opinion about interest rates. They can sell the interest portions of the loans to one investor and the principal payments to another. Why would they do that? Profit, of course. It is conceivable that a bond issuer can add as much as ten percent profit to the value of a mortgage pool by issuing derivative securities.

Investors who were expecting interest rates to rise might pay a premium for the steady income a 5.5% loan provides while the investor who believes rates may drop prefers to buy the principal portion of the loans at a discount. Mostly, these financial instruments are used by institutions to hedge large fixed income investment portfolios.

If you are an investor who is purchasing the principal repayment portions of the loans, and those loans will never be repaid…you’re screwed. And that is the risk you take…if you knew the risks going in. If those risks were misrepresented to you…you scream FOUL!

Derivatives issuers are like bookies; they take absolutely no risk whatsover. The issuers, like the bookie, match up the risk takers with a little added profit, commonly referred to on the street as “the vig” (N.B- The street I refer to is not capitalized so it’s not Wall Street. It’s more apt to be located in South Philly). There’s nothing wrong with being a bookie, especially an honest bookie.

Dishonest bookies, however, get whacked. It looks like that is what is about to happen on Wall Street.