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Why Subprime Mortgages Affect You Even If You Don’t Have One

Posted by admin on July 14, 2007 in Investment Products

This is a once in a blue-moon Saturday posting spurred by a comment on Thursday’s posting about CIBC. I wanted to expand on my comment and muse on the larger implications for all investors. In response to the speculation about its alleged large exposure to the sub-prime mortgages, CIBC has indicated that the “majority of its securities held are AAA-rated, the highest rating category.” But the question becomes, can this rating be trusted (to be clear, I am not stating CIBC is lying. It is not and all we have are unproven allegations. Credit ratings are given by institutions other than the purchaser of the security like CIBC)?

This is the issue in a extremely simplified and generalized manner and it may explain why we should care as investors even if we don’t hold a sub-prime mortgage. Sub-prime mortgages, junk bonds and other cash-flow vehicles are bundled into collateralized debt obligations (CDO’s) which the major credit agencies rate with AAA being the highest grade (in theory, a AAA security is not likely to default on its payment obligations).  But here is the biggest catch- how much can the credit ratings themselves be trusted?

This article suggests that the credit rating agencies are part of the problem. If the article is true, it appears that the credit rating agencies were helping the CDO issuers get higher credit ratings. Since the article was written in June, the rating agencies appear to be policing themselves (with the threat of SEC investigation) and have downgraded many CDO’s. To answer a question posed by Invest Skeptically, it is difficult to conduct due diligence on the underlying cash flow in a CDO because, as I understand it, how you determine cash flow default rates is determined by a financial model created by various credit rating agencies. The agencies, in turn, are paid to rate the CDO’s- this raises a huge conflict of interest issue; if the credit agency is not giving a good credit rating, it won’t get any business so the “model” will tend to yield positive results to maximize business.

Banks, hedge funds and investment vehicles buy CDO’s in the billions.  These purchasers then use the CDO’s as collateral to borrow money (financial institution to financial institution loans are a large segment of banking; remember banks sometimes get good deals when they have little available capital so they have to borrow funds from other banks).  As the collateral itself begins to be worth less and less (in simple terms, the CDO’s are not worth as much as originally thought as the mortgages default), the lenders to these financial institutions will ask for other collateral to take the place of the lost value of the CDO (called a collateral or cash call).  In everyday terms, imagine the value of your home becoming less than the mortgage; the bank will ask you to put up more collateral to secure their position.  This is what is happening now to institutions that hold bad CDO’s.

We, the investor get hurt, during these collateral calls. Few of us actually own CDO’s but we invest in banks and financial institutions that do. If they become subject to collateral calls, they are diverting funds which they could use to pay us greater dividends, buy back shares or acquire competitors and using money instead to fund bad investments in CDO’s (or, in a nightmare scenario, they dump all the CDO’s on the market and create a panic). Bears Stearns’ collateral call cost them $1.6 billion (or over 10% of shareholders’ equity). Shareholders of Bear Stearns are most likely less than pleased by the share price this last month.

How do you avoid this mess? Quite frankly, most financial institutions will hold one form of CDO’s or another. The key is the magnitude of its exposure. If you invest in a financial institution, read the press releases and financial statements for their exposure to CDO’s- a lot of people are asking for full disclosure on this matter (BNS and TD have publicly stated they have no exposure). To state the obvious, avoid investing in these institutions- financial institutions are supposed to be “safe” stocks and they, ideally, should not be investing in such risky products and, to carry this thought further, institutions that invest in CDO’s most likely have a gun-slinger mentality and will put money in the next fad and jeopardize your investment. Thus, it may be time to look at the security of the institution long term.