To most institutions and individuals, the outlook for subprime mortgages could not look more bleak.
Indeed, with today's news of record default rates, many observers see subprime as an all consuming black hole!
And yet, some people are said to be buying collateralized debt obligations (CDOs) containing subprime mortgages, at very deep discounts, usually undisclosed.
So what glimmer of future profit do they see? Let me offer some thoughts.
I see three dim rays of light that could one day allow some profit to be squeezed from CDOs.
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They are: CDO re-packaging, substantially lower interest rates, and government aid. Let's examine each in turn.
Some buyers of deep-discount CDOs may be intending to re-package the "sliced and diced" CDOs with the aim of filleting out the toxic waste (subprime and other high risk mortgages), leaving just the prime mortgage elements to be sold off at a handsome profit.
The problems I see with this are legal related. Will it be possible, legally, to repackage and thereby materially change a security, leaving the non-prime elements exposed and worthless? Perhaps not, under a strict application of current securities laws.
But, with our government increasingly desperate to find a solution, one may find the regulatory agencies extraordinarily and most unusually not just cooperative but constructive in their legal approvals — even encouraging!
In addition, what if our U.S. courts decide that elements such as "teaser" rates, when combined with complex and tricky adjustable rate mortgages (ARMs) amounted to fraudulent inducements to unsophisticated house buyers?
I am told that, under current law, a fraudulent inducement would cause the contract to be null and void, with possible damages awarded to the mortgage borrower.
So the legal hurdles to be faced by repackaging could prove to be formidable.
The second element, substantially lower interest rates, does appear to offer a small glimmer of hope.
If the recession I have forecast over the past year deepens, it should force the Fed to lower rates — big time, by about two to three full percentage points.
[Editor's Note: Why the Fed Interest Rate Cuts Won`t Work]
In theory, this should help to lower the London Interbank Offered Rate (LIBOR) for U.S. dollars, to which most ARMs are linked.
However, the LIBOR is a free market reflection of "solvency," or credit risk, in addition to merely comparable U.S. Treasury and money market rates.
In addition, many subprime mortgage borrowers should never have borrowed in the first place. They were not truly qualified to service any reasonable, commercial mortgage.
So, not much real hope there for some of the toxic waste, even at substantially lower rates!
But what if a panicked government, with its eyes on the election, decided to use taxpayer money for some "do-good," humanitarian, direct subsidies?
It may sound far fetched, but with several million people facing foreclosure and eviction in an election year, a major electoral threat emerges. So, it does not stretch the imagination too far to envisage it happening for "party political" reasons.
Such a government move would be an open abrogation of the rule of contract, a move that would be highly unpopular in certain sectors, very costly (up to $1 trillion) to the taxpayer, and offer potentially vast, ill-deserved windfall gains to some imprudent borrowers at taxpayer expense.
However, it may not be wholly out of character for a government that took us into the Iraq war, looking for weapons of mass destruction, at an estimated cost of more than $1 trillion so far.
I do not believe that any single one of these factors alone will allow room for profit for CDOs, but a combination just might just conceivably do so.
I also believe that it is this very small chance of profit that may be driving high risk takers to bid for deep discount CDOs, and that is what makes markets.
However, I understand the discounts being demanded by potential borrowers may well not stop the need for more massive write-downs by many financial institutions, now holding CDOs as cost.
In this respect, it is sobering to note that of the estimated $300 billion worth of the subprime problem, only some $50 billion has so far been written down.
Therefore, don't bet on it, but with so much blood in the CDO market, there are at least some logical reasons for high-risk, deep discount buyers to be on the prowl, shedding at least some dim rays of light into this seemingly deep black hole!
Editor's note:
Special: A Bubble on the Verge of Bursting. Act Now.
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