You may have recently read puzzling newspaper headlines like “billions at risk due to subprime mortgage debacle,” or “crisis in the asset-backed commercial paper market.”

 

What do those terms mean in simple English? Let’s begin with subprime mortgages. You might think this means a mortgage offered at less than prime rate; but in fact it means a loan to an applicant with a less-than-ideal credit status. It’s the borrower that’s subprime, not the interest rate.

 

In the old days, if someone asked his bank for a mortgage and didn’t have a down payment, the banker would either turn him down flat, or at least subject him to a series of humiliating qualifications. That’s one good thing about today’s financial environment: there are more options now for less-affluent borrowers.

 

But there’s a downside to this. In the States especially, some clever bankers and investment houses have teamed up to help make mortgage credit really easy to get. They’ve created “securitized” mortgage pools that consolidate risk. So when a borrower goes to the local bank and gets a loan, that loan doesn’t stay with the individual bank. Instead it gets packaged up with a bunch of similar loans, and is sent to Wall Street for the investors there to work their magic.

 

Wall Street divides up the loans based on their expected defaults. Let’s say the typical default rate is 5%. So the investors create a pool (affectionately known as the “toxic waste” layer), and take that 5% as equity on their own, or on the bank’s, balance sheet. Then, since they’ve already taken care of the expected defaults, the rest of the layers are assigned much higher credit rankings.

 

That’s where the fun starts. Hedge funds, ever on the lookout for market inefficiencies, notice that the highest grade of these mortgage pools (also known as “asset-backed securities”) pay out even more than government bonds. Since everyone assumes that the defaults have already been taken care of, the hedge fund borrows a few billion dollars of government money and buys into the mortgage pool.

 

So far it looks like free money. The hedge fund is making a nice profit on the difference between the borrowing rate and the mortgage-pool interest rate. Pension funds and other market players catch on and start buying these securities too, because they pay a bit more than other instruments.

 

But there’s a downside that no one is paying any attention to. Back at the bank, money is being passed out like Halloween candy. The bankers don’t worry about it, because they know these loans are only going to be on their books for a few days – or even only a few minutes. Then the loans disappear out of their doors, to become part of those giant commercial paper pools.

 

Unfortunately, recently the music stopped. Those mortgage default rates soared to unanticipated levels, well outside previous experience and models. Another factor was that real-estate prices took a downturn too. So all of a sudden, the figures that had served so well didn’t work any more.

 

The real fun began when some investors asked a hedge fund for their money back. The fund had to redeem some of its paper to meet the redemption – and discovered that no one wanted to buy it. When it was finally sold, at a whopping discount, the funds were forced to mark their portfolios to market. Losses were huge.

 

Then all the investors got panicky and wanted their cash. When everyone decides to sell at the same time, and nobody wants to buy, you have the makings of a rout. The market was sent spinning, and central bankers scurried to the backrooms. Things were pretty hairy there for a while, and the fat cats on Wall Street were wailing for a bailing.

 

Today, capital markets are in the process of re-assessing all these issues, and re-pricing risk. Financial analysts hope the worst is over; but there may be more panic to come, as even more paper comes due – and we wait to see whether there’s actually any cash on the other side of transaction.

 

So what should the average investor do? Well, unless you personally own a hedge fund, it’s unlikely that you have any of these dodgy investments. A few money-market funds included them, but they were largely covered by the banks involved. Of course, most pension funds are now being rigorous about disclosing their exposure to these particular assets.

 

What does all this mean to you, the average investor? One widely felt result is that all your non-government instruments (stocks, corporate fixed income, commercial paper) went down. That’s because the market is currently re-pricing risk to more conservative levels.

 

But like any crisis, this one will soon pass. Those leveraged players on the fringe will disappear, risks will be priced more appropriately, bank loans will be more carefully scrutinized in future – and as always, properly diversified portfolios will do just fine.

 

Alan MacDonald is an investment advisor who helps high tech entrepreneurs make smart decisions about money. Contact Alan at Alan.Macdonald@RichardsonGMP.com

 

Alan MacDonald CFA CFP

Ph: 613-788-8010

Cell: 613-863-5343

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343 Preston St. Suite 300

Ottawa, Ontario K1S 1N4

www.alanmacdonald.ca

www.RichardsonGMP.com