Washington: Wall Street may have discovered a way out of the bad debt and risky mortgages that have clogged the financial markets. The would-be solution probably sounds familiar: It’s a lot like what got banks in trouble in the first place.
In recent months, investment banks have been repackaging old mortgage securities and offering to sell them as new products, a plan that’s nearly identical to the complicated investment packages at the heart of the market’s collapse.
“There is a little bit of deja vu in this,” said Arizona State University economics professor Herbert Kaufman.
Investment strategy: The really good bonds are bundled with some not-quite-so-good bonds. The bonds come with a stamp of approval that says they are the safest investment one can buy. Chip East / Bloomberg
But Kaufman said the strategy could help solve one of the lingering problems of the financial meltdown: What to do about hundreds of billions of dollars in mortgages that are still choking the system and making bankers reluctant to make new loans?
These are holdovers from the housing bubble when home prices soared, banks bought risky mortgages, bundled them with solid mortgages and sold them all as top rated bonds. With investors eager to buy these bonds, lenders came up with increasingly risky mortgages, sometimes for people who could not afford them. It didn’t matter because, in the end, the bonds would all get AAA ratings.
When the housing market tanked, figuring out how much those bonds were worth became nearly impossible. The banks and insurance companies that owned them knew there were still some good mortgages, so they didn’t want to sell everything at fire-sale prices.
But buyers knew there were many worthless loans, too, so they didn’t want to pay full price for the remnants of a real estate bubble.
In recent months, banks have been tiptoeing towards a possible solution, one in which the really good bonds get bundled with some not-quite-so-good bonds. Banks sweeten the deal for investors and, voila, the newly repackaged bonds receive AAA ratings, a stamp of approval that means they’re the safest investment you can buy. As for the bottom-of-the-barrel bonds that are left over, those are getting sold off for pennies on the dollar to investors and hedge funds willing to take big risk for the chance of a big reward.
Kaufman said he’s optimistic about the recent string of deals because, unlike during the real estate boom, investors in these new bonds know what they’re buying.
The sweetener at the heart of the deal is a guarantee: Investors who buy into the really risky pool agree to also take some of the risk away from those who buy into the safer pool. The safe investors get paid first. The risk-taking investors lose money first.
That’s how the safe stack of bonds gets it AAA rating, which is crucial to the deal. That rating lets banks sell to pension funds, insurance companies and other investors that are required to hold only top-rated investments.
The risk is, if the housing market slips even more, even the AAA-rated investments may not prove safe.
The deal also relies on the rating agencies, which misread the risk at the heart of the subprime mortgage crisis to get it right.