Wall Street Law Blog

Bottle Of Wine Key To Understanding Subprime Debacle

Mortgage securitization for Dummies?  Not exactly.  

However, the diagram featured in this post - a tipped wine bottle floating above an inverted pyramid of wine glasses - really simplifies the migraine-inducing terminology and key concepts of mortgage securitization.  

Note- This brilliant diagram was not conceived by Wall Street Law Blog.

My goal in writing this post was to use this great visual aid to create a series of storyboards to describe the subprime debacle in a format that (a) is easy to understand, and (b) does not require readers to take any Advil, Tylenol, or Excedrin.   

I know, I know - my chicken scratch handwriting is far from easy on the eyes. And you aren't sure you can go with the whole subprime wine thing.  But hang in there. The post is pretty short.

THE SENIOR TRANCHE (lowest risk, lowest return)

THE MEZZANINE TRANCHE (Middle Tranche / Riskier than senior tranche, but still low risk/low return)

EQUITY TRANCHE (High Risk, High Return)

THE SUBPRIME DEBACLE

As long as favorable economic conditions keep default rates on subprime mortgages low, there is plenty of wine and all glasses are filled.

HOWEVER...

 

 

 

 

 Actually, the truth is that the bankers coud -- and did -- sell investors trillions in fraudulent subprime bonds.  And now, we hope, it is a little bit easier to understand how they did it.

 

By Brett Sherman

No One Foresaw The Chance of a Subprime Meltdown, right?

PART 2 IN AN ONGOING SERIES ABOUT FRAUD AT BEAR STEARNS

• Bear Stearns, among other, Sure Knew That Market Demand for MBS Backed by NonPrime Mortgages Could Disappear In the Blink of An Eye.  

• Two Meltdowns in 10 years, and yet the Denials Continue.

The future of the “entire subprime industry... [is] in doubt," reported trade magazine US Banker in an August 1999 article about the bankruptcy filing of leading subprime lender FirstPlus.  “A host of... subprime and HLTV [high loan to value] lenders have collapsed in the past year...” “A Comet Falls, and Industry Shifts.” US Banker, August 1, 1999. 

The article also reported that Bear Stearns (among others) was a warehouse lender to FirstPlus, and that Bear packaged FirstPlus mortgages into MBS.  Id.  

Why did FirstPlus fail?  Because there was a rapid decline in investor demand for “securities backed by subprime and HLTV loans.”   

The 1998 Asian and Russian crises and the fallout from those market shocks (think LTCM) produced a classic flight to quality.

In a flight to quality, markets for complex investments like MBS often run dry in periods of market turmoil, because frightened investors move their money to higher quality investments like US Treasuries and highly rated corporate bonds.   

That is precisely what happened in 1998.  Because of this flight to quality, market prices for some MBS fell as low as “50 to 60 cents on the dollar.” Id.  

* * *

To the staff of Wall Street Law Blog, something about this episode seems oddly familiar.

By Brett Sherman