Income Strategy July 20, 2007:

The bond markets in North America received more bad news this week when the Chairman of the Federal Reserve, Ben Bernanke, speaking in front of the Senate Banking Committee stated that defaults in the sub-prime mortgage sector could be as high as $100 billion.

The size estimate caught many investors off guard especially when this is just a preliminary estimate by the Fed. The uncertainty going forward is; will these estimates continue to increase as the reality of a softer real estate market forces more borrowers to panic sell reinforcing the decline in values.

The poor lending practice that have been fueling the real estate boom in the US are coming home to roost and there will be wide spread damage before this is all over. These high risk mortgages have been creatively packaged and sold to Banks, Pension funds and other institutional investors as Collateralized Debt Obligations or CDO’s. The CDCO market has boomed along with the real estate and mortgage markets.

To understand the extent of the exposure, you have to understand how a Collateralized Debt Obligation is created. An investment Bank such as Bear Stearns or Solomon buy a portfolio of sub-prime mortgages issued by a bank or trust, these mortgages are then packaged using a mathematical formula allocating potential risk. A portion (traunch) of the Portfolio is given a first charge over the entire portfolio of mortgages and is therefore considered a Triple “A” rated obligation, the second traunch is given a little lower credit rating and so on until the last traunch is given a junk bond rating.

Now investors have to remember that all of these mortgages are sub prime, in other words the borrowers are not credit worthy or the leverage is well above the normal levels. In some cases the borrower has little or no credit history and a mortgage that has 100% financed the purchase of a home including all the costs to close the deal.

The investment bankers have been doing the modern equivalent of alchemy, but instead of turning lead to gold they have been turning extremely high risk loans in to triple “A” bonds. These triple A bonds are of course owned by risk adverse investors in many cases these same investors could not buy any of these obligations if they were rated and disclosed properly due to the investment rules they are required to operate under, the banks know the rules so they create an investment that will meet the initial test and everyone is happy, until now.

The credit markets are going to over react to the current uncertain situation and lenders will tighten credit policy and restrict access to capital after the fact, just like they have done every other time. Borrowers in the bond market are going to have to pay substantially higher interest rates than they have over the past four or five years. The leveraged buy out phenomenon which has fueled much of the takeover and merger activity is coming to an end as credit dries up.