Wall Street's "mortgage monster"

You should read Tom Petruno's column in Sunday's LA Times, "Wall Street can't cage its mortgage monster". It's both a vivid description of what's blowing up (familiar to most of us), and significant that the Times's usually-bullish main business commentator is this bearish. Here are some highlights:

When the rocket scientists on Wall Street outsmart even themselves, very bad things can happen.
...

Today's version of Frankenstein turning on its creator is the mortgage loan mess. Wall Street in recent years has taken a simple concept — bundling mortgages and selling them to investors as interest-paying bonds — and concocted an alphabet soup of securities so incredibly complex they defy understanding by all but a handful of PhDs.

That complexity now is coming back to haunt the buyers of those securities, who for the most part are hedge funds and other big investors, not individuals. If you aren't sure what it is you own, you can't be confident about the thing's value. And in financial markets, if confidence dies, little else matters.
...

What's more, the line went, the trouble would be "contained".... Those assertions were all but blown away last week, after brokerage Bear Stearns Cos. on Tuesday disclosed that investors in two of its hedge funds that owned mortgage-backed securities had lost virtually all of their money.

It wasn't that the bonds became completely worthless overnight. Rather, the funds were victims of their heavy use of borrowed money to boost their bond bets.
...

Investors are losing faith in mortgage bonds up and down the quality chain because the major credit-rating firms — Standard & Poor's, Moody's Investors Service and Fitch Ratings — this month have begun to warn that loan delinquencies may be worse than what the firms had anticipated.
...

Certainly, most Americans will make their mortgage payments, as they always have. But the $1.5 trillion in sub-prime mortgage bonds sold from 2003 through 2006 tells you that a huge number of high-risk borrowers were financed in that period. Some of those loans already have failed; more assuredly will fail.

What's more, in the sub-prime loan market it's now clear that fraud played a big role in the ease with which loans were granted as the housing boom peaked in 2006.
...

As confusing as things are for mortgage bonds, it's worse for Wall Street engineers' crowning achievement in fee-generating securitization: collateralized debt obligations, or CDOs.

A CDO is, in effect, a bond backed by other bonds. And in a wondrous bit of alchemy, a CDO creator can take a pool of bonds backed by mostly sub-prime mortgages and turn it into securities that have AAA credit ratings.

It's all in the slicing and dicing of the underlying portfolio. In theory, the holder of a AAA-rated CDO slice owns a security that has almost no chance of losing principal.

But what, exactly, is backing that CDO slice?
...

That is likely to be the unfolding story of the rest of this year and the first half of 2008.

The fire sale in mortgage securities has yet to begin. But it's coming. The implications for the rest of financial markets aren't clear, but when confidence is shaken in one market there usually is collateral damage.

Once again, Wall Street's rocket scientists have created a monster they can no longer control.

I'd also suggest Niall Ferguson's July 16 column, "Owning on borrowed time".