Bad mortgages, big business

It looks like Wall Street is at it again.

Remember those bad mortgages packaged and sold on Wall Street as AAA investments? (Perhaps you knew them better as the “toxic assets” of TARP fame…)

Well, there are still heaps of bad mortgages on the market, called non-performing loans (NPLs), which can no longer be sold as AAA since Wall Street screwed up royally on that one.

Now those bad loans are being sold without pretense, as what they are: junk. The big banks and Wall Street investment firms are “securitizing” thousands of these bad loans and selling bonds at deep discounts to profit-hungry investors with cash in the bank.

The setup is essentially the same as with a mortgage-backed bond (MBB). An investment bank purchases thousands of NPLs, pools them together and then “fractionalizes” the pool into bonds that are sold to investors at steep discounts.

Whereas in the past the investment banks were betting on the failure of these securities, now investors are, ostensibly, betting on their success. In order for investors to realize a return on investment (ROI) a greater proportion of NPLs within the pool must be either modified or otherwise efficiently shepherded through the short sale or foreclosure process.

first tuesday insight

This is really a pro-con issue.

If the banks behave themselves, and all goes according to plan, these NPL securities may prove to be win-win investments. Investors win if the loans are modified or dealt with responsibly and expeditiously. Thus, the driving force of profit in this investment depends on the ethical and efficient practices of the banks servicing these loans. Investors profit and homeowners benefit? It sounds too good to be true!

And it very well may be. The potential for abuse here is great, in which case we might experience déjà vu all over again. The big banks were able to bet against their own investments during the run-up to the financial crisis because of a tricky little financial instrument knows as a credit default swap (CDS). In a CDS, the investor is paid in the event the NPLs underlying the bond actually default or otherwise lose an undue amount of value.

If this were to occur, rather than having the effect of encouraging proper loan modification and servicing, it would have the reverse effect, which could have disastrous consequences for the still fragile mortgage and real estate markets.

Lets hope regulators do their jobs this time and blow the whistle the next time a big bank bets against itself!