The manager of the world’s biggest bond fund, PIMCO, says the mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) that helped fuel the housing boom dazzled ratings agencies with their “6-inch hooker heels.”
In a strongly worded commentary on the impact of the subprime lending crisis, PIMCO’s Bill Gross says that the practice of slicing up such securities into various tranches of varying risk — and the use of financial derivatives to help manage that risk — only served to magnify the potential for disaster, not lessen it.
Gross says that while problems with two Bear Stearns hedge funds that were heavily invested in mortgage-backed securities have been “papered over,” the crisis in subprime lending threatens the entire economy, because “the willingness to extend credit in other areas … should feel the cooling Arctic winds of a liquidity constriction.”
The underlying collateral for MBS and CDOs are homes with mortgages ranging from risky subprime ARMs and piggyback loans to more traditional prime, fixed-rate mortgages. Tranches backed by prime loans got A or better ratings, while those with riskier collateral got lower — but in many cases, “investment-grade” — ratings.
“Layering” risk allows investors to choose a security that best fits their goals, with higher returns for higher risk. But many bond fund investors may not realize they have exposure to these riskier securities in their portfolios. Derivatives — which include interest rate and credit swaps, Treasury futures and options — help managers of bond funds spread the risk of issues like changes in interest rates and prepayment risk.
Gross says ratings agencies failed to take into account the “significant leverage” that the use of derivatives introduces, which can magnify the harmful effect that rising interest rates have on the values of securities. When the value of the underlying collateral — housing — falls, that’s a recipe for disaster.
“The right places to look for contagion are therefore not in the white-washed Bear Stearns hedge funds, but in the subprime resets to come and the ultimate effect they will have on the prices of homes — the collateral that’s so critical in this asset-backed, and therefore interest-sensitive financed-based economy of 2007 and beyond,” Gross writes. “If delinquencies lead to defaults and then to lower home prices, then we have problems and the potential for an extended (downturn) — not a 27-day Paris Hilton sentence.”
Gross says that using the current default rate of 7 percent on subprime mortgages — which he says equates to total losses of between 3 percent and 4 percent — “the holders of some BBB investment-grade, subprime-based CDOs will lose all of their moolah because of the significant leverage.” And if subprime total losses hit 10 percent, he predicts, “even some single-A tranches face the grim reaper.”