American Investment Services, Inc.

Disciplined, Diversified, & Cost Effective

Sept. 2007 – Sorting Out Subprime

Who is to blame for the “subprime mess?” Though there is no clear scapegoat, indignant politicians and regulators are already responding with a raft of
bailouts and proposed solutions. We are skeptical of interference. The mortgage market has the ability to emerge stronger without interference from Washington.

Mortgage lending has changed dramatically in recent years. Today, very few lenders hold the mortgages that they originate. Instead, these loans are quickly securitized and sold to other financial institutions such as mortgage REITs and hedge funds, as well as individual investors. The buying institutions have in turn relied heavily on private sector credit rating agencies to assess the credit worthiness of these securities.

At the same time, Adjustable Rate Mortgages (ARMs) have become wildly popular. ARMs come in many varieties, but most are tied to a short-term interest rate that is adjusted periodically to reflect prevailing rates. As long as low interest rates predominated, ARM lenders eagerly extended credit to borrowers, including those with very poor credit histories. Lenders had little incentive to scrutinize borrowers; few were having problems meeting their monthly payments because rates were low, but more importantly, financial institutions were buying these securitized mortgages as quickly as they were being created.

When short-term interest rates rose, many borrowers were suddenly unable to meet their payments. The financial institutions that had purchased these mortgage-backed securities were left holding the bag. Some financial institutions have been forced into bankruptcy and thousands of home buyers are facing foreclosure.

These events have been painful, but are a result of financial innovation, which is ultimately beneficial. Markets are not perfect, but they are self-correcting. The securitization of subprime debt is not inherently bad. It extends home ownership to thousands of homeowners who would otherwise be renting, by providing a liquid market for these pools of diversified mortgages. Credit had clearly been overextended prior to the meltdown, but the market reacted quickly by shutting down; buyers of these high risk mortgage portfolios have simply vanished. In time, we are confident that buyers will re-emerge, but they will insist on an improved mechanism for rating credit. There is no reason to believe that Congress or regulators will do a better job than the private sector in filling this gap.

We are therefore wary of the government’s reaction. The Senate Banking Committee is holding hearings on the role the credit rating agencies play in the subprime market and is pressuring the SEC to apply its newly expanded authority to regulate them. Meanwhile, the House panel is set to judge how well credit rating agencies value mortgage-backed securities. President Bush has responded by urging Congress to pass on more risk to taxpayers by increasing the number of homeowners who qualify for Federal Housing Authority (FHA) insurance.


Also In This Issue

A Synthetic Dividend
Broker-Dealer Exemption Rule Struck Down
Why Most Investors Fail
Sorting Out Subprime (Continued)
The High-Yield Down Investment Strategy
The Dow Jones Industrials Ranked By Yield
Recent Market Statistics