The Panic Of 2007 - The Recent Volatile Markets Explained

By Author: John F. Mauldin
Total Articles: 113
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End of the World or Muddle Through? This week I try to explain in simple terms the very complicated story of how we went from some bad mortgage loan practices in the US to the point of world credit markets freezing up. There is a connection between the retirement plans of Mr. and Mrs. Watanabe in Japan and the subprime problems of Mr. and Mrs. Smith in California. We find the relationship between European banks and problematic hedge funds. And finally, we try and see how we get out of this mess. Oddly, I think it is hedge funds (and maybe Warren Buffett) to the rescue, but not in the way you would think. It is a lot to cover, so let's jump right in. (And there are a lot of charts, so while this will print out long, it is only a little longer than the usual in word length.)

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To say the credit markets are frozen is an understatement. Talking to any number of people who have been in the markets for decades, this is the worst in their memory. Ironically, it is the 100-year anniversary of the Panic of 1907, when one banker (J. P. Morgan) stepped in and provided liquidity to the markets. The central banks of the world are providing liquidity; but as we will see, it is not mere liquidity that is needed.

You cannot explain the problems with just one or two items. A perfect storm of this sort takes a number of factors all coming together to work its mischief. Bad mortgage underwriting practices, bad rating agency practices, a destruction of confidence, excessive leverage and then the withdrawal of that leverage, the need for yield, greed, and complacency which then in a Minsky moment (explained below) becomes paralyzing fear - all play their part.

An Alphabet Soup of Credit

But let's start at the beginning. In the early '90s, investment banks created a new type of security called an Asset Backed Security (ABS). And it was a very good thing. Essentially, investment banks would take a thousand mortgages or car loans or commercial mortgages or bank loans and put them into a security. You could have a Residential Mortgage Backed Security (RMBS) or Commercial Mortgage Backed Security (CMBS) or a Collateralized Loan Obligation (CLO) and then a Collateralized Debt Obligation (CDO).

I am going to grossly oversimplify the following description, but the principle is correct. Let's take a look at how a Commercial Mortgage Backed Security is created. If you are a bank or institution, when you make a loan on a mall or office building, you incur a certain amount of risk. If you hold 100 such loans, you can almost be certain that some of those loans are going to be bad. Further, you are limited in the amount of loans you can make by the capital you have in your company. But what if you could package up those loans and sell them? You get your cash back, and then you can keep the servicing fees and make more loans. But who would want to take the risk of your loans?

Through a form of financial alchemy, you can take your loans and increase the quality of them to potential investors. Let's say you have $100 million in commercial mortgage loans. You take this pool and divide it up into 5-7 (or maybe more!) groups called tranches. The first group gets the first (as an example) 60% of the principal which gets repaid. That means that 80% of the loans would have to default and lose 50% (80% of the loans times 50% loss is 40% total portfolio losses) of their value before your money would be at risk. If the bank originating the loan is not completely asleep at the wheel, your risk of an actual loss is quite small.

So, an investment bank goes to a rating agency (Moody's, Standard and Poor's, or Fitch) and pays them a fee to rate that tranche in terms of risk. Since the level of risk is small, that first tranche gets an AAA rating. Then the agency goes to the next group. Maybe it is 10% of the pool. It would get all the principal repayments after the first group. In this case, 60% of the loans would have to default and lose 50% of their value before your group lost money. The ratings agency might give this group an AA rating.

This process goes on until you get to the lowest-rated tranches. There is typically an

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Copyright 2007 John Mauldin. All Rights Reserved

John Mauldin, Best-Selling author and recognized financial
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