Trickle Down, Now Trickle Up

The New York Times has an excellent piece (hat tip: Calculated Risk) on the collapse of the subprime market on the businesses way up stream from where we operate. The securitization and sale of repackaged mortgage backed securities is a world where billions of dollars in profit has been made over the last several years – and it is going to be feeling a lot of pain as this thing shakes out.

We’ve spent a lot of time talking about the trickle down to small lenders such as my company; but it is interesting to get some insight on how this can ultimately impact the equities and securities markets including the biggest names in global finance.

The most illuminating part of the article to me was that many of these bond holders treat their holdings like a favorite baseball card. I remember holding a Barry Bonds rookie card and as a young boy coveting it, imaging the amount that I could sell it for at my local trading-post. I read the books about baseball card values and I believed that I could get $20 for it. I took it to the store, expecting I could sell it for $20. The most the store owner would give me was $10. The morale of the story is a common refrain – something is only worth what people will pay for it.

This is the problem with mortgage holdings. A bank or institution that is holding mortgages don’t have to put a value on their holdings until they try to sell them. So there is arguably a lot of $20 mortgages being held that in reality will only sell for $10 (to carry the metaphor). Further, the ratings agencies Moodys & Standard & Poors are hesitant to downgrade these holdings. If the securities are downgraded below "investment grade" many investors that are required to only hold "investment grade" assets will be forced to sell. These are companies like insurers who hold large amounts of these securities. It would cause large scale selling in this market. This would cause even greater turmoil in the market.

â??There are delayed triggers in many of these investment vehicles and that is delaying the recognition of losses,â?? Charles Peabody, founder of Portales Partners, an independent research boutique in New York, said. â??I do think the unwind is just starting. The moment of truth is not yet here.â??