Blown Mortgage

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Hey, I didn’t say it. Check the latest from PIMCO and Managing Director Bill Gross in his commentary titled “Looking for Contagion in all the Wrong Places.” Gross points to the recent Bear Stearns hedge fund soap opera as the canary in the coal mine for future troubles fueled by the subprime loan reset problem.

Here is Mr. Gross talking about collateralized debt obligations made up of subprime mortgage bonds rated by Moody’s and Standard & Poors.

AAA? You were wooed Mr. Moody’s and Mr. Poor’s by the makeup, those six-inch hooker heels, and a “tramp stamp.� Many of these good looking girls are not high-class assets worth 100 cents on the dollar.

He continues that the problem lies not with the valuation of the CDOs and paper-valuations but with the millions of homes and subprime mortgages that are attached to them. The homes empty, the loans set to adjust “skyward” are all the ingredients for a perfect asset-based financial derivative meltdown.

Those that point to a crisis averted and a return to normalcy are really looking for contagion in all the wrong places. Because the problem lies not in a Bear Stearns hedge fund that can be papered over with 100 cents on the dollar marks. The flaw resides in the Summerlin suburbs of Las Vegas, Nevada, in the extended city limits of Chicago headed west towards Rockford, and yes, the naked (and empty) rows of multistoried condos in Miami, Florida. The flaw, dear readers, lies in the homes that were financed with cheap and in some cases gratuitous money in 2004, 2005, and 2006. Because while the Bear hedge funds are now primarily history, those millions and millions of homes are not. They’re not going anywhere…except for their mortgages that is. Mortgage payments are going up, up, and up…and so are delinquencies and defaults.

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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. If delinquencies lead to defaults and then to lower home prices, then we have problems…

Mr. Gross continues with his assessment that these delinquencies and defaults will ruin the liquidity of the Wall Street firms tied to the CDOs. That reduced liquidity will impact their ability to lend on other credit and other financial derivatives. This will impact the U.S. economy in untold ways.

Folks the point is that there are hundreds of billions of dollars of this toxic waste and whether or not they’re in CDOs or Bear Stearns hedge funds matters only to the extent of the timing of the unwind. To death and taxes you can add this to your list of inevitabilities: the subprime crisis is not an isolated event and it won’t be contained by a few days of headlines in. And it will not remain confined to a neat little Petri dish in some mad financial derivative scientist’s laboratory. Ultimately through capital market arbitrage it will affect risk spreads in markets completely divorced from U.S. housing.

PIMCO has been bearish on housing in recent commentary but this one is so strongly worded and well reasoned that it is almost chilling.  I highly recommend that anyone up in the air on whether the subprime meltdown will impact the economy and other credit grades read this paper.

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