The 1987 Crash -- a Dress Rehearsal?

On Oct. 19, 1987, a.k.a. Black Monday, the Dow dropped by 508 points, or 22.6%, making it one of the worst days in stock market history. For that to occur again today, the Dow would have to decline by more than 2,600 points. A decline of such magnitude seems highly unlikely, but if mortgages continue to deteriorate at such an accelerating pace, the result could make Black Monday seem like a dress rehearsal.

Suddenly, many supposedly smart individuals are starting to realize that they did not understand the risks of the structured deals they were involved in. Look no further than Merrill Lynch (NYSE: MER  ) to see what I mean.

Merrill Lynch has become ground zero when it comes to mortgage problems. It holds the record for the largest write-down in the financial world: some $8.4 billion. This loss is even more shocking because several weeks ago the firm predicted that total writedowns would equal $4.5 billion.

Oops. They were off by some $3.4 billion. I for one believe that the brass at Merrill is a rather intelligent group, but when it comes to the bundling, re-bundling, and re-re-bundling of pools of mortgages, it's about impossible for anyone to truly understand the risks involved. A close look at one deal reveals just how toxic and tainted they are.

Meet GSAMP Trust 2006-S3
By most measures today, this $494 million securitized pool of second mortgages was a drop in the bucket of the nearly half trillion dollars or so of mortgage-backed securities issued in 2006. GSAMP was sold by Goldman Sachs (NYSE: GS  ) and originally stood for Goldman Sachs Alternative Mortgage Products.

GSAMP comprised more than 8,000 second-mortgage loans, or loans taken as collateral for your first mortgage. In other words, the equity in the first mortgage was being funded by another mortgage. The average real equity in this pool of loans was 0.71%. The loan resembled more than 99% of the value of the home.

On top of that, 58% were no-documentation loans. To bring this all home: For almost no money down and no proof of income, you could own a $250,000 home. How easy is that? You can see why borrowers were in such a hurry for the loans. You were essentially buying a house with no money at risk. If home prices rose, you were fine. If prices fell and you were unable to make your payment, well, you just walked away having lost virtually nothing out of pocket.

Let the games begin
To sell this batch of mortgages, the issuer (in this case Goldman) pooled them and sliced them into tranches, or various pieces, to satisfy every investor's desire and appetite for risk. The top tranche is assured of first payment and is given the coveted AAA rating. On down the line we go, with each subsequent tranche being paid next, receiving a lower rating, and a higher interest rate. Just like that, a security is backed by mortgages taken out by individuals who have zero incentive to make mortgage payments that would back the securitization pool, and it is rated AAA. Leave it to Wall Street to take a toad and dress it up as a prince.

The next question is: How could the sophisticated buyers of securities such as the GSAMP Trust know how safe and sound they are? There were two ways: either read the several-hundred pages of the prospectus and related documents, or rely on the credit rating agencies -- Moody's (NYSE: MCO  ) and Standard & Poor's, which is a unit of McGraw-Hill (NYSE: MHP  ) .

Guess which option was used just about every time. Even if investors choose to read through the documents, they still didn't get all the facts, because most issuers don't reveal borrowers' identities. So the rating agencies didn't have all the information either.

While the individual loans in the Goldman pool were toxic, 68% of the issue was rated AAA by both rating agencies. Apparently, issues backed by second mortgages of subprime borrowers were as secure as U.S. Treasury bonds.

To be fair, this particular securitization was one of the worst. But with $500 billion in mortgages issued last year alone, there are probably many of them that are not far behind the GSAMP Trust. They are set up so investors cannot value them appropriately. Nor can the rating agencies.

And given the $3.5 billion margin of error at Merrill Lynch, it appears the companies themselves can't accurately measure the extent of risk of these securitized pools. It is not difficult to see how Buffett dubbed derivatives "financial weapons of mass destruction."

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