'Deepening debt crisis hits close to home'(ZT)

"Deepening debt crisis hits close to home"	ray_heritage	NEW 7/1/2007 4:59:18 PM
JimJubak quote of the day: "If the bond market does indeed suffer ameltdown, it will be brought down by things called CDOs and CLOs". "Who'slikely to get badly hurt as the subprime lending crunch assaultsvarious pools of high-risk debt? Pension funds, mutual funds and othervictims shockingly close to your wallet. Jubak's Journal (excerpts) IfI hear one more money manager who loaded up on subprime mortgages orbuyout loans say "don't worry," I'm going to tear the rest of my hairout. - Don't worry about rising numbers of subprime mortgagesgoing into default, they say, it's not going to hurt the portfolios ofpension funds, college endowments, mutual funds, insurance companies,etc. - Don't worry that the bonds issued by companies buried under a mountain of buyout debt will go into default. Intruth, either these professionals don't know what they're talking about-- which I believe is true in a number of cases -- or they'redeliberately trying to sell happy endings in the hope that they can getout with their skins intact. Bondos Insured? -"...insurance has its limits. For example, no one ever insures againstthe worst possible storm that they can imagine. It's simply tooexpensive to take out coverage for such a low-frequency event. - "...they hope that history is a reliable guide to the future and thatthey won't get hit with a 100-year storm when they've insured for a20-year storm. Or clubbed by two 100-year storms a few years apart. Orby a storm that's worse than any on record." Two very bad things Sothink about what happens when, instead of the 20-year storm you'veinsured for, a 100-year storm hits. The insurance gets overwhelmed, andthe rest of the CDO is suddenly much riskier. This is exactlywhat has happened in the market for pools of debt built on subprimemortgages. The default rate for these mortgages -- loans to homebuyerswith shaky credit histories that were often made with cursory or noexamination of the borrowers' financial conditions -- has soared. - The delinquency rate climbed to 13.8% in the first quarter of 2007from 11.5% in the first quarter of 2006, according to the MortgageBrokers Association. Foreclosures hit 147,701 in April 2007, up 62% from April 2006 That's more than enough to stress the equity-tranche-insurance level of these debt pools. - A 3% to 5% decline in a CDO as a whole, estimates Grant's InterestRate Observer, would be enough to destroy the insurance of the equitytranche -- remember it bears the brunt of the first losses -- andthreaten the BBB slices of the CDO. Once that insurance is breached, two very bad things happen. - First, the investors who elected to buy the equity tranche, attractedby the possibility of an equitylike return on a fixed-incomeinvestment, get killed. And unfortunately, those big losses won't belimited to Wall Street or to the sophisticated investors in hedge funds. - And second, after the insurance is stripped away, the prices ofhigher-rated slices of the debt pool start to tumble to reflect thatgreater risk. Some windshield. Some fly Last year,global sales of CDOs hit $503 billion. In 2006, sales of CLOs broke$150 billion. We've just started to see a massive re-pricing of all thedebt in those massive pools. And with the insurance splicesstripped away -- or on the way to being stripped away -- investors whowere counting on safety because they owned a pool of this debt arelikely to discover that they own a pool in which pretty much everythingis falling in price.