How the subprime problems here affected retirement funds in Japan?

August 19, 2007

There’s a very interesting article from John Mauldin at investor insight.

I’m going to be honest. I didn’t understand 100% of what he said, but even without all the details, I could better understand what happened to the market and how it was affected by the problems with the subprime loans and how it affected even Retirement Plans in Japan.

Unlike what I had originally (and simplistically) thought, it’s not simply a problem of liquidity, but more of a problem of credibility.

I’m going to try to summarize (as best as I can) his article.

Credit agencies can package their loans and resell them to minimize their risk. These include mortgages, car loans, commercial mortgages or bank loans. These packages are divided into 5-7 (or more) groups called tranches.

Who would buy these loans? Investment institutions. However, they need a way to assess risk, so they go to a rating agency and pays them a fee to rate that tranche in terms of risk (AAA for the best rating, AA for the second best, and so on). The lower the grade, the higher the rate. Similar to corporate bonds.

Now insurance companies, pension funds and other investment institutions can buy this security that has a higher yield than regular government bonds.

However, the problem lies with suprime-rated paper. In 2004, loan practices began to change. Loans had teaser rates that didn’t even require proof of income. We all know that the sub prime market all jumped into adjustable rate loans.

In 2005-6, about 80% of subprime mortgages were adjustable-rate mortgages, or ARMs, also called “exploding ARMs.” These loans are so-named because they carry low teaser rates that often reset dramatically higher, increasing the borrower’s monthly mortgage payments by 25% or more.

In addition to these bad loan types, mortgage companies were not even checking applicant’s income. They would trust whatever value they filled in the form.

“According to reports from loan counseling agencies across the nation, the main reason homeowners give for falling behind on their mortgage payments is not a change in personal circumstances (such as a job loss), but instead, they are not able to make the increased payments on their ARMs.
“The loan application and review process for ‘no-doc’ loans was so lax that such loans are referred to as ‘liar loans.’ In a recent report by Mortgage Asset Research Institute, of the 100 loans surveyed for which borrowers merely stated their incomes on loan documents, IRS documents obtained indicated that 60% (!) of these borrowers overstated their incomes by more than half.
“The newer mortgage products, such as ‘piggyback,’ ‘liar loans’ and ‘no doc loans’ accounted for 47% of total loans issued last year. At the start of the decade, they were estimated to be less than two percent of total mortgage loans. As a result, homeowners have never been more leveraged: the average amount of debt as a percentage of a property’s value has increased to 86.5 percent in 2006 from 78 percent in 2000.”

But that’s not the real problem. According to Mauldin, the real problem was bad rating practices.

In an effort to make it easier to sell the lower-rated tranches, the investment banks put together a Collateralized Debt Obligation (CDO) composed of just the BBB-rated paper. And then got the rating agencies to give 75% of that paper an AAA rating! So we have turned 75% of BBB waste into gold with the alchemy of ratings.

This caused a lot of securities rated AAA that were in reality just junk mortgages.

And how this affects Retirement Funds in Japan?

In Japan, bonds return barely 1%, so in order to maximize their yield (we know the feeling), they buy these papers.

If you are a hedge fund, you borrow massive amounts of Japanese yen at 1% and invest in higher-yielding investments and make the spread. Life is good. The trade goes on and on.

As you can see, the market is so globalized nowadays that problems in any of the major global economies will ripple throughout the world.

That was indeed a really interesting article to read.

Posted in Finances, Investment