Opher BanarieMortgage Collapse - Part 1
June 19th 2008 17:17
Earlier today two former managers of Bear Stearns hedge funds were arrested by Federal prosecutors. The New York Times reports that indictments will be detailed later today.
The collapse of the two funds managed by Ralph R. Cioffi, 52, and Matthew Tannin, 46, are thought to have signled the begining of the credit crunch that has caused billions of dollars of losses in investments and eventually the take-over of Bear Stearns by J.P. Morgan.
The NY Times article continues with some speculation about the likelihood of these two going to jail over their management of the funds. I think there is another issue that is being ignored both by the Times and by the prosecutors: What could they reasonably have been expected to know?
Most mortgages are sold by the originators as "packages" to investors. This means that hundreds or thousands of individual mortgages are bundled together. The credit and terms of the individual loans are aggregated and presented to investors. Within the package it would be reasonable to expect that some borrowers are more able to repay their loans than others; that some loans would be more profitable (ie, higher interest rate) than others; that terms would be more stringent than others.
The investors buy the package at a discounted amount based on the expected risk and interest rate of the package. So a package of $10 Million face-value mortgages might be bought for $8 Million, or $4 Million or $2 Million, etc. based on the varying characteristics.
The individual package may itself be bundled with other packages and presented to another group of investors and the cycle repeats, with a few additional zeros in the total value of the new bundle.
The Bear Stearns funds might have purchased packages that had been through three or four (or more!) rounds of such sales. Would the managers know how much risk individual loans represented in the overall investment? How could they?
And that's only half of the issue. See the next post for the continuation of this topic.
The collapse of the two funds managed by Ralph R. Cioffi, 52, and Matthew Tannin, 46, are thought to have signled the begining of the credit crunch that has caused billions of dollars of losses in investments and eventually the take-over of Bear Stearns by J.P. Morgan.
The NY Times article continues with some speculation about the likelihood of these two going to jail over their management of the funds. I think there is another issue that is being ignored both by the Times and by the prosecutors: What could they reasonably have been expected to know?
Most mortgages are sold by the originators as "packages" to investors. This means that hundreds or thousands of individual mortgages are bundled together. The credit and terms of the individual loans are aggregated and presented to investors. Within the package it would be reasonable to expect that some borrowers are more able to repay their loans than others; that some loans would be more profitable (ie, higher interest rate) than others; that terms would be more stringent than others.
The investors buy the package at a discounted amount based on the expected risk and interest rate of the package. So a package of $10 Million face-value mortgages might be bought for $8 Million, or $4 Million or $2 Million, etc. based on the varying characteristics.
The individual package may itself be bundled with other packages and presented to another group of investors and the cycle repeats, with a few additional zeros in the total value of the new bundle.
The Bear Stearns funds might have purchased packages that had been through three or four (or more!) rounds of such sales. Would the managers know how much risk individual loans represented in the overall investment? How could they?
And that's only half of the issue. See the next post for the continuation of this topic.
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