Savers Beware: What Are Your Underlying Assets?

06.16.08 | Money | 0 Comments | by Fred Siegmund

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There was a time when it was common for corporations to create long lived assets with borrowing. It may take several years to build a steel mill or a power plant before there is something to sell, but loan or bond payments will come from revenues and the economy will have more steel, more electricity and more assets.

Banks, or financial intermediaries as they are called now, are still happy to make loans for plant and equipment. Trouble is there are more loanable funds to loan than borrowers willing and able to borrow for long lived assets.

As a result, banks make more consumer loans that support consumption spending like credit card debt. Loans that support consumption helps support jobs and the economy and provide an outlet for savers looking to earn interest income. However, credit card purchases like vacations, housewares and clothing have little value as security for credit card balances.

The home mortgage should be a secure loan because a home is a long lived asset. It used to be that Savings and Loans would make mortgage loans at 6 or 7 or 8 percent interest and the home would be the asset in case of default.

Lenders with home mortgages on their books could sell their mortgages if they needed to raise cash but they would tend to hold them to maturity, earning a steady income. In case of selling a mortgage it would usually be sold to another financial institution such as the Federal National Mortgage Association.

That changed when adventurous money managers started to buy thousands of mortgages and bundle them for resale into something like to a bond that pays interest on invested principal. They call them collateralized mortgage obligations (CMO) or collateralized debt obligations (CDO). In that way, mortgages could be resold to smaller investors who would not normally be willing or able to buy individual mortgages.

What is important to notice though is that repackaging and reselling mortgages does not create new assets. Reselling mortgage credit means more transactions that allow money managers to charge management fees and potentially make money with price fluctuations in CDO prices.

Bear Stearns held collateralized debt obligations in their hedge fund, but apparently so many of the underlying mortgages were to people who were sub prime borrowers that defaults set off a chain reaction. Since Bear Stearns borrowed money to buy collateralized debt obligations for their investors, they defaulted on their loans and threatened the solvency of major banks.

With so many new ways for money managers to attract savers, it is more important than ever to notice the underlying assets and ability to pay.

Did Bear Stearns investors know so many of the underlying assets were sub prime loans? Savers beware!

Fred Siegmund covers America's jobs as part of work doing labor market analysis and projections for a client base of recruiters, trainers and counselors. Visit him at www.americanjobmarket.blogspot.com

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