Ilargi: Subprime is Back With a Vengeance

Yves here. While it remains an open question as to whether frenzied efforts to push investors even further out on the risk limb will come to fruition, the fact that so many measures are underway looks like an officially-endorsed rerun of early 2007. If the Fed indeed raises rates in the not-insanely-distant future, getting into subprime and other speculative credits is a quick path to losses. But even if the Fed and other central banks remain super-dovish, risky borrowers can and will go tits up independent of interest rates. Credit risk is not the same as interest rate risk, but the inability to get any return for the latter is producing an extreme underpricing of the former.

By Raúl Ilargi Meijer, editor-in-chief of The Automatic Earth. Originally published at Automatic Earth

A few days ago, I wrote an essay about how ECB head Mario Draghi seeks to redefine the definitions of certain words and terms, like the one that define financial instruments, because he needs to find hundreds of billions in new spending money in Europe without adding to the behemoth existing debt (Germany won’t let him do that). And yes, that is indeed as impossible and meaningless as you think it is. But these are desperate times.

Thing is, I called that essay Draghi To Save Europe With Semantics, and maybe I shouldn’t have, because it’s obviously not the most sexy and catchy title on the planet, but my problem there was, it captures what I was talking about. And it’s all much broader and bigger than that, but then that’s what the article tries to explain.

Moreover, the financial press also catches up. To the fact that semantics and re-defining are the flavor du jour, once again, just like they were in 2005-6-7. When ratings agencies used the confusion about what things actually mean to stamp AAA ratings on everything including your kids’ snot nose tissues and toilet paper. And that is an important development, if you care about preserving some of your remaining wealth. Which I think you’d like to do, so please bear with me.

Three months ago, Tracy Alloway stated the obvious at FT:

Doubts Raised Over Rating Agency Reform

Fitch, one of three big rating agencies, this week criticised credit ratings given by its competitors to a securitisation containing a loan secured by the Westin – the latest instance of agencies sparring with each other over so-called structured finance deals. Such deals bundle together a wide variety of loans into bonds that can be sold to large fund managers who use the evaluations of credit rating agencies to help inform their investment decisions.

Typically, these opinions are paid for by the financial firms that create the deals. But, since the financial crisis, regulators have encouraged credit rating agencies to give “unsolicited” opinions on deals that they are not hired to evaluate, as part of an effort to avoid the “ratings shopping” that proliferated before 2008.

However, as the rating agencies trade public barbs amid a resurgence of certain types of structured products, questions are being raised as to whether these unsolicited opinions actually have much effect on investors’ thinking. And are the banks that securitise loans simply taking their deals to the agencies likely to give them the highest ratings?

Translation: nothing has changed. The ratings agencies are too powerful, because the parties that pay them to issue ratings pay them too much to get rid of or even reform.

Which seamlessly takes us to Tracy Alloway today:

‘Ratings Shopping’ Makes A Comeback In The US

Sales of subprime mortgage bonds have withered since the financial crisis, but fresh concerns are arising as issuance of some other types of securitisations surges. Sales of bonds backed by loans used to finance car purchases undertaken by the least creditworthy borrowers have reached pre-crisis levels in the US, prompting a Department of Justice investigation. While losses on subprime auto asset-backed securities (ABS) remained low during the crisis, there are concerns that new specialised lending companies are making riskier loans which are then being bundled into the bonds.

Fitch Ratings has been hired to rate only four of the 29 subprime auto ABS deals sold so far this year, after telling issuers that the vast majority of the bonds did not deserve the triple-A ratings reserved for the highest-quality credits. Fitch – one of the “big three” agencies alongside Moody’s and Standard & Poor’s – warns that a flood of new entrants into the subprime auto lending market are lending to riskier borrowers as they seek to establish a foothold in the market. The creators of such securitisations typically pad the debt with extra cash or introduce other safety features – known as “credit enhancement” – to generate higher ratings on bonds comprised of riskier loans.

“The idea that recent loss history plus credit enhancement ‘heals all wounds’ can be short-sighted,” said Kevin Duignan, global head of securitisation at Fitch. “It’s often last one in, first one out in subprime.” He added: “We believe the risks associated with small lender sustainability are being underestimated by the market and some other rating agencies.”

US sales of commercial mortgage-backed securities, or CMBS, have also staged a recovery with $102bn worth of the deals sold last year – the highest amount since the $231bn issued in 2007, according to Dealogic data. At the same time, some market participants have been warning that the quality of the loans that underpin the bonds – typically secured by shopping malls, office buildings and other commercial properties – has been slipping.

You don’t have to be particularly smart to see here this is going. The floodgates are open, once more, and nothing at all, other than semantics and lip service, has been done to make them more secure. Because that would risk the flow of credit, which is the same as debt, and today gets habitually mistaken for money.

The boys in the banks are at it again, and this time their biggest supporters, if not clients, are central banks and treasury departments. If they can bring down investment requirements for pension funds enough from AAA, and they can at the same time – once again – label mezzanine (aka subprime) tranches of complex instruments ‘AAA’, they got it made. How can you go wrong when you have Mario Draghi himself begging you to to play this game?

Germany refuses to allow Draghi to buy sovereign bonds and add to the taxpayers’ risk, but what if you can simply shift it all to pension funds by moving the goalposts on what AAA really means?

We went through this 2007-8, and it ended badly, but apparently it’s just too tempting to leave alone. What is there to say? Insanity takes on entirely new proportions. It’s not just doing the same thing time and again, and expecting a different outcome, it’s doing the same thing and pretend it’s something new, because you give it a different name.

So now we get this concerted effort, the central banks are involved, the ratings agencies are too, to just about force pensions funds, the only store of real wealth left on the planet, to put their trillions into opaque and extremely risky instruments. Because Mario Draghi needs to find money, or whatever we should label it.

Draghi’s ABS-Market Revival Set for Boost From Global Regulators

Mario Draghi is trying to rebuild the market for asset-backed securities in Europe. Global regulators are set to lend him a hand. The International Organization of Securities Commissions will present criteria for marketable ABS to finance ministers from the Group of 20 nations this week, said Chairman Greg Medcraft.

Iosco wants to help create standards that would encourage non-bank investors to buy. A broader ABS market could improve companies’ access to financing and spur growth. That’s the goal behind the European Central Bank’s plan to purchase “simple and transparent” bundled securities with underlying assets including residential mortgages, Draghi said this month. “What we’ve done is develop criteria of what we consider to be simple, transparent and consistent securitization,” Medcraft said. “We’re looking at providing a framework that actually assists the market.”

The European market for ABS, like that in the U.S., was brought close to extinction in the financial panic of 2008, which was fueled in part by banks taking heavy losses on securitized U.S. subprime mortgage debt even though the tranches they held had been considered high quality. It has been slow to recover. Draghi said on Sept. 4 that the ECB will buy senior tranches – the least risky – of simple and transparent packaged securities. “We want to make sure that these ABS are being used to extend credit to the real economy,” he said.

[..] Medcraft said ABS in the right hands is a “fabulous technology.” “You look at the U.S., the auto-loan sector is booming in securitization,” he said. “I think the market is maturing, but it’s about winning back investors. We don’t want to regulate it. We want to provide a nudge.”

“ABS is a fabulous technology”. As we saw in 2008. Absolutely Fabulous. “The auto-loan sector is booming in securitization”, says one of the Three Stooges. And yes, US subprime auto loans are way up. True enough. Whether we should be happy about that is an entirely different story. It’s still subprime, homes or cars. You’re still lending to people with a huge risk that they can’t pay you back. Because they may be fired from their jobs as burger flippers. But yeah, until they are, the numbers look good.

That’s what Draghi’s policy is, going forward: squeeze the money Merkel won’t let him create out of thin air, out of fixed income, by moving the goalposts on definitions and semantics. It’s a poor man’s game played by one of the world’s post eminent central bankers, and all the rest, the ratings agencies and Wall Street banks, just play along. Draghi gives credence to anything they do. He’s a desperate man.

And by the way, the excesses and insanity of cheap credit don’t stop there either.

Banks See ‘Art of Possible’ in $100 Billion Deal

One year after pulling off the largest bond offering ever, Wall Street debt underwriters are pitching their clients on the possibility of something even bigger.

With investors clamoring for higher-yielding assets and companies on the biggest acquisition spree since 2007, bankers are talking up the ability of credit markets to fund a “mega deal” that Citigroup Inc. says could be backed by $100 billion or more of financing. That’s stoking speculation debt investors stand ready to fund potential takeovers such as a purchase by Anheuser-Busch InBev of rival beermaker SABMiller.

“We are prompting issuers to think outside of the box – in terms of the art of the possible,” said Tom Cassin, co-head of investment-grade finance at JPMorgan, the biggest underwriter of corporate bonds worldwide. “We have got clients that are certainly intrigued by it and interested in it.”

Bankers are pitching the “mega deal” even as investors brace for the 30-year rally in bonds to come to an end. They are telling companies that after fueling $18 trillion in corporate bond sales globally the past six years, including single deals bigger than the gross domestic product of countries from Slovenia to Iceland, appetite isn’t tapering.

Investors have poured about $49.4 billion into mutual funds that buy taxable bonds this year after pulling $20.6 billion in 2013, according to the Investment Company Institute. The added cash has helped shrink the extra yield that investment-grade debt worldwide pays above government securities by 15 basis points to 109 basis points, or 4 basis points from a seven-year low, according to Bank of America Merrill Lynch index data.

I doubt that anyone will have any trouble understanding what this is, and where it goes. The whole shebang is busy re-interpreting and re-defining until there are no more legal barriers for your pension money to be ‘invested’ in subprime loans packaged in ‘securities’ of whatever shape and from. So some trader in the Hamptons can make more wads of cash, through ultra low rates, off of beer brewers buying each other where they would never even have thought of that that at normal interest rates.

This is where our economies are perverted. It’s the final excesses and steps of a broke society. It’s madness to the power of infinity. The only thing that’s certain is that in the end, your money will all be gone. That’s how Mario Draghi ‘saves’ the EU for a few more weeks, and that’s how the big boys of finance squeeze more from what little you have left (which is already much less than you think).

A world headed for nowhere.

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  1. Moneta

    Moral hazard. We heard about it when the bailout were delivered but it evaporated as soon as the green chutes appeared.

    How can you distribute trillions within a few quarters to the same ones who blew up the system and expect miracles?

    We don’t need to be rocket scientists to know this rebound is running on fumes.

  2. John

    The ghost of austerity still lurks at every national capital. Whatever the ECB does it will be insignificant to the underinvesting the rest of the euro zone is forcing down everyone’s throat.

    Taxing the rich to fund domestic program has turned out be futile. France tried it and all the rich people headed towards Belgium to escape the wealth tax. So Mr ECB can’t tax the rich deposit holders so he is trying something that is going to make matters that much worse and he knows it.

    The problem we have is there are too few euroscetics. Anytime one does rear their head they are usually an extremist. We are stuck with the likes of LePen — a dynasty built on bigotry and racism.

    Yep, we are tango uniform. :-(

  3. James Levy

    Earth to Economists: raise wages!!! You are all trying to save a starving man by shoving food up his ass rather than in his mouth–the demand is generated at the other end, sparky. It does no good down there.

    But, no, of course, the Power Elite, or PTB, or whatever you want to call these greedy fiends will do anything but give the workers money so they can buy things and we can go back to making profits off of production instead of rents off of speculative “instruments.” It seems the much-vaunted profit motive no longer motivates. Profits are for losers who don’t make money off of playing with money. Real men speculate! Turning out commodities for the market is so 19th century bourgeois. The Masters of the Universe exploit the churn.

    1. NotTimothyGeithner

      Economists are 21st century priests. They exist to provide distraction from the obvious solution which is raising wages for the masses and capping hoarding.

    2. fresno dan

      “You are all trying to save a starving man by shoving food up his ass rather than in his mouth–the demand is generated at the other end, sparky”

      I think that is the best analogy I have ever seen!

  4. David in New York

    The math for rating agencies and structured deals is simple. Wall Street banks can sell most deals with two ratings, so the rating agency with more conservative standards always gets shut out.

    So when JPMorgan wanted to further emasculate its reps and warrants on its RMBS deals, it used Fitch and Kroll. For once, Moodys and S&P said they would not go along.

  5. Larry

    TINA. There is no alternative. Functional investment in growth and opportunity is just not attractive to capital now. Mergers and acquisitions to ensure the establishment of monopolies and reduction in labor redundancy, that is the rage. Why should SABMiller and InBevAB compete, when they can just monopolize the markets? Why should Astra Zeneca and Pfizer compete, when they can just monopolize?

    It’s amazing to me how long the con can go on.

  6. Jim A.

    I know I keep pounding on my little drum here, but pooling and tranching are ALL about the correlation of the underlying risk. Let’s say that you’re an insurance company (insurance is similar because in principle it uses the same method of managing risk through aggregation) If you’re selling renter’s insurance to apartment owners, there is a HUGE difference between selling 100 policies all in the same building and selling 100 policies in different building across town, even if the chance of paying out on individual policies is the same. But the chance of one apartment building burning down is far greater than the chance of 100 different apartment building burning down. In the former case you’re going out of business because there’s no way that the policy payments cover the cost. In the latter case, you can figure that no more than one or two will burn down, sock some premium money away to pay for that, and the rest if profit. LOTS of money was made by the banks and then lost by investors during the RE bubble and bust when people treated well correlated risks as if they were poorly correlated: pooling a bunch of bonds that would all go bad only if there was a nationwide decline in RE prices or mortgage defaults. These were well correlated risks and pooling them does NOTHING to manage the risk of default.

    1. Yves Smith Post author

      Before the crisis, real estate prices had never been strongly correlated across the nation.

      Your comment is hindsight bias. Your argument about correlation would have been seen as arguing for RMBS investment prior to the crisis.

      Now having said THAT, in the toxic phase of subprime (3Q 2005 through July 2007) you could see on the ground the complete abandonment of normal underwriting had one bothered to look. So that meant historical norms were out the window. But as we explained in ECONNED, the operation of heavily synthetic CDOs drove demand to the worst mortgages. It’s as if you had an arsonist in charge of home insurance underwriting. But again, normal correlation risk thinking wouldn’t allow for that possibility.

  7. Doug Terpstra

    This post correlates ominously with a prior Ilargi post:

    The “Fed” knows the US economy is dead. They’re operating a gigantic Ponzi pump-and-dump to lure in the big investors, including pension funds, who only think they’re club insiders who will get the tip-off when the time comes. In fact, they’re the final chumps intended to make cartel members solvent. Picture Detroit on a national, global scale.

    This time it will be impossible to claim well-intentention stupidity (hoocoudanode), or that banks were victims of low-income tricksters. This is The Big Sting, massive fraud orchestrated wholesale by central banks, cartel member banks, and ratings agencies, likely in collusion with regulators and Eric Holder’s Ministry of Justice. The usual propaganda campaigns won’t cover this. Catastrophic war is the most likely ruse to mask the real players in this sting, and the obvious setup for that and global dominion seems to be too eerily timed to be coincidental.

    1. Ulysses

      “This is The Big Sting, massive fraud orchestrated wholesale by central banks, cartel member banks, and ratings agencies, likely in collusion with regulators and Eric Holder’s Ministry of Justice. The usual propaganda campaigns won’t cover this. Catastrophic war is the most likely ruse to mask the real players in this sting, and the obvious setup for that and global dominion seems to be too eerily timed to be coincidental.”

      Very well said!

      The Ferguson incident, like the Boston Marathon affair, gave the kleptocrats a nice opportunity to show the proles what kind of fire-power they have up their sleeve– should people begin to actively resist the system. Our best hope is to turn the Praetorian Guard (who are, after all, proles as well) against the empire. Otherwise, our neo-feudal future looks bleak indeed. Still, the sanest response to a world– dominated by psychopaths trying to make you afraid– is to lose your fear, and organize with other decent people to construct a humane alternative to the status quo.

      1. Doug Terpstra

        Thank you for this: ” the sanest response to a world–dominated by psychopaths trying to make you afraid– is to lose your fear, and organize with other decent people to construct a humane alternative to the status quo.”

        That’s so vital when a sense of dread, doom, and outrage overwhelms us in the presence of manifest evil. Now, instead of an FDR to inspire us and exhort our courage, we suffer a Fearmonger-in-Chief, warning us of imminent threats … everywhere … and even worse, threats that he and his henchmen, including Israel, have directly created.

        So fear itself is a big threat, but for me, it’s twin or offspring, anger, often burning anger (maybe a convenient mask for fear) can also be a powerful total-paralytic if not understood or constructively channeled. Along with instilling fear, I’m certain that major con-components of these psychopaths’ propaganda campaigns are goading and stoking unfocused rage, which often blinds us into divisive conflict, impotent isolation, or quiet desperation. I think that’s what most duopoly political theater is really aimed at, not that it’s all explicitly scripted, though much is, but it’s become the perverse go-to dynamic that all “players” instinctively role play to secure the spotlight and retain power. The PTB/MOTU thrive on confict, on war as well as political enmity. So maybe we could expand FDR’s exhortation to: “the only thing to hate is hate itself!”

  8. QuarterBack

    Just to be clear that the next subprime mortgage crash will be no accident, I encourage readers to look at H.R. 5148: Access to Affordable Mortgages Act, which includes provisions to exempt certain “higher-risk mortgages” from property appraisal requirements. What could go wrong?

    There is a property near mine that is an abandoned foreclosure hulk that has been stripped of copper and even the front door. It also has spray painted swastikas and a garbage pile you can see on google earth. I know that several locals have tried to purchase the property, but BoA refuses to sell it for less than the full loan amount (about $200K more than its current value). My guess is someone at BoA had the foresight to know that future legislation would eventually allow them to stuff this property (and 10,000 others just like it) into bundles of investment MBS at full value without the ‘wasted’ expense of an appraisal (after all, it’s been on their books for so long no need for an appraisal).

    ZeroHedge has a good piece on HR 5148 here:

    1. GuyFawkesLives

      Rep Blaine Luetkemeyer is the sponsor of this bill. His bio shows, of course, that he is a BANKER.

  9. jal

    “Taxing the rich to fund domestic program has turned out be futile. France tried it and all the rich people headed towards Belgium to escape the wealth tax. So Mr ECB can’t tax the rich deposit holders so he is trying something that is going to make matters that much worse and he knows it.”

    The rich are the only ones with money and cash flow in their name/control.
    The rich are the only ones that can rejuvenate, save, or extend the life of the soial economic system.

    There is no need to “tax” or force the rich to keep the system going.
    Their wealth depends on the functioning of the system. The rich will keep the system functioning . However, it does not mean that they will make the right decissions for you or your part of the system.

  10. Vatch

    Santayana warned us that “Those who cannot remember the past are condemned to repeat it.”. But in these cases, the past events are so recent, everyone still remembers them. The subprime hucksters aren’t being condemned to repeat the past — they’re doing so eagerly, since there’s so much money to be made from the world’s suckers. The big question for me is: why are the suckers buying these things? Surely nobody has forgotten the subprime meltdown yet !?

  11. ex-PFC Chuck

    I’ve sent the link to this post to my small-town-Minnesota car dealer friend, asking him if he’s seen riskier people qualifying for car loans in his dealership. I’ll pass on his response when I get it.

    1. ex-PFC Chuck

      From my friend::
      We are experiencing more people looking for this type of financing. Also, the banks that do this financing are coming out of the woodwork.
      I don’t like doing this type of business and shy away from it.

  12. MyLessThanPrimeBeef

    Draghi to save Europe with Semantics…not sexy, not catchy?

    How about ‘Draghi to Save Europe with Anti-Semantic* Policy?’

    *Anti-Semantic as in devoid of meaning, not to be confused with anti-Semitic.

      1. MyLessThanPrimeBeef

        I am not Ms. Doubtfire, but I am certain even in Israel, there are plenty of anti-semantics engaging in meaningless policies.

  13. Louis

    Does anyone know what the consequences are when the auto sub-prime blows up? Will it sort itself out quietly or will we have to suffer through political theater–and subsequent bailouts–similar to what happened in 2008?

    1. MyLessThanPrimeBeef

      I don’t know but I do know

      1. We should not hand out loans to people who are not qualified to borrow, instead of blaming borrowers.
      2. We should not hand out money to politicians (politicians are people too) who are not qualified to spend.

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