Just Passing Through

When Wall Street names one of its fabulous concoctions “a technology,” hindsight tells us we should be wary. This is the term the Street has applied to collateralized debt obligations, or CDOs. These securities are complex packages of mortgages that have been carved up and sold to investors as a series of cash flows, each with its own credit rating. The problem is, many of these CDOs were funded by low-quality home mortgages, and the high ratings given to many of them have proved false.

As a result, CDOs have contributed to the so-called credit meltdown that has been roiling both the bond and the stock markets over the past several months. And if you think things have been bad in 2007, they could be getting worse in 2008, according to David Land, a bond-fund manager at Advantus Capital Management in St. Paul, which manages more than $700 million in mortgage-backed securities. (His company doesn’t deal in CDOs.) We checked in with Land to see if there really is cause for pessimism for the upcoming year.

{Q} How big is the subprime mortgage market?

{A} That’s an interesting question. We have seen estimates range from a low of 8 percent of the overall mortgage-backed bond market to a high of 15 percent. It ranges based on the analyst you talk to. Some people look at the securitized market. Some people look at the total home market, which includes people who don’t owe any debt on their houses—which is about 35 percent. But if you look at the total securitized market—all the mortgage-backed securities—it’s between 8 and 12 percent.

{Q} That’s not a large percentage. Why has there been such a strong reaction?

{A} The subprime mortgages that were originated in 2005 and 2006 largely went to hedge funds that used borrowed money to buy the mortgages and CDOs. If you were to look at the portfolios we own—the triple-B grade securities—we own only three triple-B securities, and they were originated in 2001, 2003, and 2007. At Advantus, we like to own securities where somebody has demonstrated the ability to pay.

{A} CDOs first came out in the mid- to late ’90s, and they used high-yield bonds, which were then carved up, and the rating agencies issued a credit rating on pieces of those bonds. They reasoned that a certain percentage of the cash flows—namely, the interest and principle payments—were worthy of a triple-A rating, even though the underlying collateral was triple-B. So what they did is rate some portion of the package triple-A, another double-A, then A, then triple-B, and so on, all the way down the structure. More recently, Wall Street began to take home mortgages and do the same thing, using low-rated home mortgages as the underlying collateral.

{Q} What went wrong?

{A} There was such demand for these securities and the yield they were generating that it’s not clear that people were paying attention to what was going into them. So if you look at the bankruptcies of California-based subprime mortgage lenders such as New Century Finance Corporation and Fremont General Corporation—they were large issuers [of these securities]. They were lending money to people with low credit scores with no income verification and no asset verification. In other words, first-time homebuyers. And in many cases, the first-time homebuyer had a piggyback second mortgage on top of that. So they had no equity in the deal.