Unless you are an insider this is where you have no idea who is holding this bad paper and how much of it they are holding.

"Larger bank pools loan with other, similar loans (same interest rate, same maturity etc....) and then sell pools to various investment groups (insurance companies, mutual funds etc...). Basically, the larger banks make one giant bond of all the loans they buy.

As part of step 2, the subprime originator agrees it will repurchase a loan under certain conditions, one of which is usually a specific delinquency rate."

And you'd have to be a cross company insider to know very much. I would imagine some of the traders have an idea, but having seen some trading in my day, the traders can get it wrong also.

A mess it seems to be.

http://mauberly.blogspot.com/

http://agonist.org/comment/reply/37546/111462

http://mauberly.blogspot.com/

So the sub-prime lenders go bankrupt and there is no one to repurchase the loans from Wells Fargo and the other major banks. Not only that but the foreclosed houses get dumped on the housing market lowering housing prices causing more foreclosures because houses become worth less than the mortgage and so on. First of all, are sub-primes required to buy back loans when the mortgage exceeds the value of the house? Is a cascade effect possible? Is it possible for Wells Fargo and other banks to become insolvent because of this?

Especially with a lot of lawyers throwing their weight around.

To Joaquin's question, if defaulting mortgages are put back to the mortgage banker, and the banker goes bankrupt (as many already have), who owns the mortgage? Probably in most of the bankruptcies so far, the mortgages were never legally tendered to the mortgage banker - there wasn't time before the mortgage banker declared bankruptcy, having clearly seen that they had insufficient capital to accept all the "puts" being presented to them. In fact, some of the press reports suggest that the mortgage banker declared bankruptcy specifically to avoid receiving these mortgages. It was probably a legal matter for the board of directors of the mortgage banker - the board cannot take actions that they know would wipe out their capital. They are in a sense forced into bankruptcy just to preserve some capital for their liabilities at that time.

So in this situation, the bondholders are stuck with these mortgages. This brings up the high likelihood that some of these bondholders will sue the investment banks and commercial banks who issued the securities, on the grounds of faulty due diligence, fraudulent conveyance, or some such argument. There are plenty of arguments to use, and plenty of precedence for nasty lawsuits dragging on for ten years.

The only difficulty here is that the bondholders have to act in concert. It may not be easy to round up dozens of hedge funds, pension plans, insurance companies, etc. for even one of these bond issues. But when your survivability is at stake, amazing things can happen. That's why it is a good bet that some sizeable lawsuits will eventually be filed by these bondholders against the investment banks in particular. It will be all about assigning someone the risk monkey, which usually winds up on the shoulders of whoever has the deepest pockets.

As to the timing, under US accounting the bondholders do not have to mark down their holdings, even if they are clearly impaired, until the ratings agencies downgrade the issue. The ratings agencies are notoriously late in doing this, and even last week were saying they saw little chance that these MBSs, CDOs, and such-like securities will be anything but Aaa rated.

That's because the subprime infection has not spread to higher tranches, but this is only a matter of time. The mortgage industry has been misleading the markets by saying the subprime component is something like 2% of all mortgages. The subprime component is 40% of all recent mortgages, which are the ones that were bundled up and sold as securities. It was this securitization process that allowed these mortgages to be booked in the first place; the securitization process gave everyone the illusion that the risk monkey rested with someone else. Now we see otherwise.

The way the infection process will work is through home valuations. Home values rocketed up at an annual rate of 20% in recent years, but this was due (as is always the case) to transactions done on the margin. One sale on each block or two was enough to propel everybody's home value higher, and it will only take one forced sale or foreclosure at a lower price to do the reverse.

The securitization process monetized, or commoditized if you will, home values. But the home itself was not made any more liquid, just its value. Every home owner across the country enjoyed an unprecedented increase in home values, not seen even in the 1920s. But the price for this benefit was that every home owner took on enormous market risk (that risk monkey again!). If nationally, prices can go up two standard deviations from their long term norm, they can go down as well under the dynamics of market risk. The only difference is, the drop in value always occurs quicker than the rise, due to market panic.

We're just getting to the panic phase. It has not reached the average home owner, most of whom will continue to make their mortgage payments and will suffer nothing but market loss, even though this loss (coupled with the inevitable decline in the stock market) will crimp consumer spending severely. But there are millions of homeowners in over their head who will be forced out of their homes, and this in turn will cause millions more to be underwater in their mortgages. The banks will then have to decide whether to allow this to occur, or to start calling in these mortgages because the collateral no longer has value. In Japan, the banks called in the mortgages (most of which were commercial, not residential). In the U.K. about 10 years ago when this happened, the banks allowed the mortgagee to carry on making payments. We'll see what U.S. banks will do, but my bet is they will pull the plug and make the problem worse. The reasons are: it only takes one bank to start the process rolling and create a competitive advantage for themselves, and all banks are now trained to "get their problems behind them." This militates towards taking drastic action now, like firing a lot of employees or foreclosing on all sorts of homes, even if they think it might snowball the process. If they are first out of the gate, the snowball effects won't hurt them as much as the late followers.

Finally, for Mauberly, yes this is the same deflationary process we talked about in 2001 and 2002. It has always been there as a key risk to the U.S. economy. It was postponed due to the Chinese/India commodities scramble, but both these economies have severe overcapacity in many industries, and they are no different than the U.S. in one critical aspect - this excess capacity was bought with debt.

The world is awash with liquidity, but the flip side of this is that the world is awash with debt, starting with the U.S. in every single sector (government, corporate, and consumer), and ending with China. The debt must be repaid or wiped out at great cost to the lenders, many of whom won't survive. Deflation on a global scale is in my view now a 60% risk or higher. The next few years are going to be very vicious indeed, and 2007 looks like the kick-off to all this unpleasantness.

Watch the stock market (it doesn't matter what country - the correlations among all markets are at unprecedented highs). There is a high likelihood of a crash, defined as a one-day drop of 10% or more, sometime this year. This will be the defining moment when the market faces up to the deadliness of deflation.

He'll squirm and struggle to convince everyone that it couldn't possibly be his beloved tax cuts that are behind any of these problems. When China and Japan start repatriating their U.S. holdings - not just because they are worried about market loss, but because they will really need the money for themselves - the U.S. will discover its free and easy access to cheap credit is over, and that it is finally time to start reducing the deficit. There will be only two places left to turn to for tax revenues - U.S. corporations, and the super-wealthy. Nobody else in the U.S. has the resources to help reduce the federal deficit. And there will be only two places in the budget to cut: entitlements, and the Department of Defense. Cutting entitlements will clearly spread even more misery around the economy, even though Kudlow will be panting for this to happen. Barney Frank and other politicians will instead look to "soak the rich" and attack a half-trillion dollar annual defense budget.

The good news for Larry Kudlow will be that no changes will likely occur with dividend or capital tax rates, because the Dow will be trading below 7000 and heading lower, making the matter moot.

The bad news for Larry Kudlow is that he will be off the air. He'll be an unmissed victim of an environment that took market idolatry too far, and now will be swinging dramatically in the other direction.