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Monday, May 3, 2010

The sub-prime multiplier

I suppose you could call it, fractional reserve subprime lending Wall Street style!

In one case, a $38 million subprime-mortgage bond created in June 2006 ended up in more than 30 debt pools and ultimately caused roughly $280 million in losses to investors by the time the bond's principal was wiped out in 2008, according to data reviewed by The Wall Street Journal.

This was a central finding of the Senate investigative panel probing Goldman Sachs Group Inc.'s actions in the mortgage market. In a memo last week, panel Chairman Sen. Carl Levin (D., Mich.) said Goldman's work "magnified the impact of toxic mortgages" by replicating mortgage securities in debt pools known as collateralized debt obligations as well as CDO derivatives, and also in an index that tracks subprime bonds.

The subprime mortgages that caused big losses generally were packaged into CDOs, in which dozens of mortgage-backed bonds were pooled together and slices of the CDOs were sold to investors. Another version of these CDOs didn't contain actual mortgage bonds but were linked to them via derivatives called credit-default swaps. Through the use of derivatives, banks created many of these synthetic CDOs using the same mortgage securities, all of which would rise or fall in value depending on how the mortgages were performing. With synthetic CDOs, those who had bet that the loans would perform well were on the hook if their performance deteriorated.

In effect, the documents said, Wall Street was "copying and pasting" what turned out to be the worst-performing securities of the mortgage boom. Such activity helped multiply opportunities for hedge funds and traders who wanted to short the housing market, but magnified the losses of those on the other side of the trades. To short a trade, in this instance, is to bet the housing market will turn down.