Subprime lending

The value of any investment is always dependent on the price that one pays for it. An example of how this would apply to sub prime lending. Let's assume that there was a marketplace where an individual could buy a single sub prime loan rather than a pool of loans. The face amount of the loan is $ 200,000 and the coupon just reset to 9.5%. You buy the sub prime loan from a distressed investor at 75 cents on the dollar. The best case outcome is that the homeowner continues to pay every month and you hold the loan until maturity or sell it at 100 cents on the dollar once the market stabilizes. The worst case scenario is that the homeowner does not pay and then you seize the house as collateral. The assumption here is that the property value will cover the loan that you payed 75 cents on the dollar. The best case scenario your yield to maturity is probably over 30%. The worst case scenario you own the house and can sell it at over what you paid for the loan.

This is an inaccurate way of examining subprime loans. They are usually securitized in traunches. This involves hierarchy of principal and collateral. It is by class. The bottom traunch that may be 10% of the package does not get 10% of every house; it gets the last 10% of the value of the collateral after the top bondholders have been serviced. This is why this stuff is toxic, its called first loss. The AAA traunches are still viable, its the AA-NR traunches which are fast becoming absolutely worthless. It the income stream stops being paid in the form of interest on the mortgage, and the principal is worth .90 on the notional value of the securtized loan, and you only have the rights on the bottom 10% of the principal and therefore its worthless. So paying .75 for something worth 0.00 is not a good investment. You also have to consider the 20 year bull market in housing is now over and the fundamental assumption that these homes will all return to value is ridiculous.

I understand how securitization works and the hierarchy of tranches. I was trying to make the Value Investing point that price is usually the most important consideration in an investment, so I broke down the argument down to a single sub prime loan. And by the way, it is just as ridiculous to assume that the value of every MBS is zero. Finally, not all areas had 20 year bull markets in housing, all Real Estate is local.

The subprime mortgage meltdown in perspective by comparing the global subprime losses of $1 trillion (Reuters story here) to the $56 trillion of U.S. household net worth. Sure, $1 trillion is a very significant loss, but it's relatively insignificant compared to the significant value of U.S. household wealth, less than 2%.

George Soros characterizing the subprime mortgage situation as "the most severe since the Great Depression." I'm not sure there is data on household net worth in the 1930s, but I'm pretty sure the stock market losses and the losses from 9,000 bank failures (about 1/3 of all banks) in the 1930s was a lot bigger than 2%.