Subprime Investments

Investors in Regions Morgan Keegan funds suffered significant financial losses as a result of the subprime mortgage lending crisis.

It was discovered their investments were tied to these funds, termed mortgage-backed securities (MBS) or collateralized debt obligations (CDO).

 

What does this mean, and how does it affect investments?

The fundamental problem, according to BBC News reporter Steve Schifferes is the new model of mortgage lending, in which banks don’t give home loans directly to customers, but borrow money from credit markets and distribute risk for these loans across a broad spectrum of third-party investors.

Through securitization, rights to mortgage payments – classified as assets – were offered as collateral for third-party investment. These were categorized as MBS or CDO. Due to securitization, investor appetite formortgage-backed securities, and the tendency of rating agencies to assign investment-grade ratings to them, loans with a high risk of default could be originated, packaged and the risk readily transferred to others. The securitized share of subprime mortgages (i.e., those passed to third-party investors) increased from 54 percent in 2001, to 75 percent in 2006[1].

The valuation of these assets is subject to the collectibility of subprime mortgage payments and the existence of a viable market into which these assets can be sold. As a result, when borrowers became increasingly unable to meet the mortgage payments, and began defaulting on these subprime loans, the delinquency rates reduced demand for MBS or CDO assets, and banks and institutional investors began to see substantial losses as a result of the devaluation of these types of assets[2].

The problem for Regions Morgan Keegan investors was that MBS or CDO funds are actually high-risk investments. However, fund managers for RMK presented the portfolios that included these types of investments to its clients as extremely low risk.

According to the BBC’s Schifferes, subprime mortgage bonds issued in early 2007 have dropped between 20 percent and 80 percent, depending on their bond rating. It is estimated that they have lost at least half their value, or $625 billion.

Schifferes says this goes back again to the fundamental problem, that the new subprime system of lending broke the link between the lender and the borrower. As a result, he says, the institutions who owned the loans, and the people who bought the bonds, had too little information about how dangerous they were.