Excellent article by John Mauldin on the credit situation

John Mauldin has written one of his best articles ever on the current credit problems. He traces out the origins and explains what the problems are and suggests some solutions. I highly recommend that you check out the full article (quotes do no justice to the details behind this article). Here are some excerpts that I find insightful.

Part of the problem is the shift towards more ARM mortgages...

In the beginning, subprime loans were made the old-fashioned way. You had to have 80% loan to value and show you had a job and could actually pay back the money. And these loans were packaged up into a subprime Residential Mortgage Backed Security...But then in 2004 loan practices began to change and had got completely out of hand by 2006. In 2005-6, about 80% of subprime mortgages were adjustable-rate mortgages, or ARMs, also called "exploding ARMs." These loans are so-named because they carry low teaser rates that often reset dramatically higher, increasing the borrower's monthly mortgage payments by 25% or more.

The financial intermediaries, with the help of rating agencies, were able to turn low-quality debt into high-quality debt. This is where a lot of surprises come from...

But that's not really where the problem is. Let's go to a great chart from good friend Gary Shilling (www.agaryshilling.com). In an effort to make it easier to sell the lower-rated tranches, the investment banks put together a Collateralized Debt Obligation (CDO) composed of just the BBB-rated paper. And then got the rating agencies to give 75% of that paper an AAA rating! So we have turned 75% of BBB waste into gold with the alchemy of ratings...

Who owns this stuff? According to Inside MBS, foreign investors own as much as 16% of the total mortgage securities. Mutual funds have about 16%. Oddly, for all the publicity, hedge funds probably have less than 5%. But they were leveraged, so the losses are magnified.

As I have remarked before, the Yen carry-trade is unwinding...

Hyman Minsky famously said that stability breeds instability. The longer things are stable, the more likely investors are to become complacent and risk premiums drop. Because of the lower yields, investors tend to over-leverage to try and keep up their returns. The markets are then likely to have a "Minsky Moment" of instability, and then risk premiums rise and all sorts of assets are repriced.

And that is exactly what has happened. The markets are de-leveraging. The yen carry trade is going away, and hedge funds and Mrs. Watanabe are driving the yen back up in as violent a move as I can ever recall. Look at the chart below of the euro-yen cross.

The role played by ratings agencies such as Moody's, S&P, and Fitch did not help the situation. Their credibility has been called into question and when all is said and done, they have a lot of PR work to do...

n short, the ratings agencies were making huge amounts of money from the investment banks for rating these structured products. And let's make no mistake about it, they were selling their name and credibility. Everyone knew what a AAA rating meant when it came to a corporation or a country. And even though there were disclaimers in the 500-page documents accompanying the CDO sales material, the investment banks were clearly pointing to the ratings as they sold that paper.

The entire process hinged on the credibility of the rating agencies. Somehow, no one seemed to think that the default rates from "no-documentation" and "liar" loans would possibly be different. I am sure you can find a paragraph in the offering documents which will make that contention, at least obliquely. Lawyers are good at that stuff. But that is entirely beside the point.

A rate cut will not make a difference as to the credibility of the ratings, nor will it transform bad debts into good ones. But my view has been for a year that the economy is heading for a recession due to the housing market problems. Given the turmoil in the markets, a rate cut may be in the offing later this year. And given that lower rates will make mortgages cost less, that will help.

John Mauldin's stance above is similar to mine. I am not sure if the Federal Reserve will cut rates to bail out the mortgage sector, investment banks, and other speculators, but I had been expecting the Federal Reserve to cut rates due to a slowing economy.