From the August 2007 issue of Investment Advisor • Subscribe!

Subprime

Is it lurking in your client's accounts?

As the implosion of subprime mortgages and junk bonds causes uncertainty throughout the markets, advisors and broker/dealer executives may want to think about what's in their clients' portfolios. Whether sold to clients by you or another advisor, the impact of what's happening in these markets will be felt the same way, and some would argue that it doesn't matter if clients actually own CMOs or CDOs directly. Simply owning stock or bonds in a firm that owns, creates, services, or rates these securities may be enough to put a client at risk for portfolio damage. Certain bonds that are not directly linked to mortgage-backed securities or junk bonds could be affected as bond markets themselves are shaken. And what about mutual funds and ETFs? If financial services companies, banks, or insurance companies are an important sector holding, it would be wise to help clients understand exactly what their exposure is.

If clients own affected securities, directly or indirectly, because you have recommended them, it is your duty to mind the store. If a client holds them because of another advisor's advice, and you help the client understand what she has, and what her options are, whether to sell, sit tight, or buy more, you will at the very least have a much better understanding of her overall holdings, and can be the hero for providing good guidance.

Part of the problem with the subprime markets is that the structures of the products are so complex and so opaque that even the experts don't know how big the effects of this debacle could be. Robert Rodriguez, CEO of First Pacific Advisors (FPA), who has 36 years in the investment business, has a unique perspective on subprime because he runs both equity and fixed-income portfolios, and started vetting his bond portfolios two years ago for anything that was not "plain vanilla."

In February, Rodriguez says, the Moody's rating service requested new information to feed its models, which were not working; one of the new data fields is the borrower's loan-to-debt ratio. Moody's had not been using the fundamental loan-to-debt ratio in its rating models. He adds that on a March 22 conference call, the ratings agency Fitch said its model for rating subprime mortgage-backed securities depended on homeowners' FICO scores and assumed continuing home price appreciation. When Tom Atteberry, a VP and portfolio manager at FPA, asked Fitch "What would happen to your model if housing price appreciation remained flat?" Rodriguez said Fitch responded by saying the model would begin to "break down." And if house price appreciation went "negative 1% or 2%?" Rodriguez says in his March 31 shareholder letter that Fitch replied that its "model would completely break down." As of press time Fitch had not provided IA with a recording of that call nor responded to IA's request for an interview to verify that statement.

Rodriguez went on to say he does not "buy the ratings from the ratings agencies," and is concerned not only about subprime but also mortgage securities backed by "Alt-A" mortgage loans--those borrowers who fall between subprime and prime with credit scores "at or near prime" but may be business owners who "do not take out income" on a W-2 basis--"approximately 40% of total mortgage originations" in 2006, according to Rodriguez. Some of the ratings agencies also run pricing services for securities, and Rodriguez argues that those pricing models are flawed as well. He gives an enlightening--and horrifying--example, in which FPA VP and analyst Julian Mann took a plain "garden variety LIBOR Subprime floating rate security," rated A3, valued at 100, or par, by "a major pricing service." They put the floater out to bid at two brokers who trade these securities and one declined to bid, the other bid 7% of par, down 93% from the pricing service's value of par on that same day, March 19.

The Subprime Pricing Fallout

That difference between where pricing services value subprime securities and what they trade for in the real world may have contributed to the need for Bear Stearns to bail out two of its hedge funds in June, and the June 22 failure of Brookstreet Securities, the Irvine, California, broker/dealer through which some customers held CMOs on margin, according to Reuters. In theory, if the value of the securities dropped sharply in those margin accounts, margin calls would have been issued and, if not met, accounts would have been liquidated by Brookstreet's clearing broker, National Financial, a Fidelity Investments subsidiary. While Fidelity spokesman Adam Banker wouldn't comment on how many Brookstreet clients owned the securities that were affected, or even how many client accounts Brookstreet had at National Financial, he did say "We've been advised by Brookstreet that its securities business is limited to liquidating trades only." When asked whether these securities were valued by mark to market or mark to model, Banker would only say: "Certain contractual provisions apply when investors borrow on margin to purchase securities. National Financial has clear margin agreements in place with its clients and uses reputable firms to price securities held in brokerage accounts," but would not name the firm that does the third-party pricing of those securities for National Financial. Brookstreet Securities' CEO Stanley Brooks did not return calls.

Meanwhile, the ranking member of the House Committee on Financial Services, Rep. Spencer Bachus, (R-Alabama) and Reps. Paul Gillmor (R-Ohio) and Deborah Pryce (R-Ohio) have introduced subprime lending reform legislation, the "The Fair Mortgage Practices Act," which includes provisions to nationally register and license mortgage originators, restrict "prepayment penalties on Hybrid ARMs," and "encourages financial institutions to evaluate a borrower's ability to repay a mortgage loan before extending credit."


E-mail Senior Editor Kathleen M. McBride at kmcbride@investmentadvisor.com.
Reprints Discuss this story
This is where the comments go.