Test for bonds tied to loans
The housing market boom of the last few years also has been a boom for Wall Street firms that have played a crucial role as conduits -- linking home buyers and investors by packaging mortgages and selling bonds backed by the loan payments.
Now, with mortgage defaults surging, it's clear that some of those investors are going to lose money.
And that is shining a bright light on the Wall Street middlemen, including Los Angeles-based TCW Group Inc., which has been one of the biggest names in mortgage investment products.
TCW, parent of Trust Co. of the West, could emerge as a hero or a villain to the hedge funds, insurance companies and wealthy investors worldwide that have been avid buyers of the firm's complex mortgage securities.
The company says it is the global leader in managing collateralized debt obligations, or CDOs. These are investments that are backed by pools of loans or other assets. The simple idea: The investors get interest and principal payments from the pools passed through to them.
But in reality, CDOs aren't simple at all. They are a creation of cutting-edge financial engineering. That engineering can turn part of a portfolio of high-risk securities into new securities that, in theory, carry low risk but still provide above-average returns.
The acid test for that seeming alchemy now looms. Much of what backs up CDO pools are securities tied to mortgages. And specifically, bonds backed by sub-prime mortgages -- loans to people with poor credit histories or high debt burdens -- are the core of many CDOs.
TCW manages $48 billion in CDO portfolios for investors. Of that total, $15 billion, or about one-third of the CDO asset pool, is in securities backed by sub-prime mortgages. An additional $3.9 billion of loans behind the firm's CDOs are "Alt-A," or mortgages to people who didn't qualify as top-quality borrowers but were viewed as better risks than sub-prime borrowers.
The question facing TCW and other investors in higher-risk mortgages: Who's going to take the biggest hit from loans that go bad?
"There are a lot of CDO managers that have a lot of toxic waste in CDOs," said Pete Nolan, who analyzes the portfolios for money manager Smith Breeden Associates in Chapel Hill, N.C.
Jitters over the growing troubles of sub-prime borrowers have been rocking financial markets for weeks. Lenders' shares slumped further last week after the Mortgage Bankers Assn. said more than 13% of sub-prime loans had fallen behind on payments, up from 12.6% in the third quarter and 10.6% two years ago.
