Puplava on subprime lending

For the time-challenged, I propose to highlight sections of Jim Puplava's Newshour. "Financial Sense" is what it says on the tin and I plan to make this a regular read/listen. Working off the transcript for July 7 (and that's another very laudable feature of his service), here is my interpretation of some points he makes about the subprime crisis:

The real sting of subprime defaults is in how they may affect the credit ratings of CDOs (Collateralised Debt Obligations, i.e. mortgages grouped together and sold on as interest-yielding investments). Some major institutional investors, including pension funds, have bought CDOs, but are required NOT to hold any bonds below "investment grade". So if these CDOs drop below a "BBB" rating, the fund managers will be forced to sell, and if there is a wholesale selloff there will be a sharp drop in the price.

Also, the hedge funds that invest in CDOs may have borrowed 10-20 times the value of their capital, to multiply their investments. The margin of safety is thin and a relatively small loss could trigger a cash call. So although Federal Reserve officials are correct in saying that subprime debt is only a small proportion of the lending market, this borrowing-to-invest vastly magnifies the problems.

Another complication is that credit ratings don't mean the same thing for all types of bond. Over the last decade or two, "BBB" rated corporate bonds have had a default rate of 2.2%, but BBB-rated CDOs have a 24% default rate. Do all investment managers fully realise this?

There is over $200 billion in subprime bonds that need to be re-rated, but rating firms are putting off the evil day. One reason for the delay is that the ratings people have a conflict of interest. It seems that many were involved in designing the CDOs in the first place, so if a re-rating happens soon, awkward questions will be asked and reputations shredded. There might even be litigation for damages. Meanwhile, Puplava speculates, the government itself might wish to encourage a more gradual unfolding of the bad news, to prevent the avalanche.