Andrew Lo, the director of the MIT Laboratory for Financial Engineering, and founder of the AlphaSimplex hedge fund, believes the next big meltdown will be in commercial mortgages (see Reuters article). While many traders and investors have been predicting that the CMBS market would be the next one to take a hit after blowups in the residential market, Lo is predicting that the losses will accelerate later this year as rates begin to be reset higher. Also of note is how Lo believes that it will be pension funds, and not the banks, that will be hurt the most when commercial real estate comes under additional pressure. In an effort to increase yield when the markets were more static, pension funds loaded up on CMBS in the years before the market meltdown. There is an expectation that many pension funds will now have a difficult time meeting liabilities, forcing the government to once again step-in with some type of bailout. While this is certainly not good news for the economy if the commercial real estate market was to play out as predicted by Lo, given the hits commercial real estate has already taken, the pressure pension funds are already under, and the number of bailouts which have already occurred, it is difficult to know - even in general terms - what the reaction and impact on the markets will be. Maybe this is the saddest realization of all.

The Worlds' Largest Hedge Fund (yes, that one, the one owned by you and I, the U.S. taxpayer) may now be adding additional securities to its portfolio. According to a recent Bloomberg article, the Fed is considering expanding the Term Asset-Backed Securities Loan Facility (TALF) to include loans for the purchase of Commercial Mortgage Backed Securities (CMBS). As you may recall, the TALF was developed to provide low-cost Federal Reverse loans that would be used to buy securities backed by consumer debt - essentially using taxpayer money to provide debt to help other taxpayers purchase the debt of still other taxpayers that took out too much debt [Yes, I know, using debt to solve a problem caused by too much debt does not really make sense, but I digress]. Anyway, since the TALF has previously been used to purchase securities tied to automotive debt and credit cards by offering three-year loans, why not try it now using five-year loans for commercial real estate? After all, it has been so successful for the auto and credit card industries (GM, Chrysler, and a White House Presidential scolding of credit card executives, notwithstanding - tongue in cheek, of course).

All kidding aside, it is hoped that such loans will create buying pressure for CBMS, thereby decreasing yields - many of which are near junk levels, making it unprofitable for banks to make new loans at such high yields. The down fall, of course, is that with such loans having a five instead of three year maturity, it will be even harder for the Fed to timely withdraw money from the system in later years, just when inflation is likely to creep back with a vengeance as the economy begins to hopefully recover. While maybe too late, at some point we are going to have to ask, are we preventing collapse and saving entire industries, or are we simply, and needlessly, juicing the system in order to save a few select companies, all the while unnaturally speeding-up the recovery? If the later, we may want to start planning for the hangover now.

Like the Harvard and Yale endowments, the endowment at Dartmouth is feeling the pain of the slowing economy and falling market, losing 18 percent, or to $3 billion over the last year (see Bloomberg article). The losses are resulting in spending cuts of 8.6 percent. Of interest is that like its bigger Ivy League members, Dartmouth had only about 12 percent of its assets in US stocks. Like Harvard and Yale, it also had a number of illiquid assets (such as private equity) whose values have not been updated. To its credit, trustees at the college projected early last year that the US economy was entering a recession and subsequently lowered its exposure to corporate bonds and MBS, and began purchasing additional TIPS. Eighteen percent is painful, but foresight and diversification seem to have helped to ease the pain at Dartmouth.

US financial institutions reported an increase in Level 3 assets in Q3 to $610 billion (see Financial Times article). This amounted to an increase of 15.5 percent from Q2 as low liquidity has made it difficult to sell MBS and CDO assets. Classifying assets to Level 3 also gives the banks more control over how valuations are modeled and set. As banks begin reporting Q4 results, many analysts expect the number of writedowns of these assets to increase, especially given the recent announcement that the Treasury plans to use TARP money for capital injections directly into financial companies, as opposed to the original purchase of illiquid assets.

There is an interesting Business Week article regarding the increased use of FHA-backed loans that are being used to continue lending to borrowers who once again may be unable and unlikely to pay back their loans. Inside Mortgage Finance (a research / newsletter firm) estimates that bad FHA-backed loans could end up costing taxpayers more than $100 billion over the next five years. As subprime loans have dried up, the FHA loans have become the only source of lending for many at-risk borrowers. Congress and the current administration have been encouraging lenders to apply for FHA guaranteed loans in order to access the current FHA loan reservoir, but the banks and loan quality are not being monitored, allowing the funds to be loaned to the very same borrowers that had trouble paying before, and which of course began the chain reaction of defaults we are now witnessing. To make matters worse, the government guarantees are creating incentives for banks to buy the FHA loans and securitize them, in what may become another bad dream realized. Hopefully the markets will wake up and be spared in a year or so when the new "FHA-insurance Armageddon" is suppose to hit - but past history is not encouraging.

I often get asked about subprime, Colateralized Debt Obligations - CDO, Collageralized Mortgage Obligations - CMO, Credit Default Swaps - CDS, and that odd thing called a tranche by people other than my students - who already had to endue my lectures on the subject. Therefore, I figured it was worth putting together something for the blog, outside of what I normally teach. Hopefully I can find the time to develop and post a series of tutorials this summer, but in the mean time the following short segment from CNBC's PowerLunch is a good start regarding subprime and the creation of mortgage-backed derivatives (such as CMOs).

There are other explanations (videos and Powerpoints) that are more entertaining and a little less tasteful at times (and also sometimes better at explaining the subject), but I will take the high road for now and let you find those on your own. A few longer presentations that are more informative, but also a little dryer, also exist.