The Ratings Charade Continues: A CLO Investigation, Part I

The role of the ratings agencies in the financial crisis went largely unexamined by the powers that be. That's a crying shame. Because the game hasn't changed: Investment banks fork over big fees for ratings agencies to sign off on phony ratings for complicated products.

Today I'm going to prove it, step by step. I'm not going to show all my work (I don't want this expanding to the length of a Scribd academic paper), but I can separately (in the comments section or in a separate post) for anyone who's interested.

We start with one of Wall Street's darlings of complexity, called a collateralized loan obligation.

If you're going to hang with me here, you have to grasp the basics of how one works. It's like this: An investment bank bundles together say 30 leveraged loans (this is the risky debt that companies take on in leveraged buyouts). Now, recognizing that different investors have different risk appetites, the bank creates "tranches" of securities that receive payments in a "waterfall" structure, which is the complicated heart of the CLO.

Okay, that sounds confusing. But there's a simple way to look at it. Each of these 30 leveraged loans makes periodic payments (of interest, or interest and principal). Once you strap all the loans together, individually they still make the same payments on the same schedule. But how the money is distributed becomes a bit more complex.

That "pot of yield" generated by the 30 loans is divided as follows. The investors in the top, or safest tranche, get paid first. This tranche is generally ranked AAA. Investors in the next tranche down, which we'll say is AA rated, get paid after that. Then the A rated tranche holders receive their money, or "water." And so it goes, right down to the bottom layer of this structure, sometimes called equity (though it's not technically equity, for you finance nerds -- and there's often also something called an "overcollateralization" feature in a CLO, but we don't need to get into that here.)

When times are good, with all the leveraged loans paying on schedule, the waterfall is bountiful and everyone gets "wet" (i.e. paid). When some of the loans default, and the gushing waterfall of yield slows to something more akin to a trickle, there won't be enough money to go around. But you always start paying off investors at the top (AAA), then move down the structure. If the loans start to sour, the AAA guys are supposed to have an ample cushion before they feel any pain.

So, in a nutshell, an investment bank has taken 30 leveraged loans, tied to 30 companies that have 30 different stories, and roped them all together into a securitization that pours forth a stream of money that satisfies investors in the manner described above. If you're Standard & Poor's, it's a walk in the park to rate any one of those 30 loans compared with rating the slices of this Rube Goldberg-ian CLO. Which is probably why banks helpfully "suggest" the ratings to the ratings agencies and provide models to demonstrate their reasoning behind those "suggestions."

Now let's say you're Mr. Ratings Guy at Standard & Poors, in charge of signing off on CLO ratings. Your bull***t detector ought to be pinging pretty hard when something with these proposed ratings lands smack dab in the middle of your desk (I've condensed this from a Jan. 13 Bloomberg story):

Citigroup Inc. has revised the proposed interest rates on a collateralized loan obligation to be managed by WCAS Fraser Sullivan Investment Management LLC, according to people familiar with the terms.
A $15 million piece rated BBB by Standard & Poor's will pay lenders 400 basis points (note: there are 100 basis points in one percentage point) to 450 basis points more than the London interbank offered rate, while a $19 million slice, graded BB, will pay lenders 600 basis points more than the benchmark...
A $273 million piece rated AAA will pay lenders 160 basis points to 170 basis points more than Libor and a $13.5 million portion graded AA will pay lenders 250 basis points more than the benchmark, the people said. There is also a $31.1 million piece with an A rating and a $51.075 million slice of subordinated notes, the people said.

Why? Remember how our CLO was constructed: out of 30 leveraged loans. These loans pay a certain floating interest rate over Libor (the London interbank offered rate, or what banks charge when they lend to each other). And that's it. You can't wring out any more yield. So the size of our "waterfall" is constrained by what those underlying loans pay. Let's say it's 10% overall right now (not a bad assumption: a CCC and lower bond index right now is at 9.97%).

Now structuring isn't free. Citigroup isn't creating this CLO out of altruism. Here are some categories of CLO expenses: 1. The cost to structure the CLO and earn a profit. 2. The yearly costs to manage the CLO (for example, there's a reinvestment period, during which the manager must replace loans in the portfolio that pay down) 3. All other expenses, including paying the ratings agency.

Let's fill in some blanks. Let's say management fees average 51 basis points, or about half of 1% (source: 2009 report from PF2 Securities Evaluations). Let's say structuring fees run about 1.75 percent (this is according to a Bloomberg story). And, finally, let's say the life of the CLO will be six to eight years. Even though the management fee must be paid yearly, the structuring is a one-time expense, and can be averaged over the life of the securitization.

Do a little math and you get about 76 basis points as the yearly cost that has to be extracted from that 10% pot of yield you're getting every year. Now the size of that pot has been whittled down to 9.24% effectively.

So, as Mr. Ratings Guy at S&P, you should be getting a little suspicious at this point, even before you look at the proposed ratings: Citigroup claims to be able to strap these loans together and, through some bit of diversification/alchemy, just sort of poof! -- extract 76 basis points a year. If these loans, after being structured, were somehow "de-structured" but with all the fees still intact, you'd be left with the original 30 loans, but paying 76 basis points less apiece, which is a pretty significant gap in bond land.

That should make you go "hmmm." But once you look at the actual numbers for the proposed ratings, your reaction should be something like, "no way."

Just look at the generous yields on the tranches of the CLO! The AAA slice is 160 to 170 basis points over Libor. That's a super-juiced AAA yield. A AAA corporate bond -- once you make a few tweaks (for the fixed-to-floating swap rate, the difference in Libor vs. Treasury -- I won't show my work now but can later for anyone interested) has a comparable yield of about 54 basis points. How can this be, at a time when the credit markets are relatively calm, when even junk debt is selling like hotcakes? This isn't a period of high market stress and irrationality.

(Brief aside: Some readers may object: "Well, a AAA bond doesn't imply the same risk profile as a AAA slice from a securitization." If you think that, you may want to look at S&P's own writing on the issue from January 2010: "In developing our updated corporate CDO criteria (note: a CLO is a type of CDO), we collaborated with Standard & Poor's corporate and government ratings group to promote comparability of CDO ratings with ratings in corporate, municipal and sovereign, as well as other areas of structured finance. When we assign the same rating level to debt instruments in varying sectors, we are expressing the opinion that they have comparable credit risk.")

Back to our unfolding narrative! This is what Citigroup is essentially saying to you, Mr. Ratings Guy: "Hey, ya know, we just structured it and all, and found this great big pot of yield left over! Son of a bitch, funny huh? I mean, there was so much yield we shook out of this thing, thanks to our genius in structuring, that we could pay the structuring fees, pay the annual manager fees, pay all other fees, PLUS hand out extra yield like candy canes right up and down the waterfall structure!"

Because here's what you have: AAA is getting 111 basis points (1.11 percentage points) more than comparable corporate bonds. AA is raking in an extra 149.5 basis points, BBB an extra 229.5, BB an extra 218.5 ... (the spread for the A rated isn't given, but it's got to be consistent with the others because this grade lies between AA and BBB, so I extrapolated that one.)

That gives us another 116 basis points of yield a year, over the size of the entire CLO, that the structuring genies claim to have conjured from somewhere, for a total of 1.92%.

[Update: Reader “Anonymous” makes a good point below about the need to adjust the numbers to account for a call option premium. A fuller explanation of what that means appears at the end of this post. So the structuring genies are actually conjuring up closer to 152 to 180 basis points of yield out of thin air -- not 192 -- but that’s still a whole heck of a lot.)]

Think about that. These individual loans pay 10% overall. That was presumably their fair value. Somehow Citigroup is claiming, through the miracle of structuring, that it has been able to shave almost 2 percentage points -- one whole fifth -- of that risk away.

This structure makes no sense, right on the ground floor. You can't extract a bunch of fees, pay a bunch of rich yields, and have the math work out, considering there's finite money being paid out by the underlying loans. Structuring, in and of itself, can't produce such enormous savings. If it could, everything in the corporate debt universe would be immediately structured for huge and immediate gains.

Now, Mr. Ratings Guy, you should be saying, "Something smells really fishy here." And if you were thinking like this, you would reach an obvious conclusion:

These ratings have to be bull***t. The AAA tranche of this CLO, for example, deserves a grade closer to junk than to AAA.

Yet Mr. Ratings Guy still signs off on the ratings. Why? Hmmmm...

Stay tuned for Part II in which we answer: Why does Mr. Ratings Guy sign off on ratings he knows can't be correct and why does this farce exist at all? Is what's going on a benign "nobody gets hurt" kind of transgression? And who gets burned if these ratings blow up down the line?

Update: One objection that's been raised: S&P doesn't actually see the pricing when these ratings are proposed. It doesn't see that the AAA tranche, for example, would pay 160 basis points over Libor. Okay, that's somewhat exonerating for S&P, but it doesn't change the math. And what's more, Mr. Ratings Guy isn't that stupid. He can figure out what's going on.

He can easily find out what AAA rated debt pays for other asset classes. Even if he doesn't have the CLO pricing in front of him, he'll discover the same problem I outlined above. This structure supports a tremendous amount of what should be low-yield AAA, and even after you add in yields for the other stuff, there's an awful lot of leftover yield to go around (some of which is used to pay structuring and management fees). All of which leads back to the same questions: How does that act of structuring manage to create so much extra yield? How can these CLO ratings be accurate?

Update, Part II: I wanted to sneak in a second update for those readers who will say -- rightly -- wait a moment, don't loans amortize? So aren't you really receiving the interest rate on the loan plus a certain chunk of principal each year? That's typically correct, and I reference that up high in the post. But just to make clear: I am keeping this example simple with a focus on the interest rate portion only, because the yield is the sexy part. That's what you make over and above your initial investment -- the return of principal is just making you whole. If anyone has further questions/comments, put 'em below and I'll tackle them. The bottom line is the math doesn't really change.

Update, Part III: Explanation of the accounting for the call option: the equity investors (the ones who hold the junkiest tranche) have a call option on the CLO fund, which typically can be exercised after 3 to 5 years. The existence of that call option is undesirable for the other investors, so they’ll demand a premium to compensate for it. So in other words, if investors wanted to be paid 30 basis points above Treasuries for a AAA CLO tranche that can’t be redeemed early, once you add a call option, they’ll want even more.

How much more? That’s the key question. See more details in my reply in the comment section, but basically I give the example of a Wells Fargo note that’s effectively 6-year debt with a call option in two years, where the option appears to be worth 18.5 basis points. In a longer-dated note, the option is worth more: a Bank of America note that matures in 13 years has a call option that kicks in 3 years from now that’s worth 39.9 basis points.

Of course those examples aren’t CLO tranches. Still, for CLOs, the call seems even less valuable. Babson Capital Management looked at spreads for CLO bonds and found in the first quarter of 2007, they were 22 - 26 basis points for the triple A tranche. So even if you assume the investor is assigning negligible credit risk (say 10 basis points, which is paltry) to the asset itself, that leaves only 12 to 16 bps for the call option.

So, relating this to the example above, you can subtract somewhere from 12 to 40 basis points from the 192 estimate to account for the call option. Still, you get a good 152 to 180 bps of mis-rating -- which is quite a lot.

A Roundup: The FCIC Republicans and an Intellectually Fraudulent Take on the Financial Crisis

Alas, I'm late to this story, but it was so mind-boggling I had to weigh in with something. The four Republicans on the Financial Crisis Inquiry Commission went rogue and issued their own (slim, fact-lite) report on their findings about what caused the crisis ... beating the publication date for the actual report. Sadly their analysis of the crime scene looks something like this, for the comprehension impaired:

FANNIEFREDDIEGOVERNMENTGOVERNMENTFANNIEFREDDIE

Most disturbing was the report (on Huffington Post -- nice job, guys) that the four Republicans voted to ban the following phrases from the official FCIC report: "Wall Street," "shadow banking," "interconnection" and "deregulation." Which is sort of like writing the history of apartheid in South Africa and not being allowed to use the words "race," "white," "black" and "prejudice."

Anyway, my best contribution at this point isn't opining but stepping back and rounding up the financial blogosphere reaction. So much good has been said that it deserves aggregation and linking (please click through and read each!) without any further commentary from me. So here you go:

Yves Smith, naked capitalism:

How can you talk coherently about the crisis and NOT talk about the shadow banking system, which grew to be at least as large as the official banking system and was the primary object of the various government rescue operations? It’s like trying to talk about AIDS and pretend there is no such thing as intercourse. Similarly, excessive interconnectedness, or as Richard Bookstaber vividly called it, “tight coupling” was another critical driver. AND HOW CAN YOU NOT TALK ABOUT DEREGULATION?!? What is there left to talk about once that is excised? Sunspots?

Barry Ritholtz, The Big Picture:

They released a silly analysis that could have been written by wingnut think tanks like the AEI or others BEFORE the crisis even occurred (and indeed, there are many examples of this findable via the wayback machines of the intertubes). ... The Gang-o-four absolves Wall Street and the banks, blames the government — for everything — and ignores the data that conclusively demonstrate otherwise.

Joe Nocera, New York Times:

To fix a problem ... it helps to know what the problem is. The F.C.I.C., with all those witnesses and documents, could have really helped here. But the paper released by the commission’s Republicans this week reads as if they couldn’t be bothered. It simply reiterates longstanding Republican dogma that could have been written without a $6 million investigation.

Mike Konczal, Rortybomb:

I have to hand it to them. They decided to take one for the team and release this report that implies markets can never fail, only governments. No sources, no numbers, no new info, not even 10 pages, but they put it out there so reporters have the option to go “well, on the other hand the Republicans said this.” That’s how seriously the conservative movement takes ideological warfare.

Paul Krugman, New York Times:

We should have realized that the modern Republican Party is utterly dedicated to the Reaganite slogan that government is always the problem, never the solution. And, therefore, we should have realized that party loyalists, confronted with facts that don’t fit the slogan, would adjust the facts.

Alain Sherter, BNet:

The document is a wholly expurgated version of events that omits key facts while twisting others to fit certain ideological preconceptions.

Nick Baumann, Mother Jones:

In this story, Wall Street, shadow banking, and deregulation had nothing to do with the meltdown. Republicans have been pushing this fairy tale for years.

Dave Ribar, Applied Rationality:

A report on the financial crisis that omits the words, "Wall Street," "fraud," "underwriting," "collusion," and "derivatives" and that overlooks Wall Street's view of most clients as "suckers" isn't worth the paper it's written on.

Ezra Klein, Washington Post:

I'm puzzled by the decision the panel's Republicans made to break away, declare certain words off-limits and release a nine-page report that reads like a long op-ed from a generic Republican politician.

Cardiff Garcia, ft.com/alphaville: (on the Republican vote to ban "deregulation" etc. from the FCIC report)

Depending on your point of view, this is either sad, funny, weird, pathetic, or just idiotic.

Revolving Whores, Dec. 15 Edition

That didn't take long!

After launching my "Revolving Whores" feature a few days ago, I've already got a second installment as Wall Street greases the palm of another public official, according to Bloomberg:

Theo Lubke, who headed the Federal Reserve Bank of New York’s efforts to reform the private derivatives market, joined Goldman Sachs Group Inc. to help Wall Street’s most profitable firm navigate the looming overhaul of financial regulations.

Ka-ching! Mr. Lubke, your bathtub full of caviar awaits ...

Too Big to Fail, the Book, and Inside Job, the Movie

I just finished reading/watching both of these (okay, I know I'm way late on "Too Big to Fail;" it's been a busy year). Some quick takeaways:

"Too Big to Fail" -- here's what particularly struck me in this fascinating fly-on-the-wall account (in fact, I've never read a more "fly on the wall" book than this one) of the events immediately leading up to the financial crisis in the fall of 2008:

* Christopher Cox, former SEC head: Inept. Clueless. Ineffectual. Stupid. It's truly mind-boggling just how bad this guy was.

* Speed dating, capitalism style: It was amazing how many mergers people were trying to engineer behind the scenes at the fever pitch of the crisis. Goldman buying Wachovia? Bank of America buying Lehman? And the Jewish mothers arranging the hookups were usually Hank Paulson and Tim Geithner (some banking executives even started calling Geithner eHarmony).

* The U.S. could have saved Lehman. Sure, you can parse all the differences between the Bear Stearns situation and Lehman's mess and make a lot of rationalizations for why the two were different -- but once Sorkin shows you how creative and frantic and ad hoc things were behind the scenes, you realize that grounds could have been concocted to save Lehman. The government just decided to draw a line in the sand and see what happened.

"Inside Job":

* If you've read a lot about the financial crisis, much of this film will be like "Sing Along with Mitch." You know the words, the characters, the plot, the outrage that's on slow simmer ...

* "Inside Job" is still a great film because, for my money, it makes its argument about what happened with the most coherence and the least distracting shrillness/gimmickry (plus, where else are you going to hear that old Ace Frehley classic "New York Groove" dusted off?)

* The film's original contribution is the spearing of the academic economists. Watching Glenn Hubbard's facade of reasonableness degenerate to hostility is revealing, as Ferguson pressures him about his connections to the financial industry. Even more unnerving though is watching Marty Feldstein, who seems amusedly detached and really doesn't appear to give a shit about all the havoc that ensued from flawed theories about economics and deregulation.

Revolving Whores

The debut of my new acerbic feature, "Revolving Whores: An Attempt to Shame the Shameless and Expose How Broken Our Damn Government Is." (I'm channeling my inner Denninger today, with some spicy zero hedge-type attitude on the side.)

Today's featured personality: Peter Orszag. (I meant to blog about this earlier in the week, but now Mike K. has alertly jumped on the story; he has some good observations about Orszag's latest career zig).

Reuters lead:

Citigroup Inc. named U.S. President Barack Obama's former budget director as a senior global banking adviser on Thursday, strengthening its ties to high-profile former officials the same week the bailed-out bank finished shrugging off U.S. government ownership.

So a bank that was, not long ago, the largest in the world in assets, the quintessence of "Too Big to Fail," has now paid a (presumably) big contract to free agent Peter Orszag, who will help Citi hit a few dingers out of the park using his special knowledge of all recent things White House.

America, cleanse thyself.

L'Arrogance: The High-Finance Scent That Never Goes Out of Fashion

By now, unless you've been under one of those proverbial rocks, you've heard about the massive, pending insider-trading charges, a story apparently broken by the Wall Street Journal:

Federal authorities, capping a three-year investigation, are preparing insider-trading charges that could ensnare consultants, investment bankers, hedge-fund and mutual-fund traders and analysts across the nation, according to people familiar with the matter.

The criminal and civil probes, which authorities say could eclipse the impact on the financial industry of any previous such investigation, are examining whether multiple insider-trading rings reaped illegal profits totaling tens of millions of dollars, the people say. Some charges could be brought before year-end, they say.

Admittedly, I'm a guy sometimes entranced by small detail, so I found this bit of the article most curious, an e-mail sent by a John Kinnucan, a principal (or analyst) at a firm called Broadband Research LLC (and former portfolio manager at Crabbe Huson Special Fund, so his high-finance bona fides are legit):

Today two fresh faced eager beavers from the FBI showed up unannounced (obviously) on my doorstep thoroughly convinced that my clients have been trading on copious inside information," the email said. "(They obviously have been recording my cell phone conversations for quite some time, with what motivation I have no idea.) We obviously beg to differ, so have therefore declined the young gentleman's gracious offer to wear a wire and therefore ensnare you in their devious web.

My first reaction was: Wow. You could build a whole psychology class around the tone of this e-mail. If you were enterprising, you could even bottle it into a scent to be sold to financiers.

"Obviously," the first thing you notice is how effortlessly the writer captures a breezy arrogance. There's a strong grace note of condescension, as if a visit from a couple of FBI agents is to be treated with the same disdain as the appearance on one's doorstep of a pair of vacuum cleaner salesmen. A sniggering-up-the-sleeve quality ("ah yes, these bumbling little investigator types!"). Self-importance. High-brow sarcasm. Haughty disdain for the rule of law. Megalomania.

Where have we seen this before?

Oh yeah. Throughout the whole damn financial crisis.

Banks ungrateful for being bailed out (remember it made headlines when a few bailed-out CEOs actually managed to say "Thank you, America," in testimony a good year after the meltdown). Banks riding the Bernanke liquidity wave to enormous profits and, with little sense of irony, declaring themselves master surfers and paying out lavish bonuses for their "skill." Indignant workers at AIG Financial Products who couldn't believe anyone would try to reduce their fat bonuses even though their division cratered the damn company. Lord Blankfein telling us that Goldman Sachs is doing "God's work."

Plus ca change, plus c'est la meme chose.

The Foreclosure Mess: 7 Reasons Why It's Much Worse Than You Think

We're in a big, big mess with home foreclosures in the U.S. (foreclosuregate, if you will). I'm not sure many people understand the awful magnitude of this train wreck. So here is my look at seven reasons why it's much worse than you think. Below I partly synthesize much of the fine analysis being done elsewhere (Mike Konczal has been absolutely superb on this issue, as has Yves Smith).

Quick background: In 1996, a private company was formed called Mortgage Electronic Registration Systems, or MERS for short. Why should you care? Chances are better than 50-50 that, if you own a home, MERS officially recorded the mortgage -- probably unknown to you. MERS is headed by R.K. Arnold, a former U.S. Army Ranger with a law degree from Oklahoma City University, ranked #104 in the nation this year by the Association of American Law Schools.

Now you may be worried that Arnold, a guy who apparently doesn't exactly have a stellar legal pedigree, is the CEO of this giant institution that registers millions of mortgages from Big Sur to Beacon Hill. Don't be. Because MERS doesn't have any real employees. It's kind of a shell. MERS Treasurer William C. Hultman revealed as much during a deposition in Bank of New York v. Ukpe:

Q I thought, sir, there’s a company that was
formed January 1, 1999 [sic], Mortgage Electronic Registration
Systems, Inc. Does it have paid employees?
A No, it does not.

Q Does it have employees?
A No.

Q Does MERS have any employees?
A Did they ever have any? I couldn’t hear you.

Q Does MERS have any employees currently?
A No.

Q In the last five years has MERS had any
employees?
A No.

Why the heck would you form a company, then not hire anyone? Well, what's the purpose of your company? If you're making widgets, you need widget inspectors, widget engineers, widget fabricators etc. But MERS was created for mortgage banks to dodge paying local recording fees (and doing the associated paperwork, one assumes) when mortgages were re-assigned. So let's say Wall Street wants to bundle a bunch of mortgages into a security, which then is cut up into teeny pieces to go into another security, which is diced once more to go into another security ... thanks to MERS, you can do all this with a minimum of hassles/expense.

Cool beans, until it all starts to come apart at the seams, and you realize that the companies making the original loans were extending credit to people who could barely fog a mirror in the midst of a huge housing bubble and you've got to foreclose and where's all that paperwork you're going to need dammit?

So, without further ado, here are seven reasons we're in the middle of a really epic mess right now:

1. MERS may be a fraudulent company at its very core.

This becomes obvious in the answer to a simple question: How does a company with no employees foreclose on millions of homes across the U.S.? Easy. Apparently it "simply farms out the MERS Inc. identity to employees of mortgage servicers, originators, debt collectors, and foreclosure law firms." MERS even sells its corporate seal for $25 on its Web page. This corporate structure "is so unorthodox as to arguably be considered fraudulent," says Christopher Peterson, a law professor at the University of Utah.

Exacerbating this problem: no state legislature or appellate court ever gave its stamp of approval to MERS in the first place, so it has no acknowledged legitimacy.

2. Widespread fraud may be taking place to cover up the lapses of MERS.

Mike at Rortybomb does a great job explaining how your mortgage consists of two parts, a promissory note (you promise to repay the lender X dollars, and under what conditions, and with what penalties for missing payments) and a mortgage, known in some states as a deed of trust. Mike reduces all this nicely: "The note is the IOU, it’s the borrower’s promise to pay. The mortgage, or the lien, is just the enforcement right to take the property if the note goes unpaid." Common sense dictates that both parts are necessary to move to foreclose. You can't apply the enforcement without knowing the terms of the note and how much remains unpaid.

But as Yves Smith alarmingly details at naked capitalism, the banks apparently got impatient with the messiness of paper notes in an electronic age. Again, without anyone's approval to do this (no courts signed off, no legislatures gave authority), it looks like they converted physical notes on a massive scale to electronic documents -- safer, cheaper, easier to store etc. ... and destroyed or misplaced a lot of those original notes.

The trouble is when the homeowner being foreclosed on demands that the note be produced. The ensuing document scramble has led to fraudulently created replacements. It's hard to say on what scale this is occurring, but Yves included a chilling quote that she says came from the CEO of a big subprime lender, who defended the practice of transfers lacking paper notes, then had a nervous moment of doubt: “Well, if you’re right [that it's a problem], we’re f**ked. We never transferred the paper. No one in the industry transferred the paper.”

3. This mess is greatly complicated by long, complex chains of securitization.

Mike at Rortybomb provides a good diagram. Start with Joe Homeowner, whose mortgage is originated by say Easy Mortgages 'R Us. Easy Mortgages 'R Us passes the note to the next link in the chain, a sponsor for the security being created (say it's Bank of America, which will scoop up a thousand mortgages, including Joe Homeowner's, and turn them into a product called a residential mortgage-backed security). Then there's a depositor that stands between Bank of America and the trust itself for the mortgage-backed security.

Phew. That's plenty complex. But Mike gave readers only the short form. The residential mortgage-backed security can itself be bundled with other similar securities into a creature called a collateralized debt obligation, or CDO (that should sound familiar from Congressional hearings). And then the CDO can be sliced up and bundled with other strips of CDOs into something known as a CDO squared. Now do it one more time and you get a CDO cubed.

Now remember that old saying: a chain is only as strong as its weakest link. Now here are the many links we've just created for Joe Homeowner's mortgage:

Joe Homeowner --> Mortage Originator --> Sponsor --> Depositor --> Trust for RMBS --> CDO --> CDO squared --> CDO cubed. Moreover, I've probably left out a few entities on the CDO level; I'm sure they use similar intermediary units as the RMBS to create their securities.

Exacerbating this problem: The chains were created too quickly, during what turned out to be unstable times (a bad real estate bubble being inflated). So they're not even relatively robust chains.

4. Ladies and gentlemen, I present: Lawsuit-palooza.

Mike delves into this. Foreclosuregate is a full employment act for lawyers. You could have lawsuits anywhere up and down that chain of document transfer. Investors in the mortgage-backed securities will sue servicers. Homeowners will sue on being foreclosed on, demanding to see the note (with the number of suits increasing exponentially as there are more victories, creating a crushing backlog of cases in our legal system). Investors in the securities will jostle for position and battle with each other, the junior debtholders aligned against the senior. The RMBS trust will go after the sponsor for dumping mortgages on it that lacked the proper paperwork.

5. This will be resistant to fixes, for one, because the mortgage-servicer system for the securities is badly set up, with all the wrong incentives.

Mike nails this one too. The smart way to fix these problems would involve lenders working with homeowners to pare down the loan principal for deeply underwater homes. This approach has been shown consistently to work out better for all parties than foreclosing. At the same time, the lender could take the opportunity to remedy the defective paperwork.

But the mortgage servicer, the one who controls what happens with the mortgages that are now embedded in a security (or maybe multiple securities -- remember those CDOs squared?), doesn't have an incentive to do this. His incentives are narrowly structured: he gets fees, on a certain schedule, for foreclosing. He doesn't get paid for the time-consuming process of working out a solution that would ultimately benefit the investor in the security and the homeowner as well.

In fact, as Mike notes, securitizations must be passive entities to win a bunch of tax breaks. As such, they can't do much hunting down of notes or anything else, it seems, without risking losing their tax-exempt status. A really miserable setup, which is going to be an obstacle to resolving this mess.

6. This will also be resistant to fixes because it's going to be hard to wave a magic wand on the federal level and make the problems disappear.

This situation is playing out locally, not federally -- county by county, state by state. And as the political heat builds on the big, bad banks -- much of America already hates them for their oversized bonuses, for their lack of repentance after driving the economy into the ditch, for the bailouts that saved their asses while leaving double-digit unemployment in its wake -- it's going to be hard for Congress, operating under the klieg lights, to ram through the kind of legislation that could straighten things out. Congress is already perceived as being snugly in the pockets of Wall Street. One thing is for certain: NOTHING will happen before the election. This is a live third rail right now.

7. MERS owns more than 60 percent of U.S. mortgages.

I haven't seen anyone sort through the implications of this, but I've seen in the comment sections of blogs, some people sniffing about, sensing the implications. Namely: I make regular mortgage payments, I have great credit, but what if I ask to see my note? What if they can't produce it? Does that then make me foreclosure proof? This will add an interesting element to valuing more than 60% of the mortgages in this country. How much will Joe Investor pay for the right to payments from a mortgage that may be "foreclosure proof"?

So there you have it. Seven reasons why we really need to be paying attention to the mortgage mess. It's hard to overstate how serious it is.