This scenario actually puts the mortgage defaults in perspective and shows the potential return if you were able to buy in.

On the ‘bond’ (CMO) I referenced Tuesday, a few people wanted clarification, so let me wind and slog through the details:  The deal / AAA mezzanine CMO/bond started as $850-million 2.5 years ago,.  That was 2,466 loans.  Today the deal has just over $620-million among 1621 loans.  These are pay option arms - so on day one they had just under 75% LTV values, and now they are just under 82% LTV loans as people chose to pay interest only in many cases (to keep the home). 

If you just look at a single loan on a $500-thousand house, then that loan typically started out as a $375,000 loan on a $500,000-thousand house.  And that borrower took the option of doing a minimum payment, so that over the last 2 1/2 years, that loans has gone up to $410,000.  Still the same house. LTV sliding up.

Now comes the situation where that loan is foreclosed.  So for the first few months, when the borrower isn’t paying, the servicer is actually advancing the money.  That because most borrowers get flaky once in a while, so that goes on for a few months.

Then it turns out that borrower is never going to pay.  So the servicer starts the foreclosure process and along come a few thousand in legal fees.  And the servicer continues to advance until the foreclosure is completed..  The servicer may be on the hook for half a year of payments plus fees for legal and the green pool guys.

Bottom line: Once this house hits the foreclosure bucket, and the people get moved out, it then moves into the ‘real estate owned’ (REO) bucket, that’s what this deal had 21% of as it went to the wall on Tuesday.  So that’s how the $621-million slices and dices.

When we look at an individual loan, remember, these are going up, and there may have been $10-thousand in taxes, payments, insurance and such, so we did all that - so maybe $15,000 out of pocket.

Next the house goes on the market.  Starts at $450 large but it quickly becomes obvious it won’t move.  Eventually, maybe it sells for $200-thousand.  Major discount. 

The ‘deal’ doesn’t get the whole $200-thousand.  Costs of servicers, pool guys, and such, after all the bills, it’s about a 65% loss on the $410-thousand  on a net of $144-thousand.

If we assume that 20% of the loans get foreclosed every year, then that ends up with 88% of the pool getting foreclosed with these kinds of horrible losses on each loan. Fortunately its a 3-year mess deal.

If we assume all of that, then this this bond which we offer 30-cents for each dollar of face value, then the yield will be 21% over the life of the bond.

Does the Bond Dude feel that 88% of the people with 700 credit scores in California going to lose their homes in the five 1/2 years between 2006 and whenever?  No.  Anything better than his worst case makes money for the company beyond his 21% forecast.

If only 83% get foreclosed, this bond yield pops to 28 1/2 percent.  But, this begs the question, why would anyone buy conventional corporate or stocks? Not when these kinds of yields are out there.  Believe me, the bond guys are hoping for low default rates - it means a higher yield.

Knowing this you might go looking for a good real estate bond game, but lotsa luck finding them.  Big money can play, but much harder for us  ‘little guys.’ 

Oh, and if you dig up one of the super senior bonds that sit ‘over’ the mezz level offerings, you might get the chance - as they are out there -  to lock up 18% for 10-years in a deeply discounted a senior subordinated CMO.

And that class, is why the rich keep getting richer and why at a certain level, a good wringing out is good for the fat cats ov er in fixed incomes.  Gotta know people and have real dough.