Wall Street reverts to an old con game

Wall Street may have discovered a way out from under the bad debt and risky mortgages that have clogged the financial markets. The would-be solution probably sounds familiar: It’s a lot like what got banks in trouble in the first place.

In recent months investment banks have been repackaging old mortgage securities and offering to sell them as new products, a plan that’s nearly identical to the complicated investment packages at the heart of the market’s collapse.

"There is a little bit of deja vu in this," said Arizona State University economics professor Herbert Kaufman.

But Kaufman said the strategy could help solve one of the lingering problems of the financial meltdown: What to do about hundreds of billions of dollars in mortgages that are still choking the system and making bankers reluctant to make new loans.

These are holdovers from the housing bubble, when home prices soared, banks bought risky mortgages, bundled them with solid mortgages and sold them all as top-rated bonds. With investors eager to buy these bonds, lenders came up with increasingly risky mortgages, sometimes for people who could not afford them. It didn’t matter because, in the end, the bonds would all get AAA ratings.

When the housing market tanked, figuring out how much those bonds were worth became nearly impossible. The banks and insurance companies that owned them knew there were still some good mortgages, so they didn’t don’t want to sell everything at fire-sale prices. But buyers knew there were many worthless loans, too, so they didn’t want to pay full price for the remnants of a real estate bubble.

In recent months, banks have been tiptoeing toward a possible solution, one in which the really good bonds get bundled with some not-quite-so-good bonds. Banks sweeten the deal for investors and, voila, the newly repackaged bonds receive AAA ratings, a stamp of approval that means they’re the safest investment you can buy.

"You’ve now taken what was an A-rated security and made it eligible for AAA treatment," said Richard Reilly, an analyst with White & Case in New York.

As for the bottom-of-the-barrel bonds that are left over, those are getting sold off for pennies on the dollar to investors and hedge funds willing to take big risk for the chance of a big reward.

Kaufman said he’s optimistic about the recent string of deals because, unlike during the real estate boom, investors in these new bonds know what they’re buying.

"We’re back to financial engineering, absolutely," he said. "But I think it’s being done at least differently than it was before the meltdown."

The sweetener at the heart of the deal is a guarantee: Investors who buy into the really risky pool agree to also take some of the risk away from those who buy into the safer pool. The safe investors get paid first. The risk-taking investors lose money first.

That’s how the safe stack of bonds gets it AAA rating, which is crucial to the deal. That rating lets banks sell to pension funds, insurance companies and other investors that are required to hold only top-rated investments.

"There’s no voodoo going on here. It’s just math," said Sue Allon, chief executive of Allonhill, which helps investors analyze such hard-to-price investments.

Financial gurus call it a "resecuritization of real estate mortgage investment conduits." On Wall Street, it goes by the acronym Re-Remic (it rhymes with epidemic).

"It actually makes a lot of fundamental sense," said Brian Bowes, the head of mortgage trading at Hexagon Securities in New York. "It’s taking a bond that doesn’t necessarily have a natural buyer and creating two bonds that might have a natural buyer for each."

The risk is, if the housing market slips even more, even the AAA-rated investments may not prove safe. The deal also relies on the rating agencies, which misread the risk at the heart of the subprime mortgage crisis, to get it right.

And then there’s the uncertainty about the value of the underlying investments, which FBR Capital Markets analyst Gabe Poggi called "totally combustible." Poggi likes the deals because they appear to have breathed some life into the market, but he said it only works if everyone knows exactly what they’re buying.

The Obama administration is also working on a plan to get banks buying and selling risky bonds. But the public-private partnership announced this spring is still in the works and has yet to help investors figure out what those bonds are worth. By creating Re-Remics, banks can help start the process themselves.

The concept has been around for years, but it has become increasingly popular lately as a way for banks to sell off bonds backed by commercial properties such as malls and office buildings. Analysts say they’ve seen a few dozen deals aimed at repackaging debt held over from the mortgage boom. Investment banks have also dabbled in turning collateralized debt obligations, or CDOs, into Re-Remics.

That’s where Allon gets nervous.

"I think that’s trouble," she said.

CDOs are already complicated. Repackaging them makes it harder to figure out what the investment is worth. The more obscure the concept, she said, the more likely the deal has gotten too creative.

Wall Street has a tendency to push the boundaries of good ideas, Bowes said. But he said banks are still smarting from the market implosion and are unlikely to rush into new, risky ventures.

"A lot of the market innovations, they all started out with this fundamentally good concept and they often tend to deteriorate over time, or just evolve into more and more risky versions of the same concept," Bowes said. "This time around, the likelihood is, it will take a lot longer for that to happen."