Junk bonds by another name...still bring down the economy

For those who remember Mike Milken and the junk bond scandals of the 1980s, the mortgage crisis has a familiar ring. Although the general public thinks of Milken as an "insider trader," the bigger racket, as Ben Stein pointed out in the fantastically educational License to Steal, was more about creating a market for junk bonds and not being accurate about their default rates.

Milken said that his junk bonds had a default rate of only about 1%. That sounds fantastic. Imagine: normally you have to take a higher risk to get a higher return. Milken basically told people that they could have both low risk and high return by charging companies high-risk rates. Magically these companies that were willing to pay the higher rates wouldn't really be a higher risk of default.

In reality, the default rate became much higher because Milken was lending to companies that weren't that strong.The default rate went up to at least three, maybe 5%. That's why Milken's junk bond world fell apart. The same thing has happened with subprime mortgages. Only this time there isn't a Milken-like figure to blame. There's no one person that was hyping this market. There are just the rating agencies.Sure, there were many industries involved. Financial houses selling CDOs, mortgage brokers pushing risky loans, real estate agents urging everyone to buy -- all of them played some role. But I still have to lay a big hunk of the blame on the ratings agencies. They're the ones that got the default rate wrong. And it was their job to get it right. If they'd gotten it right, none of this would have happened.

The subprime CDOs held a collection of subprime mortgages. Again, the banks were charging these people higher rates because they were higher risk. (Or, in some cases, because they were sold a crappy mortgage by a broker.)

Yet rating agencies gave lots of subprime CDOs an AAA rating. That corresponds to a default rate of 0.1%. Instead, right now about 3% of all homes with mortgages are in foreclosure. Another 7% are a month late. For subprime loans, the Fed recently calculated that by mid-2008 (before the fall's crisis), 10% of fixed rate subprime loans were seriously delinquent and 30% of variable rate mortgages were. The Fed predicts subprime defaults could go as high as 25% if housing prices really fall. Loans made in later years will probably be worse -- like 50%.

So, the rating agencies said one in 1,000 subprime loans would fail. Common sense tells you the default rate would be higher -- but they were using complex formulas instead of common sense. The reality might be that one in four or one in two of these mortgages go bad. That's quite a difference.