One Bad Bond

Mortgage bonds used to be the stars of finance. Home loans, after all, have a lot going for them: the vast majority of people, even today, make their mortgage payments on time. What's more, mortgage bonds are made up of thousands of home loans, giving them safety through diversity. So how did these bonds become so toxic that they've poisoned banks and threatened the entire economy?

Look under the hood of a bond called Jupiter High-Grade CDO V, and you can understand why we're in trouble. Bankers from the 1970s, when mortgage bonds first took off, would hardly recognize Jupiter. Unlike a traditional bond, Jupiter's underwriter does not buy people's mortgages, collect the payments and pass them on to its investors. Instead, Jupiter holds other mortgage bonds--and not just any. Jupiter's investments are made up of the riskiest portions of other bonds, some of which are themselves a collection of other poorly rated mortgage bonds. In a rising real estate market, such risks were deemed acceptable. When it was issued in March 2007, 93% of the Jupiter deal was rated AAA. But when things unwind--and have they ever--any default gets compounded by the chain of linked bonds. The multiplier effect works like this: while 4.4% of the typical loans tied to Jupiter's bonds are in default, nearly 59% of Jupiter's investments are now worthless. Hello, toxic asset. (See the top 10 financial collapses of 2008.)

The valuation of a mortgage bond like Jupiter is a white-hot argument. Most Wall Streeters agree that a large number of such bonds--amounting to hundreds of billions of dollars, perhaps trillions--are worth far less than their stated, or par, value. How much less is central to resolving the financial crisis. In early February, Treasury Secretary Timothy Geithner said he wanted to start a public-private partnership to buy up toxic assets. Banks hold tens of billions of dollars in mortgage bonds, and as the bonds fell in value or were wiped out completely, they erased precious capital the banks need to survive. Geithner and others believe that rescuing banks from these bonds will save them. To do that, the bonds have to be priced to sell.

A look at Jupiter shows how hard that can be. Jupiter owns 223 other mortgage bonds. One of those bonds is Mantoloking, which in turn owns 126 other bonds. Not done yet. Mantoloking's mortgage bonds own hundreds of other mortgage bonds. Those mortgage bonds are then all made up of thousands of actual loans, some of which may be current, while others may have expired. Go figure.

"It's an informational nightmare," says Andrew Lo, director of MIT's Laboratory for Financial Engineering. "It's very hard to collect all the information you need to figure out what these things are worth."

A recent Goldman Sachs report estimates that most investment banks believe bonds like Jupiter are worth 40% less than what was paid for them, or 60¢ for every dollar invested. But given how many of Jupiter's bonds have gone bad, you could just as easily guess that it is worth 41¢ on the dollar. And that might be generous. A top bond trader who looked at Jupiter for TIME said that on the basis of where loan defaults are headed and the loans Jupiter holds, even the best part of the bond could be worth as little as 5¢. A near total loss.

"Banks thought they could buy these bonds and lock them in their closet," says Rohan Douglas, chief executive of Quantifi, which helps investors and banks evaluate the riskiness of their portfolios. "Now those doors are being pried open, and what we are finding is one big mess."

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