Merrill Lynch’s Gamble on High Risk, Low Yield Loans

Last year, Merrill Lynch wrapped up a securitization that invested, at a very low yield rate, in financing mortgage “piggyback” loans made to risky borrowers who put no money down. The securities were bought by buyers like the Bond Fund of America, one of the largest mutual funds around. One year later, it is obvious Merrill Lynch made a very bad and risky gamble.

These loans are called “piggyback” loans because typically, a buyer will take two loans: one for 80 percent of the purchase price and another smaller loan to pay the remaining 20 percent. It turns out that these smaller loans are also highly vulnerable to homeowners who default on their mortgages. Foreclosure is usually not worth the effort, since all the money would go to the first, bigger mortgage holder. However, that doesn’t mean homeowners are completely off the hook for that smaller loan; their liability would resurface if they ever tried to sell the home.

Worse, less than 30 percent of those loans were made to borrowers with complete documentation of their income and assets and many probably lied about their income. With shaky credit, most had borrowed the full appraised value of the home and it’s highly possible that some homes were overpriced even before home prices began falling.

The lender of most of these loans, Ownit Mortgage Solutions, has since gone bankrupt because so many of those loans turned bad almost immediately. Moody’s predicts that, by the end of all this, the high number of bad mortgages will mean that 60 percent of the money lent will not be paid back. Merrill Lynch disclosed this bankruptcy in its prospectus for the securitization but failed to mention that it was Ownit’s largest creditor and the loans were quickly defaulting.

So far, the defaults are the worse in California, Florida and Nevada. Home prices declined significantly in these states, and California and Florida loans were likely to have been made without full documentation.

How could sophisticated investors not see the all the glaring red flags in these investments?

The even bigger irony is that Merrill Lynch isn’t alone in thinking these high risk but low yield securities were a good idea. A year ago, Moody’s gave these securities an “Aaa” rating, the highest possible. Now, Moody rates them as Baa3, one level above junk. And Moody’s lists three other similar securitizations underwritten by Goldman Sachs with losses comparable to Merrill’s.