C'mon guys.

Yesterday Sallie Mae got a takeout bid that pumped certain lenders HARD. Chief among them was Countrywide, with Cramer (among others) banging the table that "there's too much money flying around - private equity!" being screamed again and again.

Guys, are you really that dumb? This is a serious question.

Sallie Mae makes college education loans. These are, on balance, pretty damn good investments. After all, you go to college, you earn more money, right? So that means you can probably pay those loans back. In addition, you don't have to start paying until you leave school, so you don't get buried during the time you're learning - and spending the money.

There really isn't much risk here in the portfolio, other than the raw credit risk.

ALT-A paper is an entirely different matter. Let's examine why.

First, we'll break out the mortgage universe into roughly three components:

1. Prime loans. These are 30/fixed conforming, Jumbos (too big for Freddie and Fannie but otherwise 30/fixed), and combinations of 30/fixed and an ARM (usually 5/1) to get around the higher rate on Jumbos. They are all full documentation with a back end ratio of no higher than 36%. They don't make a lot of money; spreads are small because default risk is low.
2. Subprime loans. These are typically 2/28 loans ("debt bombs") but are also typically verified income and assets. The problem is that the borrower has crap credit. Bad FICO, missed payments, etc.
3. ALT-A paper. These loans are "high FICO, claimed good credit" loans that do not fit the requirements for prime paper. PayOption ARMs, Stated Income (SIVA), Stated Income and Assets (SISA).

Now some people are pointing to the "detachment" of LEND and FMT's subprime portfolio as "proof" that ALT-A is "turning around."

Beware with that analysis. It is fatally flawed.

The bomb in the ALT-A space is not credit quality. It comes from the stated income piece of it.

According to a small study done by HUD, half of all those "stated" loans have incomes overstated by 50% or more!

This is a really big deal, because lenders either can or should require you to sign an IRS form 4506-T when you take such a loan. That allows the data that was stated on your "1003", which is the foundational document for mortgages, to be verified by the lender through the right to pull your tax returns.

The issue is that the lenders aren't pulling the returns, because (1) it takes "too long" and (2) it takes too much work!

Unfortunately, any loan that has a fraudulent statement on the 1003 can potentially be put back on the lender until the loan is retired!

Now sit back and think about that for a minute. You turn $500 billion worth of loans over a five year period. Half of them are stated income. Half of those have the income overstated by 50% or more.

That's $125 billion worth of loans you might have to take back. And guess what - the ones you will be forced to take back won't be the ones that people are making the payments on!

What's worse is that the "swap" and "insurance" you think you bought to limit your risk on defaults will not pay on these, because fraud voids all contracts. You can't make an agreement to do an illegal thing; that's against public policy and void on it's face.

Now with certainty, the insurance companies and swap writers won't go quietly into the night and the originators of these loans won't take 'em back without a fight either. There will be lots of litigation on this - bet on it.

Now, if you're thinking M&A, are you going to buy a company with a potential one hundred and twenty-five BILLION worth of contingent liability?

Forget about it - until this issue is resolved - which it will not be for quite a while.