6 replies to this topic

[bullshort]

This isn't TA. I'm no expert, or even well-versed, on the subject of hedge funds and subprime mortgages, but following is my understanding of the true problem and the potential "edge-of-the-cliff" risk we face - right here, right now. I welcome comments from those more versed on these things than I.

Some posts below have pointed out that the amount of subprime loans currently in default (not counting those due for interest re-sets over the next two years) have been estimated to be as much as $600 billion. So if lenders had to take losses on these current loans of, say 20%, that's a $120 billion hit to the industry. I also read somewhere that Bank of America did a study that shows that there are $700 billion in ARMS set to adjust rates in 2008, and that almost 75% of those are subprimes. If my math is correct, that's another $500 billion in potential foreclosures in 2008, and again assuming a recovery rate of 80 cents on the dollar, that represents a $100 billion hit to the lending industry.

Frankly, while the above would be a significant hit, so far I don't see a problem of bone-crushing magnitude. At least not with respect to the foreclosure losses. Aren't these numbers in the ballpark of the S&L crisis back in the 80's?

My understanding is that hedge funds, which are unregulated and have no reporting requirements, have been buying up most of the collateralized debt obligations (CDO's) and similar packages of debt instruments with almost no regard to the underlying credit worthiness of the debt because the potential return was simply too irresistible. For example, if a hedge fund was capitalized with $10 million, it could borrow $90 million in yen at 1% and invest its $100 million in mortgages yielding 6.5%. Its income would be 6.5% on the $100 million, less 1% interest on its $90 million yen loan per year. That's a return of 56% on equity per year. And that would be based on debt secured by U.S. real estate, an asset that has a proven track record of only going up in value . . . more or less.

Yet, here is my understanding of the real risk, and here is where I need some help. The above process, simplistic as I have described it, has been adding liquidity to the system far in excess of anything customarily provided by the banking system. Forget the reserve requirements imposed by the Fed upon banks, requiring what, 10% in deposits relative to loans? The banks haven't cared about credit worthiness. They could package these subprime loans (or any loans for that matter), take their fees, sell them to the hedgies, who have their own 10% reserve system, and the banks actually end up showing no loans on their books at all. Liquidity has been exploding in spite of the Fed, under this process, and that's why interest rates have been so low, medium term or long term, AAA or junk. Essentially there was a huge demand for CDO's and the like by hedge funds which has driven down mortgage rates and greatly reduced discipline in lending practices. But suddenly, we have a liquidity crisis. How serious is it? After all, we have the Fed.

With real estate prices on the decline, with hedge funds holding CDO's and similar garbage that can't really be valued since there is no market, what kind of further liquidity are hedge funds going to be able to create? In fact, it's just the opposite - their investors are in redemption mode. Banks are nervous, are they in a position to start lending money more readily and take up the slack? And finally, what kind of liquidity does the Fed have the power to create now, particularly by lowering the discount rate????? Is the consumer going to respond to a half point decrease. . . in the discount rate?

Comments are appreciated.

[Iblayz]

Did this happen? Sure it did. But there are now some 10,000 hedge funds. And there may be a bunch with some big problems. But what is a bunch? Did all 10,000 funds do this? Not even close is the correct answer. I read just this weekend about one that doubled it's money already this year by betting correctly on the severity of the subprime problem. And therein lies another problem. It is one of generalities. So hedge funds are in trouble. So that means we are all in trouble. Well does it? Is it possible that there are way, way more hedge funds that are doing quite well and have plenty of capital to invest than there are funds in trouble? Did they all make the same mistake? Is it possible that everybody is selling short because they think "everybody else" was an idiot and "everybody else" was not everybody after all?

[ogm]

I think you got the estimate pretty close. I read the report with 150 bil estimated total losses from the subprime fall out. Keep in mind though, that its not just hedge funds.. the risk was spread out ALL OVER THE WORLD. Even in US Pension plans and other invetstment managers where buying this, not just hedge funds. Plus all kinds of investment managers in other countries. This is a global economy, and the multi trillion global economy can take a 150 bil dollar hit. Discount window rates certainly don't do anything for consumer though. Its just for the banks. And the Fed can create as much liquidity as needed, especialy considering that in the current environment there is a deflationary threat from the debt destruction. So they aren't running too much risk in overinflating. A lot of money has been destroyed in debt repricing already. They can easily support the system, IMO.

[redfoliage2]

This isn't TA. I'm no expert, or even well-versed, on the subject of hedge funds and subprime mortgages, but following is my understanding of the true problem and the potential "edge-of-the-cliff" risk we face - right here, right now. I welcome comments from those more versed on these things than I.

Some posts below have pointed out that the amount of subprime loans currently in default (not counting those due for interest re-sets over the next two years) have been estimated to be as much as $600 billion. So if lenders had to take losses on these current loans of, say 20%, that's a $120 billion hit to the industry. I also read somewhere that Bank of America did a study that shows that there are $700 billion in ARMS set to adjust rates in 2008, and that almost 75% of those are subprimes. If my math is correct, that's another $500 billion in potential foreclosures in 2008, and again assuming a recovery rate of 80 cents on the dollar, that represents a $100 billion hit to the lending industry.

Frankly, while the above would be a significant hit, so far I don't see a problem of bone-crushing magnitude. At least not with respect to the foreclosure losses. Aren't these numbers in the ballpark of the S&L crisis back in the 80's?

My understanding is that hedge funds, which are unregulated and have no reporting requirements, have been buying up most of the collateralized debt obligations (CDO's) and similar packages of debt instruments with almost no regard to the underlying credit worthiness of the debt because the potential return was simply too irresistible. For example, if a hedge fund was capitalized with $10 million, it could borrow $90 million in yen at 1% and invest its $100 million in mortgages yielding 6.5%. Its income would be 6.5% on the $100 million, less 1% interest on its $90 million yen loan per year. That's a return of 56% on equity per year. And that would be based on debt secured by U.S. real estate, an asset that has a proven track record of only going up in value . . . more or less.

Yet, here is my understanding of the real risk, and here is where I need some help. The above process, simplistic as I have described it, has been adding liquidity to the system far in excess of anything customarily provided by the banking system. Forget the reserve requirements imposed by the Fed upon banks, requiring what, 10% in deposits relative to loans? The banks haven't cared about credit worthiness. They could package these subprime loans (or any loans for that matter), take their fees, sell them to the hedgies, who have their own 10% reserve system, and the banks actually end up showing no loans on their books at all. Liquidity has been exploding in spite of the Fed, under this process, and that's why interest rates have been so low, medium term or long term, AAA or junk. Essentially there was a huge demand for CDO's and the like by hedge funds which has driven down mortgage rates and greatly reduced discipline in lending practices. But suddenly, we have a liquidity crisis. How serious is it? After all, we have the Fed.

With real estate prices on the decline, with hedge funds holding CDO's and similar garbage that can't really be valued since there is no market, what kind of further liquidity are hedge funds going to be able to create? In fact, it's just the opposite - their investors are in redemption mode. Banks are nervous, are they in a position to start lending money more readily and take up the slack? And finally, what kind of liquidity does the Fed have the power to create now, particularly by lowering the discount rate????? Is the consumer going to respond to a half point decrease. . . in the discount rate?

Comments are appreciated.

The subprime default will get worse by October. We are not out of the wood yet.

[blitz99]

This isn't TA. I'm no expert, or even well-versed, on the subject of hedge funds and subprime mortgages, but following is my understanding of the true problem and the potential "edge-of-the-cliff" risk we face - right here, right now. I welcome comments from those more versed on these things than I.

Some posts below have pointed out that the amount of subprime loans currently in default (not counting those due for interest re-sets over the next two years) have been estimated to be as much as $600 billion. So if lenders had to take losses on these current loans of, say 20%, that's a $120 billion hit to the industry. I also read somewhere that Bank of America did a study that shows that there are $700 billion in ARMS set to adjust rates in 2008, and that almost 75% of those are subprimes. If my math is correct, that's another $500 billion in potential foreclosures in 2008, and again assuming a recovery rate of 80 cents on the dollar, that represents a $100 billion hit to the lending industry.

Frankly, while the above would be a significant hit, so far I don't see a problem of bone-crushing magnitude. At least not with respect to the foreclosure losses. Aren't these numbers in the ballpark of the S&L crisis back in the 80's?

My understanding is that hedge funds, which are unregulated and have no reporting requirements, have been buying up most of the collateralized debt obligations (CDO's) and similar packages of debt instruments with almost no regard to the underlying credit worthiness of the debt because the potential return was simply too irresistible. For example, if a hedge fund was capitalized with $10 million, it could borrow $90 million in yen at 1% and invest its $100 million in mortgages yielding 6.5%. Its income would be 6.5% on the $100 million, less 1% interest on its $90 million yen loan per year. That's a return of 56% on equity per year. And that would be based on debt secured by U.S. real estate, an asset that has a proven track record of only going up in value . . . more or less.

Yet, here is my understanding of the real risk, and here is where I need some help. The above process, simplistic as I have described it, has been adding liquidity to the system far in excess of anything customarily provided by the banking system. Forget the reserve requirements imposed by the Fed upon banks, requiring what, 10% in deposits relative to loans? The banks haven't cared about credit worthiness. They could package these subprime loans (or any loans for that matter), take their fees, sell them to the hedgies, who have their own 10% reserve system, and the banks actually end up showing no loans on their books at all. Liquidity has been exploding in spite of the Fed, under this process, and that's why interest rates have been so low, medium term or long term, AAA or junk. Essentially there was a huge demand for CDO's and the like by hedge funds which has driven down mortgage rates and greatly reduced discipline in lending practices. But suddenly, we have a liquidity crisis. How serious is it? After all, we have the Fed.

With real estate prices on the decline, with hedge funds holding CDO's and similar garbage that can't really be valued since there is no market, what kind of further liquidity are hedge funds going to be able to create? In fact, it's just the opposite - their investors are in redemption mode. Banks are nervous, are they in a position to start lending money more readily and take up the slack? And finally, what kind of liquidity does the Fed have the power to create now, particularly by lowering the discount rate????? Is the consumer going to respond to a half point decrease. . . in the discount rate?

Comments are appreciated.

[traderpaul]

Let us take the hedge funds out of the equation.....That left us with the mortgage problem with little j6p.....Reset time.....What are they going to do?.....In the past ......Refinance.........Now......They say no way.....If uncle Ben lower the rate.....They thoses guys (subprime) will not get punished.....That will creat more problem down the road.....

[SandStorm]

The real problems are confidence and psychology. Fed can do this and do that but the banks DO NOT HAVE TO LEND. Sure they can cover their own butt by going to the discount window but you are dreaming to think they will help others getting thru tough times. Facts are credit availability is reduced and credit terms are raised - across all categories. This is what we have to deal with for now no matter what the Fed does. What will the "bad feelings" do to a credit dependent US economy in the immediate quarter or two? This is tooo easy.