Hedge Fund Greed vs Distressed Homeowners-The Battle's On!

Hedge funds in New York City such as Paulson and Co (and others as well) have been profiting from the sub-prime mortgage mess by shorting an index called the ABX and by using credit default swaps that act as insurance . As the ABX index fell, they made tremendous profit, but as it rises, they stand to lose billions. What could cause them to lose on these bets is if the sub-prime loans get re-written to more favorable terms and that's exactly what they're trying to prevent.

Part of the problem with sub-prime mortgages are that their rates (and monthly payments) are set to adjust up, sometimes by hundreds of dollars per month. These "automatic adjustments" were written into loans which were originally written at affordable rates, enticing borrowers with bad credit to borrow in order to get into the home of their dreams.

There's good chance that if a sub-prime loan is re-written to more favorable terms the borrower would be able to stay out of foreclosure. Jobs are plentiful so in theory, most of these homeowners would be OK if they can maintain their payments at current levels. The problem is that in order for the loan originator to re-write the terms, they have to either find a new source of capitol, or sell the loans to another entitiy that does.

This is where investment bank Bear Sterns comes into the picture. They've been buying up sub-prime loans and want to be able to re-negotiate the terms, making foreclosure less likely and allowing distressed homeowners to keep their homes. Don't think of Bear Sterns as some kind of "knight in shining armour" though, because Bear Sterns stands to make billions if the loans don't default. That's their motivation.

Caught in the middle of this are the homeowners who could more easily have their terms re-written, if not for the Hedge funds that bet against them.

The question now is how involved regulators and other banking officials are going to be and the answer is likely to be a lot. Paulson and Co have written to entities such as the Federal Reserve, claiming that Bear Sterns is performing "market manipulation" by making "uneconomic transactions" in re-writing terms. The politicians, smelling a hot-button issue in election season, are sure to get involved as well.

If Paulson and Co and the other Hedge Funds that bet with them aren't successful in stopping Bear Sterns-a debacle could occur that will make Long Term Capitol Management look like a picnic. Any Hedge Fund that is caught holding these short positions won't be able to unload them. Billions of dollars are likely to be at stake.

As this starts to play out-it could create some panic on Wall Street, because the money placed on these short positions was likely borrowed in the credit default swap market, a major source of the liquidity that has driven global stock markets to their lofty heights this year. Any threat of a Hedge Fund meltdown or dried-up liquidity will cause equity traders to run for the nearest high window.

Greedy hedge funds, distressed homeowners, stock market meltdowns, and politicians. This could turn into one of the biggest stories of the year.

Hi NewstraderFX,

Nice article. If you don't mind, I'd like to add some additional info to substantiate your last sentence....

First, if I may, let's clarify "sub-prime." It is a mistaken assumption by many that the subprime market consists primarily of individuals with poor or substandard credit histories. Subprime is anything that is not "conforming," which essentially means any loan w/less than 20% equity, isn't a straight 30 or 15 year amoratization periods, and dollar value more than $417,000 (single family residence outside of Alaska or Hawaii). Conforming loans are underwritten by Fannie Mae and Freddie Mac guidelines; these agencies package the loans and sell them to investors on the secondary market, thus providing a flow of funds to help people buy homes. The sub-prime companies do exactly the same thing, except they have developed products which aided individuals to purchase homes. (Note, in areas such as SF Bay Area, it is nearly impossible to find a home in the conforming limit, and the downpayment required would be in excess of $80K). So, you are absolutely 100% correct in your assumption of illiquidity issues resulting from the present situation....and it is panning out a bit differently IMHO....and in a much more worrisome way. (Before I go on, you are aware that Bear Stearns owns a sub-prime co., so they stand to benefit no matter how the situation pans via the hedging?).

Back to how the meltdown is panning....It is not just people with bad credit who are stuck w/loans that will adjust soon (and most likely go from interest only payment to straight 29 -25 year amoratization, thus increasing expense even more -- oh, & most of these loans are tied to LIBOR). Borrowers, who in the past, were able to refi, are having difficulty because lenders have tightened up the money supply! Not only have they made the underwriting criteria difficult, but competion in the field is narrowing. There aren't as many primary market lenders available to supply loans to the public because of political saber rambling. Fear of over-regulation has driven players out of the market and consumers are stuck. Re-negotiation of terms traditionally played out by trading your mortgage into another product, not through negotiation w/the servicer (who usually purchased the loan on the secondary market). As long as Washington keeps shaking their fists, the consumer will suffer. Loan terms will not be re-written. Foreclosures will esculate. Banks will have to get the homes off their books b/c of reserve requirement, and will sell the properties Cheap. Home values will decline rapidly. Homeowners will walk away from their homes. Values will fall further. No one will lend money. Liquidity is gone. Markets fall...all because politicians were looking for votes. (& because consumers didn't want to believe the refi bubble would burst). This scenario can be avoided only if the actions taken in Washington do not restrict investors from developing products to provide liquidity to the market..where a reasonable return can be expected for the risk.

Thanks for letting me write out my thoughts. This is a topic that interests me greatly, for many reasons.

Oh... I forgot...lenders to the public get penalized immensely if they are unable to sell the loans to the secondary market. Penalties are huge and assessed daily. These penalties are responsible for bankrupting multi-million dollar companies within a very short period of time. So why write a loan to the public if you can't sell it?