How to gain from their pain

The American Dream for many folks is turning into a nightmare as the home they tried to buy buries them in debt. But for the professional fund-slingers who trade on that debt, it's their wetdream.

There's no point repeating the stories that the US housing market is taking a caning, and that the ones taking the most severe beating are the ones who were late to the party and only just managed to get in at the top. The questions being asked are, is this the worst it will get? Is the housing market bottoming? Or is there more misery to come?

A Bloomberg report by Darrell Hassler and Hamish Risk suggests, based on an analysis of the price of risk in the subprime mortgage market, the housing crunch has more slump ahead of it. Following are bits and pieces from the report, rearranged and excerpted so that Guambat can follow the story:

The housing boom spawned new types of mortgages that allowed consumers to buy homes they may not have been able to afford otherwise.

About 18 percent of all mortgages issued in the first half of the year were to borrowers considered most likely to default, such as those with high credit-card balances, up from 2.4 percent in 1998, based on data from the Mortgage Bankers Association.

The ABX index, created by London-based Markit Group Ltd., measures prices of credit-default swaps based on the $565 billion of bonds secured by so-called subprime mortgages and home-equity loans.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on the ability of borrowers to repay debt. An increase in price indicates deterioration in the perception of credit quality; a decline suggests improvement.

Based on the index, it costs an investor $267,000 to protect $10 million of bonds against default for five years, up from $205,000 in August.

The increase in the index shows traders expect mortgage delinquencies and foreclosures to increase at a time when the number of homes for sale as measured by the National Association of Realtors is at a 13-year high. The percentage of home-loan payments more than 60 days delinquent rose to 7.23 percent in July from 5.9 percent a year earlier, the fastest rate of increase since 1998, Moody's Investors Service said Oct. 17.

"Delinquency trends and home prices" show a weakening real estate market, said Scott Eichel, head of credit trading for New York-based Bear Stearns & Co., the biggest underwriter of bonds backed by mortgages. "A lot of investors that have concerns about the housing market" are using the ABX index to speculate on a continued drop, he said.

"The unequivocally bad housing data we've seen" is prompting investors to seek to profit from potential declines in mortgage-backed securities, said Greg Lippmann, the head of asset-backed trading at Deutsche Bank AG in New York who helped create the ABX indexes in January. Contracts covering $5 billion of home-loan debt change hands daily, he said.

A Merrill Lynch & Co. index of debt securities derived from home-equity loans rated AA to BBB is having its worst month this year, falling 0.01 percent. They have returned 4.54 percent since the end of December. Banks and lenders such as Countrywide Financial Corp. in Calabasas, California, and Washington Mutual Inc. of Seattle typically take mortgages and package them into bonds for sale to investors. The bonds are then divided into pieces of varying risk.

Most credit-default swap trading is in securities rated BBB or BBB- because they are the most volatile and have the greatest chance to be profitable, said Jack McCleary, head of asset-backed trading for UBS AG in New York.

Subprime mortgages with those credit ratings historically have had losses of about 5 percent of the loan value, McCleary said. Some investors are betting that losses may increase to 12 to 14 percent in the next three years, which could exponentially increase value of credit-default swaps, he said.

Housing in U.S. Poised to Worsen, Derivatives Show

See An arm and a leg

AFTER THOUGHTS: It may be that focusing on the subprime market will lead to a wrong conclusion about the state of health of the housing market as a whole. In the overall cycle, it is intuitive that the subprime sector not react in absolute synch tith the rest of the market; neither is it the most significant part of the housing market. But it is important at the margin and, while it is not tremendously large compared to the whole market, neither is it insignificant in absolute terms. Perhaps it is just the "grain of salt" that Economonitor consumes along with his "consensus".