Monday, October 30, 2006

A nice, big, juicy subprime stake

The Venerable Wall Street Journal is shadowing the Bloomberg reports that Guambat added to his stew a week back.

How to gain from their pain, Guambat "networked" the idea, first reported by Bloomberg journalists, that you can profit from those edgy marginal borrowers, betting they really will go down with their ships, and make money on your bet if they do.

Whoo-hoo. Financial carnage as a profitable spectator sport, sort of like the cock-fights as the financially strapped battle to the death for their piece of the American Dream. Damn, you gotta love this system.

First, the VWSJ sets the stage: Pain From U.S. Housing Slump Is Likely
To Linger, but Some Say Worst May Be Past
(VWSJ articles require a ticket to read):
Former Federal Reserve Chairman Alan Greenspan, whose interest-rate cuts helped create what he once called "froth" in house prices, said in a speech last week that he detected "early signs of stabilization" in the housing market. [But see Paul Krugman's VNYT piece,Housing Gets Ugly, brought to you without payment of the toll by the Economist's View blog.] Some Wall Street economists also are saying the worst may be behind us.

Not so fast, replies Ian Shepherdson, chief U.S. economist at High Frequency Economics Ltd., a Valhalla, N.Y., research firm: "It's going to get worse before it gets better."

Both camps are making valid points. For now, the consensus among economists is that the housing downturn will remain a drag on the economy but probably won't sink the U.S. into a recession next year.

Then the VWSJ walks us through the various dark corners of the debt markets where vampires and werewolves prey on the weak and defenseless, sucking the life blood out of them. Ooops, sorry. Too much hallowweenie in my beanie.

Back to the sober VWSJ:

Risk Management
As Home Owners Face Strains, Market Bets on Loan Defaults
New Derivatives Link Fates Of Investors and Borrowers In Vast 'Subprime' Sector
'These Are the Marginal Guys'

Mr. Whalen, who manages a multibillion-dollar mortgage-bond portfolio at Los Angeles-based Metropolitan West Asset Management, stands to gain if Mr. Spirou, a financially stretched homeowner in New York City, reneges on his mortgage loan. That's because Mr. Spirou's $360,000 loan was packaged with thousands of others into a bond, and Mr. Whalen has entered a newfangled derivative contract -- similar to an insurance policy -- that will pay off if enough loans in the bond go bad.

"The sophistication is remarkable right now," says Mr. Whalen. "You can profit in any scenario."

Mr. Whalen represents a new breed of investor: people who are using financial instruments to bet against the homeowners they consider most likely to suffer in a housing downturn. Many such investors, including Mr. Whalen, don't expect the current slide in house prices to lead to widespread economic malaise. Rather, they're betting on trouble for folks like Mr. Spirou -- so-called "subprime" borrowers who have become homeowners thanks to the increasing availability of easy credit.

Whatever happens with Mr. Whalen's wager, there's a lot more at stake than his fund's performance or the roof over Mr. Spirou's head. Subprime lending has put as many as two million families into homes over the past decade, helping push the U.S. homeownership rate up to 69% from 65% -- a major shift toward an "ownership society" that politicians of all stripes have touted as one of the nation's economic successes. As the bets play out, they will show how much of that success is permanent, and how much a temporary phenomenon fueled by overly aggressive lending.

"You've got a lot of borrowers who didn't have credit before, and a lot of them don't know how to manage that credit," says Dan Castro, managing director at GSC Group, a New York asset-management firm that focuses on the mortgage market. "The place where you're really going to see fallout is in the subprime."

The advent of the subprime market reflects a sea change in the way banks make home loans. As recently as the mid-1990s, potential homeowners had to get over high hurdles to borrow money. Background checks could take weeks or months. Lenders typically required down payments of at least 20% of a home's value. People with dented credit, or young folks without adequate credit histories, had few if any options.

Over the past decade, though, a convergence of factors has emboldened banks to lend where they wouldn't before. For one, the development of the Internet and advances in computing technology have made it much easier and cheaper to process and package new loans. Electronic databases on borrowers have made it easier for banks to assess the risk of lending to people with shakier credit, while new insurance-like derivatives have helped them mitigate that risk. And robust demand from investors -- both in the U.S. and abroad -- has given banks a big incentive to lend, because they can easily turn around and resell the loans in the form of bonds, reaping a tidy profit.

As a result, both the volume and variety of subprime loans have boomed. Since the beginning of 2002, banks and specialized lenders such as ACC Capital Holdings Corp.'s Ameriquest Mortgage Co., New Century Financial Corp., and H&R Block Inc.'s Option One Mortgage Corp. have made some $2.2 trillion in loans. That is more than five times the amount in the preceding five-year period, and includes a growing share of "affordability" products such as "piggyback," "interest-only" and "no-doc" loans. These products, respectively, allow borrowers to avoid a down payment, make extra-low payments in a loan's early years, and state their income without supporting documentation. Subprime loans' actual interest rates are typically much higher than those on more traditional "prime" loans.

A recent study by two researchers at the Federal Reserve Bank of Chicago, Jonas Fisher and Saad Quayyum, suggests that subprime lending alone could account for close to half of the four-percentage-point rise in the ownership rate since 1995, almost as much as demographic changes, low interest rates and government programs combined.

"We looked at this and thought we're going to see lenders who are misusing these tools," says Mr. Whalen. "We're going to see the performance of their bonds deteriorate."

At about the same time, in early 2005, Wall Street bankers were developing a new kind of derivative contract that would allow investors such as Mr. Whalen to make bets based on their misgivings. Called a credit-default swap, it had previously been applied mainly to corporate and sovereign bonds. Like an insurance contract, it pays off if a subprime-backed bond suffers a certain amount of losses to defaults. The holder, known as a protection buyer, makes regular payments to a bank or other counterparty for the insurance, and also has the right to resell the contract. If defaults prove higher than expected and the bond starts to look riskier, the value of the contract rises, and the holder can resell it at a profit.

In January 2005, for example, Mr. Whalen bought an insurance contract on the Long Beach Mortgage Loan Trust 2004-2, the bond into which Mr. Spirou's loan had been packaged. He agreed to pay the counterparty, Citigroup Inc., $20,300 a year for a contract that would pay up to $1 million if more than 3.35% of the loans originally in the bond went bad. So far, the wager hasn't made money: He says he could sell the insurance for close to what he paid.

Lately, though, more investors have started worrying about what will happen to subprime borrowers as house prices plateau and start to fall. Rising home values rescued many borrowers who didn't have enough income to make their payments, because they were able to take the needed cash out of their homes. Now, if homeowners run into income problems and can't sell their houses for enough to pay off their loans, they will be left with no option but to let the bank take the house.

"While prices are appreciating or steady, people try harder to make those mortgage payments," says Stuart Feldstein, president of SMR Research Corp. in Hackettstown, N.J., which has done studies of house prices and foreclosures during previous downturns in California, Texas and other states. "But when their investments become worth less than what they owe, they tend to just walk away."

What's more, many will face an added shock as the monthly payments on their loans -- most of which are fixed for only two years -- reset to reflect higher interest rates. Christopher Cagan, director of research at First American Real Estate Solutions in Santa Ana, Calif., estimates that about $640 billion in subprime loans made in 2004 and 2005 will reset to higher rates over the next five years -- a trend that he expects will lead to some 450,000 added defaults.

"And that's just resets," he says. "That's not including things like job loss, divorce, death in the family or serious illness."

Meanwhile, data on loan delinquencies suggest that lending standards have indeed fallen. As of August, about 3% of borrowers who took out subprime loans in 2006 were more than 60 days behind on their payments -- about three times the level two years earlier and more than four times the level for all types of borrowers. Kenneth Rosen, chairman of the Fisher Center for Real Estate and Urban Economics at the University of California, Berkeley, predicts that by 2008 as many as one in five of all subprime borrowers will be in arrears, and that foreclosures will help send the homeownership rate back down by about a percentage point.

"While 80% of this is a good thing, the 20% that's bad is going to come home to haunt us," he says. "That's just the way it happens: Bad practices get exposed in the downturns."

That worry is reflected in the derivatives market. The annual cost of $1 million in insurance against moderately risky subprime-backed bonds has gone from a low of about $21,500 in early August to $25,000 Friday, and has spiked as high as $27,800. Market participants say big hedge funds increasingly are using the derivatives to make outright bets against U.S. homeowners. This summer, for example, New York hedge-fund manager Paulson & Co. launched a fund that has aimed specifically at profiting on subprime defaults.


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