Ten Years Ago in Grasping Reality: July 16-18, 2007
Clueless DeLong Was Clueless: Hoisted from the Archives from 2007: The Domestic Macroeconomic Outlook: February 28, 2007

Clueless DeLong Still Clueless, But Slightly Less So: Hoisted from Ten Years Ago: High-Grade Structured Credit, and Time for the Fed to Start Cutting Interest Rates

Clueless DeLong Still Clueless—Albeit Slightly Less So: High-Grade Structured Credit, and Time for the Fed to Start Cutting Interest Rates: Hoisted from Ten Years Ago http://www.bradford-delong.com/2007/07/high-grade-stru.html: BondDad writes:

Daily Kos: $10 Billion Hedge Fund Now WORTHLESS: $10 Billion Hedge Fund Now WORTHLESS: From CBS Marketwatch:

A Bear Stearns Cos. hedge fund that made leveraged bets in the subprime mortgage market is worth nearly nothing, according to two people briefed by the investment bank. Investors have been waiting for Bear to update them on the High-Grade Structured Credit Enhanced Leveraged Fund and a larger, less leveraged fund called the High-Grade Structured Credit Fund. The Wall Street Journal reported on Tuesday that the larger High-Grade Structured Credit Fund is worth roughly 9% of its value at the end of April.

bonddad's diary :: For those of you catching up on this story, here's the short version.  About 2-3 weeks ago, Bear Stearns announced that two hedge funds invested primarily in the structured finance area (Collateralized Debt Obligations and Collateralized Loan Obligations) were experiencing record redemption requests.  The problem with these requests is the fund was heavily leveraged -- meaning they had borrowed a ton of money.  Reports have the leverage ratio at either 9 or 10 to 1, meaning for every $1 in equity/investment there were at least $9 or $10 in borrowed funds.  These redemptions forced the funds creditors to make a margin call, or asking for their money back. Eventually, Bear made a loan of $1.6 billion to the funds to bail them out.  Now, a few weeks later, we learn the [HGSC] fund is pretty much worthless.

I have been an optimist about the subprime market. It seemed to me that there would be four and only four consequences:

  1. People sold zero-down effectively non-recourse loans at teaser rates who found that they could not afford the reset payments will have to move, but will have gotten several years of relatively cheap rent.
  2. People with equity in their homes sold negative-amortization loans that they could not afford will get creamed: they will lose their equity, which will have been effectively stolen from them by financial sharpies.
  3. Wall Street professionals and investors who did not read or understand the fine print as to what the ABX was or how the rating agencies did their backward-looking calculations will lose--some because they didn't understand that you cannot hedge a prospective loss by shorting a retrospectively-calculated index, some because they bet the liqudity flood would push spreads even smaller, and some because they didn't understand how large the nonlinearities were that meant that the synthetic risky securities you created by leveraging-up higher-grade ones didn't behave like the real risky tranches.
  4. Wall Street professionals and investors who did read and understand the fine print as to what the ABX was and how the rating agencies did their backward-looking calculations will profit, and will boast to prospective investors in the future about their high returns.

Of these, only the second is worth worrying about--only the second group is truly getting the shaft.

It seemed to me that these would be the four and the only four consequences because the losses would be contained. They would not spill over into massive numbers of foreclosures and substantial housing price declines in large chunks of the country. Because there would be no melt-down in the price of the underlying--the actual houses--the tempest would be confined to the financial teapot rather than spreading throughout the rest of the economy to wreak havoc (with the exception of the people who are fleeced of their equity by financial sharpies).

Now I am not so sure. It no longer looks like things are as contained as I had thought.

Duncan Black directs us to:

Irvine Housing Blog: 100% Financing Failure: Part of the bearish argument for a dramatic drop in prices is predicated on an infusion of “must sell” inventory to the housing market. Sellers won’t sell at a loss unless they have no choice. This is why prices generally are sticky in a housing market decline. Foreclosures and short sales are by their nature must-sell inventory. For this must-sell inventory to be forced onto the market people must be unable or unwilling to make the payments on their mortgage. The “unable” part will come from reseting ARMs with higher interest rates; the “unwilling” part will come from people walking away from 100% financing deals when market prices do not continue to rise.

It is this latter category of unwilling homedebtors that is unusual in this market. In previous bubbles, lenders were not so stupid as to offer 100% financing, so there were not as many people who utilized “jingle mail” as they went underwater. It is my opinion that jingle mail will be epidemic as this bubble unwinds. Today’s property is a typical short sale. The seller overpaid with 100% financing and now is going to walk away...

And to Nouriel Roubini:

RGE - U.S. Homebuilder Confidence Drops to 16-Year Low as Housing Slump Persists: There are at least four factors that will increase the excess supply of new and existing homes this year and next and lead to even lower home prices:

First, the credit crunch in the subprime market will reduce the demand of new homes by potential subprime borrowers. Goldman Sachs estimated this effect to be as large as 200k less new homes sold this year.

Second, about  $1.5 trillion of ARM will be reset this year and next: a rising fraction of these borrowers will be unable to afford the much higher rates on their mortgages and will be forced to sell their homes.

Third, it takes about six months or so for a subprime mortgage deliquency to lead to foreclosure, and the bank taking over the home and then putting it on sale in the market; once that occurs, the supply of homes in the market will increase. Some forebearance will occur but many homes will end up in foreclosure and then sold by the creditors adding to the housing supply glut.

Fourth, folks who bought homes in the last two years for speculative reasons with little equity (the condo flippers) will sell their homes as rapidly as possible as now falling home prices are wiping out the little equity they did have in these homes.

In summary, all four factors will increase the excess supply of unsold new and existing homes and will push further downward home prices. The housing carnage will get much worse before it gets any better. And the financial fallout of this subprime - and now near prime - mortgage meltdown is only beginning to show its effects in financial markets: not just in the RMBSs, CDOs,  TABX and the ABX markets; but increasingly in commercial real estate and corporate risk spreads as the recent market performance of the CMBX, LCDX, CDX, ITRAXX indices shows. Certainly the contagion to the LBO loan financing market is already clear...

Certainly it's time for the Federal Reserve to make noises about how minimizing foreclosures and evictions is a good strategy for financial institutions to adopt.

And if I were on the FOMC I would start voting to cut interest rates.