By now, unless you've been living under a rock (either by choice or if you house was foreclosed), you have heard of the subprime crisis. This has been due largely because of cheap credit and the ability for banks to package up loans and sell them to various investors in CDO's and CLO's. Buttonwood had an interesting article this week on Prime Brokers are Hedge Funds. It is a very good article and if you haven't read it then you should. In the article, Buttonwood writes,
"After all, prime brokers provide the finance that allows hedge funds to gear up their returns and lend them the stocks so they can sell individual shares short (ie, gamble that their prices will fall). And monitoring is made all the easier because three investment banks—Goldman Sachs, Morgan Stanley and Bear Stearns—dominate prime brokerage. The trio act as brokers for about 60% of hedge-fund assets.
But this is where the paradox appears. Hedge funds are supposed to be dispersing risk. But if their chief financiers are just three Wall Street banks, is this dispersion more apparent than real? Could banks have shown risk out of the front door by selling loans, only to let it return through the back door of prime broking? Take credit insurance. Banks that own corporate bonds may use the swaps market to hedge against a company defaulting. But if the other side of the swap is taken by a hedge fund whose finances are dependent on loans from that same bank, has risk really been transferred?"
An interesting paradox indeed. So on one hand the banks "eliminated" risk by securitizing crappy loans to a fund that they then count as assets when assessing prime brokerage loans. Oh so this is what they mean about contained? How much different are hedge funds than subprime Borrowers? Both have been given loans that were secured with an assets that were worth much more on paper than what they are in the market and now both are now encountering solvency problems due to this. They are no different because they are the same. According to REIdepot, the definition of a subprime loan is "any loan in which the borrower has challenges in obtaining mortgage financing because of poor credit, hard to document income or assets, or any unique situation that would prevent them from obtaining funding through "conforming" lenders." Hedge funds don't really have a credit history - many have only been around for a few years. The industry in general has also had some derogatory credit events equivalent to bankrupcty for the consumer (Long Term Capital, Amarenth, etc). Their assets are sure hard to document as we found out w/ Bear Stearns. More important that that, their income is based on the loan that they are being given. Since hedge funds by nature earn money based on capital flows and performance, if they perform poorly they will soon have no income as they miss out on performance fees and lose assets - talk about stated income. Is this not the same thing as the real estate "flipping" that occurred at the end of the real estate bubble, but on a grander scale? Where people were lent money so that they could buy a house, but there only source of income was the houses that they were flipping.
This raises some interesting observations:
1. It is in the interest of the Investment Banks to ensure that these loans do not go bad. With the power that the wield, I would not surprise to see some "manipulation" of the market on the behalf of their biggest clients. If I were a retail investor I would be leery of any proprietary products or research they are selling you at the moment.
2. Inflation is caused by too much money chasing too few assets. In housing this resulted in an enormous boom and a subsequent and continuing bust. Hedge funds own many assets - stocks, commodities, bonds, et cetera. And we all know many assets have been inflated in the past few years. What will be the effect of a subprime default on their end? Will assets such as stocks follow suit?
This is how subprime spreads. Yes, it could have been contained but it would never have existed if it WAS NOT contained. Banks do not take risks unless it is in their self-interest (in this case it probably wasn't and they were wrong). They spread the risk around. If subprime is a contagion and a disease like AIDS, if you spread it around, everyone gets sick. It just takes time to diagnose and develop.
Fantastic Post. Homeowner Loans are a popular way of borrowing larger sums of money by securing it against your property. Remember though, while the rate and monthly amounts look good, you will be paying back over a longer period of time and therefore will pay more money back in the long term. If you can try and overpay so your term will reduce and you won’t pay as much interest.
Posted by: Homeowner Loans | January 22, 2008 at 05:27 AM
Great Post. I would also suggest readers to be careful and think carefully before taking on any additional credit and if consolidating, remember not to run up those store and credit cards again.
A secured loan did help me get back on my feet but I am overpaying each month so I don’t pay as much interest in the long term. Also means I will be debt free sooner!
Posted by: Homeowner Loans | January 22, 2008 at 05:29 AM