The problems are only beginning...

Discussion in 'Trading' started by capmac, Aug 14, 2007.

  1. capmac

    capmac

    The problem is the leverage. It starts with the home/property buyer or speculator(house flipper). He buys a $300,000 property with little to no money down. A mortgage is generated through a lender who gets funding from an outside source. That document is now an interest bearing note. Who buys that note? Someone who borrowed money at 4% or less and buys that note yielding 6% as part of a tranche of morgtages. The differential in the interest creates yet another derivative or opportunity to leverage.

    So now we have unkown amounts of leverage applied to a house that cost 300k. 10:1 leverage, maybe more is used to enhance the spread of 1-2 points. So what happens when that house declines to $250k in value? What risk is there to the face value of the note? Roughly 16%+ under water, right? Now multiply 10x. Minus 160%, right? Hummm, that's a problem. You lost your principal and some of the leverage. That CDO you bought with 10x leverage is not only worthless, it's less than worthless. But don't worry, the loans are still paying interest, so everything is still cool.

    Now what happens when a portion or all of the mortgages in that CDO go into default? Now there is little to no yield and the assets are in decline. It becomes a chain reaction. The homeowner stops paying, the mortgage company stops getting payments, they can't pay the CDO holder. So now you have dead paper that if leveraged, is definitely worthless and you have lost part of the leverage also. You are not only insolvent, you owe money.

    The home buyer has it easy. He walked away from the property when he went under water and stopped his monthly bleeding. He just stuck the bank for the loan and the bank now has to pick up the taxes and insurance to protect their position. That costs money. If the buck stopped there, the bank could liquidate the house for 200k and take the 100k hit, no problem, it ends there.

    But it doesn't stop there. Some investment banker leveraged the interest differential and then sold it to a hedge fund that uses borrowed Yen to buy those notes to leverage them even more. He just added another level of risk, the $/Yen risk. If the Yen appreciates 4-5%, he is all done. It's a house of cards and the parties in the chain are all at risk for far more than their principal.

    I don't think the average person could even begin to understand how bad this really is. We know that 15% of subprime is in default, roughly 300 billion, 10x leverage means that on average there are 3 trillion in potential losses. There are 2 trillion in subprime loans. That means 1 trillion is owed to those who supplied the leverage. Yes, they can recover some of the losses from the sale of the property.

    If 50% of subprime goes to default, losses will be 10 trillion. That's just subprime, how about prime debt .
     
  2. Nice writing. No way out, I guess?

    Ursa..
     


  3. Great post.
     
  4. MattF

    MattF

    Slicing and dicing to reduce overall risk...for some.

    The rest, well, that's your problem to deal with...:cool:
     
  5. Very true and old story. People who created and pushed these CDOs could not care less about devastation they could cause. Their primary goal was commissions made in order to get bonus as big as possible. I have recently seen some article that all major financial firms bonuses will be 20% larger than last year, supported by income generated in first ½ of the year. At the end it is the taxpayers who get stuck with the bill. But it has always been like this.
     
  6. You gotta be kidding if you think your assumptions are correct. There is no way in hell all the subprime debt out there is leveraged 10x across everyone's books.

    Sure there may be the occasional case of some funds overleveraging their holdings, but highly doubtable this was universal to the degree of 10x.

    And just in case there was 10x leverage, remember the buyers of the credit default swaps on subprime, junk, and even A+ paper have been making a killing. The point that each trade has two sides.

    just because some GS quant fund leveraged equity holdings to 9x (or 6x, whatever it was) doesn't mean thats the universal trend or even anywhere near the avg leverage amount.

    The panic you're seeing lately has more to do with risk premiums exploding on all debt held, and thus margin requirements increasing, creating a surging demand for cash. Imagine you are a bank and you owned top quality A debt but only kept minimum cash on hand against the bond holdings. Then your bonds drop in value, stimulating a margin call. Cash becomes needed.

    etc etc.
     
  7. da-net

    da-net

    Great Post!!!

    Yes, the subprime problem is a house of cards. It has just started to collapse. The banks & hedge funds are taking some hits now The central banks are bailing them out.

    The hedge funds are selling what they can to raise capital and the stock mkt is having problems as they unload things that are profitable and hold onto non profitable positions (see attached article from NY Times).

    Home Depot, Lowes and others are taking hits. The next casualty appliance makers?? The insurance companies will no longer be collecting insurance premiums because the former home owner does not care and the banks & mortgage companies usually self insure through a company they own.

    But now...how do we make money off of it?? Let's put our collective intelligence & research together as a group and locate those opportunities created by this mess and share information freely!
     
  8. da-net

    da-net

    file didn't attach
     
  9. What is everyones opinion on the best thing the Fed can do to sort out this mess?
     
  10. Exactly. The OP thinks the sub-prime market is bigger than the U.S. equity market, the national debt ect. Hell, the entire U.S. mortgage total is only 6.5t......
     
    #10     Aug 14, 2007