interesting fight

there is a scrap going on in the mortgage market that is pretty interesting. i’m not an expert, but this is a simplified explanation as i understand it (the actual markets and products are extremely complicated, for example tranches are involved). the housing boom was made possible by increased securitization and risk management in property finance. the process is basically that a company originates the loan, then turns around and hands it off to an entity like one of the bulge bracket investment banks or fannie mae. they package the loans together as securities, and sell them to investors.

there is also a derivatives market for the mortgage securities and their indexes (i.e. risk management). one party pays a premium to another party for a kind of insurance, called a credit default swap. from wikipedia: “It is an agreement between a protection buyer and a protection seller whereby the buyer pays a periodic fee in return for a contingent payment by the seller upon a credit event (such as a certain default) happening in the reference entity.”

speculators (hedge funds) have bought swaps in anticipation of a large number of mortgage loan defaults. they have bet that there are going to be increasing numbers of property owners who are unable to continue making their payments. on the other side of the bet, putting money on fewer loan defaults, are bankers like bear stearns.

so this is the fight shaping up between hedge funds and big investment banks. the banks on the protection-selling side of the swaps are buying individual distressd loans, or negotiating new repayment terms with struggling mortgage payers  in order to avoid having to make good on their bets. being lenient with borrowers may be viewed from the protection-buyer’s position as interfering with, or manipulating the mortgage market. that is a pretty big issue i think.

no matter who wins in this fight, my guess (as an economics n00b) is the end result will be less liquidity in the mortgage market.

sorry if this was a convoluted explanation.






5 responses to “interesting fight”

  1. Jondi Avatar

    You should just get your economics PhD already.

  2. eric Avatar

    hmmm but maths is hard. armchair economist is easier 😉

  3. […] she has a post up about the scrappiness going on in credit default swaps and subprime that i had previously written about. Going even farther, it isn’t the smallest leap in the world to then wonder if a clever bank […]

  4. Dan Avatar

    What’s interesting is to look at how the IB shops own a lot of hedge fund interests. For example the critical bailout by Bear Sterns IB side of two of its hedge funds in exactly these securities – to the tune of 3.2BB


  5. eric Avatar

    yeah the bear stearns bailout is a touchy situation. it’s going to be interesting to see what happens if these securities do get sold off and marked-to-market.

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