Warnings over hedge fund crisis

Richard Gluyas raises Warnings over hedge fund crisis because:

They have had their values slashed since May because of their exposure to the CDO (collateralised debt obligation) market, which in turn was partly exposed to the US sub-prime mortgage market.

What this means is that a whole lot of smarties got a lot of people with very shaky ability to pay to sign up for fixed rate, low-doc home loans in a rising housing market. These loans had their interest rates fixed for about three (3) to four (4) years. The buyers hoped to make a profit by selling their homes before the interest rate became variable and higher.

Unfortunately, the housing market was acting like a pyramid selling scheme. As long as there were enough mugs to pay ever increasing prices for houses, the market prices could keep on rising. When the market ran out of mugs, the bubble was bound to burst. The reason for the shortage of mugs is the relatively slow growth in supply because of immigration restrictions and native birth rate.

Even if these restrictions were overcome, the limit would still be reached. The great majority of home buyers can only afford one (1) home loan at a time.

Underlying this looming disaster is the mistaken belief that people can become rich by buying and selling. Here, people believed that, by buying a house for $250,000 and selling it for $650,000, they would become $400,000 richer. (Ignoring all of the costs associated with this - payments, taxes, etc.)

The problem is that the price of the houses have risen. To repeat the same trick, the punter would have to buy at $650,000 and sell at $1,050,000. This requires some other mug to raise a $1,050,000 loan. As the values rise in a stagnant wages market, the ability to pay off such loans becomes increasing unlikely.

In the owner's mind, his house is worth $1,050,000. In the lender's mind, the house is worth $650,000. So, the lender sells this loan along with other loans of the same ilk to another mug who thinks that he is buying the right to collect the interest and principal on these loans and as well as the collateral.

The lender wins because they are no longer exposed to these loans going bad, but they lose the income from the loans. So, they are making money off the fees for raising these loans and selling them. As long as there are mugs to take up the loans, and mugs to buy the loans, how can they lose?

They lose when they run out of mugs! This is what is happening at the loan buyer end of the market. The buyers are devaluing the CDO (bundle of loans) so much that the fee income for the lender is not covering the discount needed to on-sell the loan. As the lenders are unwilling to carry the risks themselves because of their low capitalisation, they have to restrict supply of loans by either increasing the interest rates or increasing the quality of the loan. Either way, the chances of finding mugs with $1,050,000 to buy a home are becoming very unlikely.

Thus, housing prices should fall thereby making existing loans far riskier because there are enough buyers to buy the house at the principal. This will further drive down the price of the CDO and cut the capitalisation of some hedge funds who rely on them as assets.

This is almost like 1929 with the high-leverage schemes masquerading as asset growth.