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Foreclosures & The Multiplier Effect - OurBroker : OurBroker

Foreclosures & The Multiplier Effect

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If we’re just having a subprime crisis, then how come the impact is worldwide? That’s the essential question raised by Ben Stein, an attorney and economist who you may also know as a droll actor and TV pitchman.

Writing in the New York Times, Stein points out that we have a $10.4 trillion mortgage marketplace in the U.S. “Of that,” he writes, “a little over 13 percent, or about $1.35 trillion, is subprime — certainly a large sum. Of this, nearly 14 percent is delinquent, meaning late in payment or in foreclosure. Of this amount, about 5 percent is actually in foreclosure, or about $67 billion. Of this amount, according to my friends in real estate, at least about half will be recovered in foreclosure. So now we are down to losses of about $33 billion to $34 billion.”

“The rate of loss in subprime mortgages keeps climbing. In time, perhaps it will double, maybe back to $67 billion. This is a large sum by absolute standards, and I would sure like to have it in my bank account.”

But, says Stein, “the fears and terrors about subprime mortgages have helped knock off 6.7 percent of the stock market’s value in recent weeks. This amounts to about $1.1 trillion, or more than 30 times the losses so far in the subprime market. In other words, these subprime losses are wildly out of all proportion to the likely damage to the economy from the subprime problems.”

So is Stein right? Are subprime losses out of proportion to the financial turmoil we’re now seeing?

The answer is this: The apprehension and mayhem we’re seeing in stock markets worldwide is not just a by-product of a subprime melt-down. It’s largely an outgrowth of far-bigger worries.

One Link In The Chain

“In a global sense the subprime implosion is just a small part of the worldwide financial marketplace,” says Jim Saccacio, Chairman and CEO at RealtyTrac.com, the nation’s leading foreclosure marketplace. “The growing anxiety — and the real cause of apprehension — is different: The worry is not so much that we’re having a subprime debacle, rather it’s that rising foreclosure levels throughout the U.S. mortgage system will set in motion a series of bigger problems in related financial instruments.”

While a growing volume of subprime foreclosures is plainly an issue, the increasing concern is about loan formats, how mortgage repayment terms are arranged.

If you want a dull, boring loan with full docs you’re in. The easy financing choices now include conforming, 30-year, fixed-rate loans; self-amortizing ARMs and loans backed with FHA, VA or private mortgage insurance (MI).

What’s out are the toxic mortgage products which have flooded the market since 2000 — loans with little down and small up-front payments such as interest-only mortgages, option ARMs, 2/28 and 3/27 ARMs and loans generated with “stated-income” mortgage applications. Investors are increasingly unwilling to buy such “nontraditional” loans from originators. Without investor demand, lenders who continue to originate toxic mortgages are forced to hold such loans in portfolio — something few lenders want to do.

It’s Not The Mortgages

Looming in the background is something potentially far more dangerous than large numbers of foreclosures. There is a multiplier effect at work which greatly magnifies mortgage market ups and downs.

Derivatives are essentially bets that some asset or index will have more or less value in the future. Derivatives are purchased with substantial leverage, meaning that a small number of dollars can produce enormous profits — or losses.

To reduce the risk of highly-leveraged derivatives, investors — meaning hedge funds, large corporations, insurance companies, pension funds, short-term money market funds and international investors — try to balance their bets by acquiring an array of derivatives so that no matter which way the market moves losses are offset by gains.

It might seem that if bets are absolutely balanced then losses would be avoided — and profits would also be impossible. But, say advocates, complete balance is not the goal. Instead, profits can be made when computer models identify a small advantage in the marketplace. A small advantage multiplied many times can produce a massive profit.

Unfortunately, leverage works in both directions. Computer modeling systems assume there are predictable levels of symmetry, but when old benchmarks fall then risks can suddenly become totally unbalanced. In effect, once-prudent economic models will suddenly become risky.

There’s no question that the value of derivatives is substantially greater than the value of all mortgages because while mortgages must by secured with real property, derivatives only require an off-setting gamble by another investor. In effect, while the number of mortgages is limited, the number of derivatives is not.

No one knows the actual size of the derivatives marketplace, but it’s huge. For instance, there are believed to be 8,500 hedge funds worldwide with assets of $1 trillion, according to the International Monetary Fund.

Leverage At Work

How much have investors bet on derivatives? Again, no one knows, but we do know that tremendous multiples can be involved: As one example, according to the IMF at the start of 1998 a Greenwich, CT hedge fund named Long-Term Capital Management had capital worth $4.8 billion as well as derivative contracts amounting to roughly $1.3 trillion.

By September 1998, nine months later, the IMF says “LTCM’s equity (net asset value) stood at just $600 million and supported balance-sheet positions in excess of $100 billion, implying balance-sheet leverage of 167 times capital.” A consortium of financial sources put up $3.6 billion to rescue the fund when bad bets caused liquidity worries.

Why would anyone want to bail out a hedge fund? Because hedge funds leverage their bets with borrowed money. Big capital sources such as banks, insurance companies, pension funds and stock brokerages have loaned or invested billions of dollars with hedge funds. If hedge fund bets turn sour, then those loans — and the institutions that made them — can face massive losses if there are insufficient dollars to repay the advances.

If one hedge fund with $4.8 billion in capital can hold derivative contracts worth $1.3 trillion, then how much is held by 8,500 hedge funds as well as other investors?

The worry is that huge investors have borrowed from banks and other financial sources and then placed many of their leveraged bets on the movement of mortgage-backed securities. With a growing volume of foreclosures the value of mortgage-backed securities are less than they were six months or a year ago, meaning once-profitable computer models are no longer on target.

“Computer models based on the assumption of old default levels have resulted in derivative purchases by some bettors which are now totally unbalanced,” says Saccacio. “In the same way that leverage magnifies profits, leverage also magnifies losses. Small value changes multiplied many times can produce big results, and that’s why some funds are adding billions of dollars to shore up endangered investments.

“It is the threat from derivatives to financial institutions which increasingly worries investors worldwide, not just foreclosures in Flint, Miami or Stockton.”

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Published originally by RealtyTrac.com during August 2007 and posted with permission.

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