Friday, February 02, 2007

Critical Mass Meltdown

We have touched on the obvious foreclosure problem. The graph on Bankers Worst Nightmare has a new point to plot 9,900 foreclosures February 1, in California. That’s pretty close to the 10,000 projected. Now we have financial lenders dropping dead and closing their doors at an increasing rate. The Bakersfield Blog has been on top of this particular item. I've included them in the Links list on the left for easier tracking.

There is some confusion about whether or not the right choice of words for the financial loan writer is a “bank” per se or “mortgage lender.” These entities’ closing their doors don’t seem to have all the attributes of banks. Who ever they are, they are writing the 80/20 loans with no PMI. And right now the 20% part of the loan is toast.

Notice how the interest rates on secondary paper is starting to climb. As a footnote, if you want to sell a $100,000 second that is written at say 7% you may have to discount it to say 10% interest in order to move it off the books. The discount would be $30,000. The face sale of the note would be $70,000 (Interest paid by the note is $7,000). A lot of the major banks are reducing their exposure to the secondary trust deed market.

The housing market might not be the first thing to collapse. It could be an institution that supports it. Right now, lenders are closing their doors. They are getting out of the loop as fast as they can to avoid being sued. I can’t really blame them.

If you look at the graph on Bankers Worst Nightmare ,you see that the doubling of foreclosures projects about 20,000 homes at the beginning of May of this year. Here is where it gets interesting. The hedge funds have insured all of this 80/20 risk with derivatives. Question, if they were able create a multiplier that increased their wealth by say 10 times with the use of derivatives, doesn’t it make sense that it works in reverse as well as it did going forward?

So let’s see the chain. Homeowner--> Foreclosure -->Loan Originator -->Loan Insurance--> Hedge Fund -->10X multiplier -->Critical Mass! The hedge funds have insured these loans. In an up market, everything is business as usual. In a down market things can get fugly. There could be a call to satisfy the contract against loss by the bank to the Hedge fund. This could signal the beginning of a hedge fund melt down.

It doesn't look like its too far away at this point in time.

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