Research

Podcast: Hedge funds and the collapse of the subprime market

The collapse of the subprime market has hit hedge funds hard. According to Anthony Sanders, professor of finance and real estate at the W. P. Carey School of Business, many hedge funds forgot due diligence when the real estate market was hottest, and are now stuck with bad paper. Although the long term effects have yet to be seen, some consumers will feel the repercussions in constrained lending policies. An upturn in the housing market would help, and Sanders thinks that may happen sooner than some have predicted.

2007-08-01

The collapse of the subprime market has hit hedge funds hard. According to Anthony Sanders, professor of finance and real estate at the W. P. Carey School of Business, many hedge funds forgot due diligence when the real estate market was hottest, and are now stuck with bad paper. Although the long term effects have yet to be seen, some consumers will feel the repercussions in constrained lending policies. An upturn in the housing market would help, and Sanders thinks that may happen sooner than some have predicted.

Transcript:

Knowledge: The collapse of the subprime lending market has hit hedge funds hard. These funds have bought, sold or invested heavily in the once highflying subprime market. Business Week reports that hedge funds Carrington Capital and Greenlight Capital may face a world of hurt because of their dealings with major subprime lender New Century Financial, which saw its stock plunge 84 percent in four weeks as its accounting practices are being investigated by the Justice Department.

Anthony Sanders, who holds a Bob Herberger Arizona Heritage Chair, and is a professor of finance and real estate at the W. P. Carey School of Business, takes a look at why hedge funds have been hit so hard by the collapse of the subprime lending industry. He also looks at who else may be facing tough times as a result of the debacle.

Anthony Sanders: Hedge funds that have purchased subprime mortgages or securities that are backed by subprime mortgages have had enormous write-downs in their value. In fact Bear Stearns came out recently and said that their hedge funds that were investing in subprime mortgages were virtually worthless. So, that has kind of wiped out the … value in those hedge funds and, in fact, every hedge fund out there that has subprime mortgages in it has taken a real beating for the following reasons.

Number one, subprime defaults have been much higher than anticipated. Number two, when they have attempted to collect on the subprime mortgages, they are finding out that some of the subprime lenders were undercapitalized, meaning they didn't have sufficient funds to pay off their bad loans.

And three, one of the problems with the subprime market is that the paper issued on it tends to be highly illiquid, meaning that if Bear Stearns or anyone else has to actually sell the paper, there is virtually no market for it, other than at a steep, steep discount.

So, anyone that purchased this, I hope they got above average returns when the market was good because now they are paying the piper on the backend, meaning that they are stuck with this bad paper and its value is very, very, very poor. Now, having said that, if the subprime market turns around and the housing market returns, these securities will be worth more than what it was being posted at. But it's pretty rocky out there for the hedge funds.

Knowledge: So, how did it get to this stage?

Sanders: Between securities and investors — I mean, people who have bought hedge funds etc. — two words that have kind of vanished recently that must be brought back are "due diligence." I'm hearing a lot of stories from various people who call me saying that they work for hedge funds. They have bought all this paper. And I usually ask, "Where is the due diligence that you check on some of these mortgage brokers.

You check on the loan practices. And once you've entered a relationship, you are supposed to be constantly checking to make sure there is not fraud going on etc." What's happened to the due diligence in the market? It seems to have evaporated. And that usually happens when financial markets are hot, meaning that everything is fine. So, people kind of forget about the words due diligence. Now we are paying a huge price on the market.

And in fact consumers are kind of paying a price for that too because when everyone gets sloppy, not only do investors get hurt in the market but borrowers get hurt too. Some borrowers have made money, but some borrowers have actually lost quite a bit in the subprime crisis. In fact, a good example that is happening now is WaMu — Washington Mutual — will no longer originate 228 or 327 arms.

So, they are cutting back on their loan issues, which means that while some may say that's a good thing, on the other hand there might be some people on the fringe who will no longer be able to get into the mortgage market because these loans have been curtailed. And that's why I'm talking about predatory lending. It's when you say, "This contract should be illegal etc.," you have to be careful not to throw the baby out with the bathwater.

Knowledge: So, what has been the impact on the overall market?

Sanders: Well, the overall market, in terms of — let's just say the stock market — really hasn't shown up because consumer spending has remained strong. The stock market is, of course at an all-time high. So, it's rather paradoxical and this is one of the big questions a lot of investors — both in the United States and overseas — have been worried about.

It is that how are the housing market slump and the subprime crisis going to hit this general stock market? And so fraud of course is not really showing up. What it's hitting is investors and some lending or some lenders. I think some of the Wall Street firms that have been engaged in this have also taken a hit. But the rest of the market, for example the retail sectors, etc., have really rallied more than it has hurt the financial services sector.

Knowledge: What has been the impact though on, say individuals' 401(k)s, whose 401(k)s go into some of these companies that may have gotten these subprime lending rates? Has that been tracked?

Sanders: That's a separate issue. I think in the short run — that is in the stock market — everything is apparently rosy. The pension funds, 401(k)s, etc. that have these tainted loans in it, certainly that's going to devalue many of the pension funds out there.

In fact, there have been some interesting stories written that I have seen discussing how much of some of the major pension funds, such as CalPERS, which is the California Public Employees Retirement System and the Texas State Retirement System, have gone in and purchased some of this commercial paper on products such as CDO's, which are backed by subprime mortgages. And it's liable to hurt some people in the future that are planning on retirement because that's going to hurt the basic value of their retirement savings accounts.

Knowledge: And I guess that goes to the long-term effects?

Sanders: Oh, absolutely. That is, right now what we are seeing in the newspapers is just the short-term effect. The long-term effect is yet to be seen but we clearly know that if Bear Stearns, who is one of the preeminent investment banks in the world is having trouble unloading this paper, I shudder to think about some of the pension funds around the United States and how successful they are in trying to preserve the value of their paper.

I think there is really some blood in the water over this. And it's going to be ugly for some people, and particularly for people that are planning their retirements based on what some of the portfolio managers have been purchasing.

Knowledge: There seems to be a lot of "ifs" involved in order for some of these — the worst of this to be avoided. That doesn't sound very good.

Sanders: Well, it's interesting. There are a variety of opinions. Ben Bernanke was just recently discussing the future of the housing market and he's very concerned about its future. Well he should be. S&P and some of the rating agencies have come out and said they think that the housing market is weak and may be continuing to get weaker.

On the other hand, the Mortgage Bankers Association came out and said that actually mortgage applications have risen recently, which is usually a sign that the housing market has kind of bottomed out and is coming back. Based on my experience of the Mortgage Bankers Association, the MBA, I would say there is a very good chance the market is actually going to rally faster than Mr. Bernanke or the rating agencies or the Wall Street Journal thinks.

Knowledge: So, do you think this subprime lending market collapse has been part of the reason why we are here? We pretty much expect that the Fed will be holding its interest rates where they are?

Sanders: Oh, absolutely. The Fed right now really cannot risk raising rates because with the sheer volume of subprime adjustable rate mortgages or ARMs coming out, refinancing or resetting this year and next year, higher rates are just going to cause a cascade or a kind of a tsunami of subprime defaults.

So, realistically, in spite of the fact that the economy seems very good and ordinarily he would probably raise rates a little bit to cool off the economy, that's just part of the economy. The other economy is that he doesn't want to create this tsunami effect. So, I think, keeping rates right where they are is probably the right thing to do. That makes perfect economic sense.

Knowledge: So, what can the individual consumer do to remove some of this impact on them, or can they?

Sanders: Well, for the people who have already gotten involved in this product, there is one word of advice that could be very useful for consumers and that is if you start to not be able to make your payments, rather than just capitulate and roll up in a ball, what they should be doing is contacting their servicer. Their servicer of course is the entity that they make their monthly payments to.

The servicer right now, along with the ultimate holders of the notes, really would much rather have, what we call, a recasting. They would much rather see the borrower try to make some sort of short-term arrangements, lower the mortgage payment for several months, do something to avoid a default. Because right now, nobody wants to see additional delinquencies come on the market. No one wants to see additional defaults.

So, that's one thing they can do. They can talk to the servicer about legally recasting their payments. On the other hand, there might be some rather nefarious servicers out there who might take advantage of people who are in delinquency, such as accelerating foreclosures etc. But by and large, get an attorney, number one. But go talk to your lender, or to your servicer and see if you can do something about postponing what seems to be inevitable but maybe isn't.

Knowledge: You know, as I say, there is as much money to be made in the destruction of something as in the building of something. Are there actually some people who are winning as a result of this?

Sanders: Oh, absolutely. First of all, many of the people in the subprime market who were out in California until just recently, and made millions of dollars or made $1 million let's say off of a subprime loan. That is, they got in the market. They got their subprime loan. The housing market went way up. They were sitting very nicely. On the other hand there were people in California, if they had an ARM — adjustable rate mortgage — last year; they're probably not doing too well.

So, who's winning? Who are the winners in this market? Well, there are companies out there that actually go out and find subprime loans that have defaulted or they actually purchased the house at a substantial discount or they buy the subprime loans that somebody may want to get off their books at a substantial discount. So, you're right. Everywhere there is somebody that is winning — and that's legal — it's legal to go out and offer people cash for their house.

And you can actually offer a lending institution etc., cash for their mortgages just to get them off their books. And so, if the market turns around these people make a lot of money. But also this type of market sets up a real hustler's game, meaning that there are some people out there who can default, and let's face it going into default is for many people a very painful, awful process.

And there are some people, of course, in the market, who take advantage of that, such as try to induce people into early foreclosure and seize their house for violations that didn't really occur. It's just like any other market. By and large I think it performs very well but there are some people in the market who don't want it to go very well.

Particularly if you are a minority and you're not seasoned in the lending situation, or you are for example, a recent immigrant into the country in the last 10 years and you have not really used the American financial system, you may be kind of naive as to what's going on. And there are people that will of course definitely exploit those people.

Finance Real Estate Faculty