Banks May Rescue Defaulting Homeowners
This is a guest post I wrote for Five Cent Nickel this week.
There’s an interesting wrinkle developing in the ongoing housing bubble/sub-prime saga. It looks like many large banks may be coming to the rescue of defaulting borrowers. Why would they do something like that? Because it lets them avoid huge payouts to hedge funds.
Credit Default Swaps
There’s a common derivative called a Credit Default Swap (CDS). It’s essentially an insurance property against mortgage defaults. A Mortgage Backed Security (MBS) is sold by a bank to a hedge fund (or anyone else). To hedge the exposure, the fund buys a CDS that pays off big if certain default criteria are met. Interestingly, the hedge fund doesn’t even have to own the MBS to buy the swap. Kind of like taking out a life insurance policy on someone else with you as the beneficiary.
So what we have is banks lending money per their normal business model. But because they’ve also sold CDSs, they really, really, really don’t want people to default on their mortgages. If enough do, the bank will be on the hook for serious cash.
What’s a mega-bank to do? Help out the borrower, of course. Banks are rewriting loans to borrowers at risk of defaulting in an effort to prevent the default criteria from being met.
Market manipulation or good banking practices?
Hedge funds and other purchasers of CDSs are naturally not pleased with this development. They’re arguing banks shouldn’t be able to do this to avoid paying on the swaps. The hedge funds call it market manipulation. Banks say they’re doing nothing of the kind, they’re just trying to help the little guy keep his or her home.
Hedge funds have a real problem here for precisely the same reason they normally the freedom they do - they’re very lightly regulated. There’s no governing body to make the decision on whether what the banks are doing is ok or not.
So if you read or hear about banks benevolently reworking loan terms for at-risk borrowers, now you know that they’re not doing it out of the goodness of their hearts.
But you already knew that, didn’t you?
mortgage
July 2nd, 2007 at 12:58 pm
Smart move by the banks. Even if there was a regulatory body, as long as they’re controlled or appointed by elected officials, they’re going to side with the little guy losing his house over the big bad hedge fund anyway.
But that’s not to say that they should! Changing the rules during the game to help out the people that are losing at the expense of those who are winning stinks! Well, unless you are an economist, in which case you might say that laws should just keep the poor above water (so they can spend) and that the rich will continue to make the right moves and spend the same amount so that they end up saving less (thus keeping the economy growing).