Advanced Personal Finance

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?

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Businessweek.com had a really interesting angle on the sub-prime mortgage situation. In this article, author Peter Coy explains that many sub-prime borrowers are choosing to pay the credit card bill first and the mortgage if there’s anything left over.

It seems the percentage of sub-prime borrowers 30 or more days late on their mortgage rose from 32% to 36% from 2003 to 2006. At the same time, those with credit cards 30 or more days late dropped from 32% to 24% over the same time period.

I find this fascinating. I always assumed in an extreme emergency people would pay their bills in roughly this order: shelter, food, utilities, everything else. It seems that’s not the formula for a large group of people (according to Freddie Mac, 5% of all home loans are to sub-prime borrowers) .

I tend to agree with the author’s analysis that the reason for this peculiar finding is that many sub-prime borrowers have little to lose in foreclosure. They’re already sub-prime credit risks. A foreclosure’s not going to lower their already-low credit score much. And many of them put little or no money down on these houses. Combine that with the fact that foreclosure takes a remarkably long time and I can see why you’d get people more interested in making their credit card than mortgage payments. With a current credit card you can buy groceries and gas. Not so much with a current mortgage.

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