Will Sub-Prime Loan Defaults Create Another Amaranth?

Will Sub-Prime Loan Defaults Create Another Amaranth?, 2/14/2007: When HSBC Holdings (NYSE:HBC) announced an earnings restatement last week, setting aside 20 percent more for loss provisions on sub-prime mortgage loans, the equity market for HBC and other sub-prime lenders such as New Century Financial Corp (NYSE:NEW) sold off sharply. But the prospect of rising loan defaults on bank balance sheets, in relative terms, is the good news.

Rising loan defaults are a normal feature of any credit cycle. What makes the past few years different is the degree to which derivatives and aggressive loan securitizations have spread the risk around, beyond the financial institutions which historically have specialized in creating and managing such illiquid risks. According to the FDIC, in 2005 almost 68 percent of home mortgage originations were securitized. …

Over the rest of 2007, we fully expect to see most of the major money centers announce higher loan losses and provisions for retail mortgage portfolios, and some banks may even be forced to restate previous periods. But the real threat to all of the major US banks involved in significant asset securitization lies in the probability that many of the collateralized loan structures employed to shift risk off bank balance sheets will unwind.

As Jody Shenn of Bloomberg wrote this week: "Subprime loan buyers typically can force lenders to buy back the mortgages they sell if borrowers miss their first few payments, any type of fraud is discovered, or the loans otherwise fail to meet the guidelines laid out in a sales contract." This is true even if the loans were packaged into a collateralized debt structure or CDO, anointed with a credit derivative enhancement from a hedge fund, and blessed with an explicit credit opinion from a rating agency, before being sold to yet another hedge fund.

Jamie Dimon, chief executive of JPMorgan Chase (NYSE:JPM), disclosed last week that JPM held only $5bn of higher-risk sub-prime loans, just two per cent of its total retail portfolio. He then bragged that the bank had sold much of its mortgage exposure — but to whom? Fact is that JPM, the largest derivative dealer on earth, likely sold much of its loan exposure to its hedge fund clients, highly leveraged entities that have significant clearing and credit exposure to JPM.

As the wheels start to come off of the mortgage collateral wagon in 2007, a number of money center banks and broker dealers, particularly the ones with large prime brokerage operations, may be forced to repurchase CDOs from hedge funds, mutual funds, banks and other clients who discover to their dismay that there is no bid for this paper, credit agency rating or no. This situation will be particularly poignant for JPM, which seemingly was the proximate cause of the Amaranth hedge fund failure and even profited from the fund's demise, as we wrote in a previous issue of The IRA. …

(via Institutional Risk Analyst):

See also, Hedge Fund Problems Start With the Fed, 2/5/2007

Comments

[bailey]

Dave,If you haven't seen it, this Charles Hugh Smith post of 2/21/07 on our housing exposure is info. loaded & includes a few wonderful links (new to me).
http://www.oftwominds.com/blogfeb07/pareto-housing.html?ref=patrick.net

[Dave Iverson]

Thanks for the "tip" Bailey,

I hadn't been to Charles Hugh Smith's site. I love his stuff, particularly re: housing market and hedge fund trends/expectations.

For others here is the link. I'll put it on my sidebar too.
http://www.oftwominds.com/blog.html