8/12/2007

Volatility in the Credit Markets

The world of loans and finance is like a global pile of pick-up-sticks, and this last week demonstrated how one move rolls everything. On August 9th France's largest bank BNP Paribas halted withdrawals on the investment funds it said could not be fairly valued because they held subprime loans. The European Central Bank and Federal Reserve in the U.S. each added money to their own systems in response to the European banks' sudden demand for cash over the subprime loan market problems here.

The analyst at SCME Mortgage Bankers tells us that actually what you don't hear in your television news reports is that subprime loans themselves are not the problem: subprime loan delinquency rates are close to the delinquency rates on FHA/VA loans. When was the last time you heard about HUD-insured FHA loans in the media?--those low down payment loans which have been around since the Depression. Both types of loans lend to borrowers with lower FICO scores and other credit profile issues.

The difference is that the subprime loans are backed by bonds, and some hedge funds have raised capital to buy those bonds, and also borrow additional funds using that same capital, to buy more bonds through leverage. With a decrease in the value of the bonds, such as is now going on the subprime market, these hedge funds are receiving margin calls, meaning the lender wants its money. If the hedge fund cannot meet the demand, it suspends withdrawals. Some mortgage sources have paid out cash to meet the margin calls, and eventually are having to close their doors, American Home Mortgage--a strong and solid lender--being a good example. Banks which lent money to the hedge funds are now in the last few days backed up by deposits from the country's central bank, thus creating news when we read about the European Central Bank loaning $130 billion to its banks, and the Federal Reserve adding $24 billion to the U.S. banking system.

What has happened in the subprime loan market is a much larger story than a short spot on the 6 o'clock news. It's tied into our system of investing, who is regulated and is not regulated, and what happens when market factors change.

For another look at the current situation, click on this Singapore post.


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