Subprime Mortgage Meltdown Explained From The Hedge Fund Perspective

I‘m constantly getting bombarded with questions about exactly how the meltdown was allowed to happen by readers, reporters, and consumers. So I thought I’d take a minute and explain just how the hedge funds used subprime mortgages and how they got caught with their pants down in the last few months causing the mortgage meltdown and the credit crisis that followed.

The typical subprime mortgage hedge fund trade goes like this:

1. Borrow in Japan paying 2% interest, then convert to US dollars.
2. Invest US dollars in US CMO (collateralized mortgage obligations) paying 8% (subprime mortgages get higher yields).

If that was all that the hedge funds did they would have lost money, but a credit crisis could have been averted.

But they didn’t do that because an easy 6% profit simply wasn’t enough for our typical hedge fund manager…he got greedy.

In his greed, he did this:

Instead of simply buying his subprime CMO’s dollar for dollar from his broker, he asked for a loan to increase his leverage…like buying on margin. The hedge fund was granted typically $3 borrowed for every $1 invested. This increased leverage on an already leveraged investment increased the hedge funds yield to over 15%!

Wow a risk-free annual return over 15%!! You’d be a fool not to do this with billions and billions, right?

Wrong!

If you or I wanted to buy on margin we would only be granted a maximum of $1 borrowed or every $1 invested, as a protection from getting over-extended. So the hedge fund managers got special treatment. This special treatment would be their undoing.

As anyone knows who has ever bought on margin, the biggest fear is the dreaded “margin call”. This is when your underlying equity drops in value and your broker calls demanding more money to “cover” which is slang for “get us back to $1:$1 or we will sell your margined equities to get there”.

The same thing happened to the hedge funds when the underlying value of the CMOs started dropping. Once the defaults on the underlying mortgages inside the CMOs became known, then the CMO itself was devalued. Now the hedge fund gets the dreaded “margin call”. Pay us now!

The hedge fund manager doesn’t have a Billion dollars sitting idly by so he must look at selling the CMOs themselves to cover his margin…but because everyone is now worried about how deep the defaults go inside the CMO’s, no one is a buyer.

So now the hedge fund manager needing to raise cash fast is forced into selling other stocks, bonds, etc….and the stock market takes a beating.

The hedge fund manager is still holding the CMOs and may experience another round of devaluation and margin calls, triggering his need for even more “bail out” money. When the Fed opened the discount window and would accept CMO’s giving 30 days terms, this temporarily gave the hedge funds a source of cash to cover their calls.

But it didn’t solve the underlying problem…hedge funds who played this greed game will continue to drop like flies.

As a side note:
Without the hedge funds greed game, the subprime wholesale lenders would not have had a subprime CMO to dump their crappy loan on.

Without subprime wholesalers, the retailers, banks, and brokers would not have had a “stated income, 100%, 560 FICO”, crappy product to sell.

And finally, your house would not be sitting next to 3 foreclosure houses all purchased in the last 3 years using said crappy subprime loan.

So when deciding who we should all blame for the “subprime mortgage meltdown”…start at the top and work your way down.

There’s enough blame to go around.

Good Luck

Author: Rob K. Blake
Published September 11, 2007
Modified January 9, 2008

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