Many hedge funds loaded up on the mortgage-backed paper and leveraged the investment, sometimes by as much as 90%. To clarify: say a hedge fund put up $10 million of cash -- investors' cash. It would borrow another $90 million and control a total of $100 million worth of mortgage-backed paper.
The $90 million was borrowed at say, 6% interest, so the fund was responsible for repaying its lenders $5.4 million per year in interest. But off the underlying mortgages, the $100 million was earning about 7%, or $7 million per year. So the fund was paying $5.4 million on the borrowed money, but earning $7 million on the total fund. Net, it was ahead by $1.6 million. The fund's objective was, if the Federal Reserve began to lower interest rates, the total $100 million fund might grow to be worth around $110 million, for a $10 million profit.
That's the upside of leverage. Remember, the initial investors' cash was only $10 million. If the fund profited by $10 million, that would be a 100% profit to the fund, plus the minor $1.6 million of positive cash flow. Pretty good investment and fairly sound. Until...
Home values began to fall off in late 2006. No big deal, just a "correction" in the market place, expected to work itself out in short order. By the way, the Federal Reserve in late 2006 and early 2007 was more concerned about inflation than interest rates -- the Fed was not about to drop rates. Also, millions of "teaser rate" mortgages were about to re-set to higher rates and unqualified buyers -- now homeowners --became scared and nervous. The top was seen and homes began to hit the market. Inventories of unsold homes began to grow, and of course, home builders were still building new homes like crazy.
Stop the madness... it's all coming to a head.
Under normal market circumstances, the United States economy could handle and manage a slower real estate market. It's a thing called " normal cycles." But remember those leveraged hedge funds? That's where the "crisis" really began.
Continue reading The Good, the Bad and the Ugly: The Financial Stocks, Part 3
Georges Yared is the CIO of Yared Investment Research and the author of Stop Losing Money Today.
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