Is there worse to come for the subprime mortgage market?

With billions of dollars' worth of subprime loans set to be reset from their artificially low starter rates of interest in the coming months, the market still has plenty to be scared about.

Six months ago at about the time the housing market in America peaked, we learn that subprime mortgages represented 13% of the total of their mortgage stock quite incredible! Financial institutions knowingly lent, at artificially "low start" rates of interest, 100% mortgages to people with bad credit records; not checking on anything, accepting the word of the applicant about income and all other financial matters. Given the figures quoted above, they did this on a massive scale. This would be understandable if it was the result of rogue bankers but it was not. It was a deliberate thought through business plan.

The rates of interest initially charged for many of these loans were not the correct rates but "teaser" rates - in other words, a lower rate of interest, well below the market, was charged with the unpaid amount accumulating to the debt. At a certain predetermined date, these mortgages are reset from when the full payment has to be made, not just on the original loan but also the accumulated amount of any unpaid interest.

The fact that these loans were unaffordable in the first place and even more unaffordable following the resetting, should come as no surprise. Huge numbers of these loans are still scheduled to be reset over the next few months which must lead to massive additional delinquencies. We are grateful to John Mauldin for publishing the figures, they are listed below, starting from the current month of August and the numbers are billions. If you want to know why the market is running extra scared, one reason is the knowledge of this huge poisonous cloud hanging over it.

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August 2007 $52bn

September $58bn

October $55 bn

November $52bn

December $58bn

January 2008 $80bn

February $88bn

March $110bn

April $92bn

May $76bn

June $75bn

July $50bn

Justification for this madness was the dispersal of risk. As you will have probably read elsewhere, these loans were sliced and diced and repackaged and sold as mortgage-backed bonds. They were rated by Moody's and Standard & Poor's, often as high as AAA. These CDOs, as they are called, were then sold to investors such as hedge funds. These toxic investments are now spread throughout the world causing immeasurable contamination. What has made the whole situation so much worse is the excessive leverage.

Leverages are everywhere. To give an example of this, the Goldman Sachs funds that have been in great difficulty were leveraged by a factor of eight to ten times and therein lies the rub. Goldman Sachs, who deny bailing the fund out, have nonetheless injected $2 billion of their own money and persuaded outsiders to contribute a further billion, in so doing, have reduced the gearing to 3.5 times still very rich!

What astounds us is that so many of the participants have been surprised at what has happened. They have the brightest brains and the most modern of computer systems. These computer systems were mentioned in a recent article in the Financial Times by GillianTett and Anuj Gangahar; they said that Goldman Sachs, renowned as one of the savviest players on Wall Street, had to admit that their flagship global equity fund lost over 30% of its value in just one week because of problems with its trading strategies created by computer models. In particular, the computers had failed to foresee recent market movements to such a degree that they labelled them a "25 standard deviation event"; something that only happens once every 100,000 years or more, yet very recently several occurred on consecutive days.

The conclusion one must draw is that in some fashion or another this extraordinarily, but we say predictable, chain of events that could only end in disaster are like alchemy, transformed when fed into complicated mathematical equations and crunched by computers to a one in 100,000 years or more probability of collapse. The fact that these computer programs have control over such huge amounts of money should send shivers through the system and bring a smile to Nassim Taleb's face. Nassim Taleb makes a living out of betting on such rare events. He is famous for his books "Fooled by Randomness" and subsequently "The Black Swan". He uses the symbolic "black swan" as an example of a rare event and explains that just because you haven't seen a black swan doesn't mean that one does not exist, as indeed they do!

By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.

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