News of troubles in the sub-prime lending sector for home mortgage loans has dominated the financial press in recent days. Here’s why it may all be another case of much ado about nothing. But first the back-story …
In case you’ve just returned from the far-side of the moon, HSBC -- a leading-edge innovator in sub-prime mortgage lending -- warned last week of problems in their mortgage loan portfolios.
The troubles at HSBC stem from its purchase several years ago of the old U.S.-based Household Finance for $15 billion. Household Finance's core business of course was somewhat akin to a loan-sharking operation – only slightly more regulated.
Hubris Gets the Better of HSBC
HSBC and its Household Finance unit made a fortune during the late-great housing boom by lending money to home buyers with scant loan documentation and sketchy credit histories. Now that adjustable rates are ratcheting higher – while home prices are rolling over – it seems that an increasing number of home-owners are willing to leave their keys under the doormat and move on.
The resulting increase in defaults caused HSBC last week to increase its loan-loss reserves to $10.5 billion. But even in a worst-case scenario in which the entire amount of bad loans is written-off – HSBC may still salvage $5 billion or so in remaining equity from its $15 billion investment in Household just three years ago – so all is not lost.
Since HSBC’s troubles hit the financial press, media pundits have been falling all over themselves declaring that the housing sector is about to plunge over yet another cliff, but that remains to be seen. It seems more likely that the HSBC case is more of a company-specific problem being magnified out of proportion. In fact, it looks like a classic case of hubris getting in the way of good business sense.
Bleeding-Edge Mortgage Loan Innovator
When HSBC acquired Household Finance in 2003, as mortgage lending innovation was reaching its zenith, it was a clear-cut case of reaching for market-expanding growth at any cost. The Household business was expected to transform the stodgy reputation of HSBC and offer the company a new platform for higher-margin lending. By combining Household’s consumer-lending prowess with HSBC’s capital base – the sky was the limit.
But in a classic case of pushing too much of a good thing, a few years post-merger HSBC decided that originating loans wasn’t enough; it would also start buying up risky mortgages from other lenders and add them to its portfolio to earn even greater profits.
Apparently the thinking at HSBC was that its own staff of cracker-jack lending experts was smarter than the competition at judging risks. HSBC of course found that they just weren’t as smart as they thought when it came to assessing default risks. Sounds eerily similar to Enron’s energy-derivative trading strategies, designed to transform the company from a stodgy old utility.
Insurers Of Last-Resort Raise Rates … After The Storm Has Passed… Sounds Familiar
As for the chicken-little act in the financial media, it seems unlikely that HSBC’s troubles are a sign of more sinister problems ahead. For the most part, the sub-prime credit market seems to be functioning normally.
It's been reported that in the derivatives market, the cost to insure sub-prime mortgage loans against default has just about doubled in the past few weeks. But that’s the nature of the beast -- a natural knee-jerk reaction to the fear-mongering headlines in the Wall Street Journal.
Naturally the cost of insurance will go up whenever there’s a quick market disruption of this sort. Underwriters of these derivatives have pricing-power right now to command a premium in exchange for their willingness to take the other side of the trade – and guarantee companies like HSBC against even more loan defaults.
Think about the market for windstorm insurance policies immediately following a hurricane … as a homeowner in coastal South Florida, I can tell you first hand all about skyrocketing insurance costs just after the storm has passed.
Apparently, investors willing to step-up now and take the other side of this default-protection trade can earn nearly 13% per year on their money over the next decade. That’s a pretty good return in today’s low interest rate environment.
And it’s all in a day’s-work for a properly functioning credit market!
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Posted by: Shaina | July 30, 2007 at 07:48 PM