Default Rates on Subprime Loans Blamed for Dow Jones Drop
Subprime mortgage loans have a bad reputation to say the least. In addition to being cast as a major culprit in the rise in mortgage foreclosures in the United States, subprime mortgage loans were recently attributed to a 185-point drop in the Dow Jones Industrial Average.
Subprime loans are catered to people with less than stellar credit histories and other financial red flags, and are thus considered very risky. Essentially, a subprime mortgage loan lets a prospective buyer purchase a home at an initial low interest rate. However, these interest rates are not fixed and may be jacked up in time, leaving homeowners unable to pay monthly mortgage payments and in jeopardy of foreclosure.
As just one example of the dangers of subprime loans, Housing Predictor has estimated that at least 2 million residential properties will be foreclosed in the next 2½ years because of subprime loans. In December of last year, the Center for Responsible Lending noted its findings that 2.2 million subprime home loans made in recent years have failed or will end in foreclosure and ultimately cost homeowners as much as $164 billion dollars.
While subprime loans have been attributed to the startling numbers of U.S. homeowners who desperately need to stop foreclosure, these loans are also attractive to high-stake investors. With high risk comes the potential for high rewards, and many hedge fund managers have poured money into subprime loans hoping for such payoffs. Hedge funds are typically limited to wealthy investors looking to hit it big via unconventional strategies. Hedge funds are also appealing to these investors because they go mostly unregulated.
However, with the default rates on subprime loans around 15 percent, some of these big-time investors have had reservations and withdrawn their money. A recent 185-point drop in the Dow Jones Industrial Average was attributed to a $3 billion bailout of one of Bear Sterns' hedge funds. This bailout allegedly prompted fears within other investors about the current prospects with hedge funds, especially when considering the rate of subprime mortgages going into default.
Janet Tavakoli, president of Tavakoli Structured Finance, expressed her opposition to the Bear Sterns' bailout in a recent CBS story and elaborated that these types of power investors should be aware that they are taking a risk.
Tavakoli added that pension holders with hedge funds should not be alarmed by the troubled subprime market since most pension funds have small amounts of discretionary money in hedge funds. The story noted a Securities and Exchange Commission statistic that $72 billion in pension fund assets are in hedge funds.
Some people have called for Congress to begin regulating hedge funds. In March, ranking Senate Finance Committee member Charles Grassley unsuccessfully proposed that large hedge funds have to register with the Securities and Exchange Commission.
As this story reveals, subprime loans have continued to live up to their reputation as being risky propositions. While looking good in the short term, the allure of subprime loans can be dangerous in time. Unfortunately, many U.S. homeowners are learning this tough lesson firsthand as they try to stop foreclosure and save their homes.