Funds Swap Into Subprime Short Plays

Rather than shorting troubled subprime lender stocks, many hedge funds that are bearish on housing are using derivatives to bet billions of dollars against the shakiest parts of the subprime market.

The recent plunge in New Century (NEW Quote) and warnings from giant HSBC (HBC Quote) have highlighted the growing risks inherent to the sector. Subprime lenders offer mortgages to homebuyers who do not qualify for regular mortgages, usually because of low credit scores.

Lenders in recent years sold off the bulk of their originated loans to Wall Street investment bankers, which securitized the loans into asset-backed securities. As homeowner defaults increase nationally, lenders such as New Century are being forced to take back bad loans from the banks and record losses.

In turn, New Century's stock has fallen 84% this year, while Accredited Home Lenders(LEND Quote) is down 36%.

Rather than continuing to short the subprime stocks, which have proved wildly volatile, some hedge funds are instead focused on betting against the asset-backed securities market itself by using derivatives -- specifically, credit default swaps.

One veteran hedge fund manager says the best short trade right now in the real estate sector is betting against the ABX.HE Index, a basket of 20 credit default swaps that reference subprime asset-backed securities. The index is managed by Markit Group of London.

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