Wrecking Ball Looms for Big Housing Spec

I have tried to make this column's topic simple, but what I'm writing about is complex because it deals with the derivative markets. It's doubly or triply complex because this situation has many layers to unravel, but there are two good reasons to address such a complex topic.

First, because residential housing is a large part of the U.S. economy, understanding what's going on beneath the surface of housing finance can be valuable. Second, anytime financial markets are highly levered, there is a higher probability that there could be a dislocation. When dislocations happen, it's unwise for investors to try to average down or up. Rather, the best strategy is to wait for the trend to overshoot, and take a contrary position.

There are a lot of players trotting out the bear case for residential housing and mortgages. I'm one of them, but I don't want overstate my case, having commented a few weeks ago on derivatives in the home equity loan asset-backed securities market. This arcane-sounding market is not small potatoes; it actually comprises several billions of dollars' worth of bets by aggressive hedge funds -- the same type of big bettors who blew up so memorably earlier this year, Amaranth and Motherrock.

A shift of just 10% up or down in residential housing prices might touch off just such another cataclysm, so it's worth understanding just how this "arcane-sounding" market works.

I said I might expand on my earlier post, but the need for comment and explanation of this market just got more pressing: To my surprise, one of my Googlebots last Tuesday dragged in a Reuters article and a blog post on the topic. I've seen other writeups on this as well, notably in Grant's Interest Rate Observer (a fine publication) and The Wall Street Journal.

How a Securitization Works (Basically)

It's difficult to short residential housing directly, so a market has grown up around the asset-backed securities market, in which bulls and bears can make bets on the performance of home equity loans. How do they do this?

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.