Publish date:

Funds Swap Into Subprime Short Plays

Rather than short lenders, hedge funds turn to derivatives.

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.


recent plunge in

New Century

(NEW) - Get Puxin Ltd. Sponsored ADR Report

and warnings from giant



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) - Get Amplify CrowdBureau Peer to Peer Lending & Crowdfunding ETF Report

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.

TheStreet Recommends

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.

In essence, buying protection in the form of a credit default swap is the same as shorting the subprime asset-backed securities. The riskiest parts of the ABX index -- the triple-B tranches -- are the best bet for a fall, the hedge fund manager says. As assets become riskier, the swaps go up in value.

"This is a leveraged bet against subprime finance," the manager says.

This is a not a trade that your average retail investor can make. Credit default swaps are traded over the counter by major Wall Street brokers catering to institutional clients.

"A lot of hedge funds are using it," says Ben Logan, managing director of Markit Group, adding that longer-term investors are also buying the swaps. Logan estimates that there is currently $350 billion of default risk being insured against across the ABX index.

As of Tuesday, buying protection on the riskiest subprime indices, the BBB- tranches, cost about 13.4% on a spread basis to cover $10 million of default risk, equating to $1.34 million per year, according to Markit and CDS IndexCo. This is up sharply from 4% at the beginning of the year and 2.2% in September. The spread hit a high of 19.9% in late February, when New Century's stock started to tank.

Whether the ABX index will drop further -- resulting in more profits from those shorting the index -- remains to be seen.

"It depends on how bad the subprime collapse is going to be going forward," says a Wall Street credit analyst, whose firm prevents him from being quoted in the media.

The major wild card for the subprime market is home price appreciation -- which stood at 5.2% last year, down from double-digit annual growth from 2003 to 2005. If home price growth goes to zero or turns negative, "then things will be very bad for subprime," and the ABX index could fall hard, the analyst notes.

If home price appreciation stays in the low single digits, then the subprime bonds may remain stable at current levels.

The other variable for the market is employment. On Friday, the government will release the latest jobs data for February.

A poor jobs report, coupled with any further discounting of homes by homebuilders such as


(LEN) - Get Lennar Corporation Class A Report

during the spring selling season, will only put more pressure on subprime borrowers, and shorting the ABX index could remain a profitable trade.