by Tanta on 6/01/2007 07:28:00 AM

We've talked a lot about the individual and community misery generated by housing busts, irresponsible lending, and waves of loan failures. We have pondered the potentially devastating effects on employment, residential investment, and consumer spending. We have surely noted the damage to shareholders of bankrupt mortgage originators and investors--true bagholders--in mortgage-backed bonds.

Evidently we have forgotten to spare a tear for those poor hedge funds, whose honest day's work of betting on failure, without having to pony up any real capital, apparently, is under threat. Yes, friends, there's a conspiracy afloat to put the interests of homeowners--the people who supply that cash-flow--and actual capital investors--the people who supply the actual loan funds--ahead of the credit default swap punters. I don't know that I've ever been so moved.

From the Financial Times, "Fears Over Helping Hand for Mortgage Defaulters":

The hedge funds are worried about modifications that mortgage administrators, or servicers, sometimes make to home loans for troubled subprime borrowers – for example, changing the interest rate, or extending the repayment term.

Some investment banks are active in the mortgage servicing business as well as being mortgage lenders, underwriters for mortgage-backed securities and derivatives traders.

The hedge funds claim that the banks’ ability to modify the terms of individual mortgage loans could go beyond helping borrowers and enable them to profit – or avoid losses – on the derivatives contracts sold to the hedge funds.

“Manipulation is a charged term, but there are concerns that the potential for manipulation is there,” said Karen Weaver, global head of securitisation research at Deutsche Bank.

This is because, in contrast to other strategies for managing troubled mortgages, these loan modifications show up in performance reports as no longer in arrears. Loans modified in this way would not trigger writedowns of bonds backed by such mortgages, and in turn, this could mean an investment bank would not have to pay out on derivatives contracts tracking those bonds.

Oh, my. Someone stands to profit from "helping borrowers." And a bunch of hedgies stand to lose some bets if those borrowers get back on their feet. Why, this is predation.

Ms Weaver at Deutsche Bank said: “The bottom line is that when a servicer modifies a loan, they have to represent that they believe they can maximise the value of the loan by doing a modification as opposed to choosing another option. There’s a fiduciary responsibility there.”

Moreover, whatever their motivation for modifying loans, dealers can only make changes if borrowers agree.

“A lot of the most problematic mortgages were taken out in late 2005 and 2006, when many borrowers took on huge loans on the belief that house prices were going up,” said Ms Weaver. “That hasn’t happened and those homes have become albatrosses, so a lot of borrowers may just walk away.”

Part of the problem is a lack of specialist knowledge on the part of some hedge funds, one dealer said. “There are participants in the derivatives market that don’t understand the servicing process and don’t understand the mortgage process. They are great macro players that made a great call on a sector that was going to underperform but they didn’t take into account that servicers have options to modify the loans.”

Ah, yes. Risk always ends up where it is most understood. And who'd have thunk that Mary Ellen in the Servicing Department could be causing all this grief for the big-money punters just by servicing a loan?

Oh, the humanity. I am driven, as I am so often, to take refuge in the consolations of great literature.

"I suggest, Headmaster, that Potter is not being entirely truthful," he said. "It might be a good idea if he were deprived of certain privileges until he is ready to tell us the whole story. I personally feel he should be taken off the Gryffindor Quidditch team until he is ready to be honest."

"Really, Severus," said Professor McGonagall sharply, "I see no reason to stop the boy playing Quidditch. This cat wasn't hit over the head with a broomstick. There is no evidence at all that Potter has done anything wrong."

Dumbledore was giving Harry a searching look. His twinkling light-blue gaze made Harry feel as though he were being X-rayed.

"Innocent until proven guilty, Severus," he said firmly.

Snape looked furious. So did Filch.

"My cat has been Petrified!" he shrieked, his eyes popping. "I want to see some punishment!"

Harry Potter and the Chamber of Secrets