“We’ll be God-damned if over the last several months fear has crept into investors psyche. While some of that might be just prudence, the kind of fear that grips most of the folks who take the time to drop me a line is often based on the role hedge funds play in the current economic cycle. It is understandable. These are a somewhat mysterious entity that fascinates those of us that report on their comings and goings and frighten those that believe they are manipulating the system for the benefit of the few.
“One note, received just last week struck me as typical.
“Carl writes: "What do you think of their [hedge funds] role in artificially keeping mortgage interest rates low by intervening in the short-term treasuries market [2-year notes] in order to flatten the yield curve with return on the 10-year notes low? I suspect there is massive collusion between the banks and the hedge funds to keep the real estate bubble from bursting at the expense of small and institutional investors, who may not be aware that housing has been the engine of the recovery that began back in 2001. What are your thoughts on this and the prospect for an economic/stock market collapse?"
“Whether or not his fear is well-founded remains to be seen, but I did answer his question, and with any luck, many similar ones.
“I replied: To answer your question about hedge funds and their role in the housing market you have to consider two questions. The first: is it necessarily a bad thing for hedge funds to play the flattened yield curve to their best advantage? And second: Are these instruments of risk actually predicting risk with their back room involvement with housing?
“Playing the flattened yield curve by trading off two-year Treasuries in favor of the price rally in the ten-year is just good a fixed income strategy. The Fed has given fixed income investors a good deal of problems especially when it comes to predicting what their next move will be.
“Hedge funds have been buying up mortgage-backed securities at a good clip recently, which does appear to be suspicious at first glance. Do they know something that we don't? The housing market's cool down is based on the assumption that the riskiest loans issued over the last several years will lead to a wave of defaults and those houses will detract from the sale of new housing.
“There are a lot of unfortunate homeowners sitting on property whose value has dropped significantly. Whether these mortgages turn negative (the loan is worth more than the underlying property - a purely paper situation that might affect about $500 billion in outstanding loans and I emphasize the word "might"), remains to be seen. There is an awful lot of talk about wage increases even as personal spending slows. and Consumers are resilient and resourceful and should they be confronted with their own personal economic slowdown, they will react rationally. This is evidenced in the lack of borrowing in the most recent months. I'm fairly certain that homeowners will pay the bills first, starting with the mortgage and keep a losing property rather than admit their mistake.
“If that is the case, mortgage-backed securities are not as risky as they would appear to be and hedge funds that realize this are being rewarded with higher yields than Treasuries of any maturity can offer….”
http://www.axcessnews.com/modules/wfsection/article.php?articleid=11206
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