It looks like lenders are not only facing a tidal wave of subprime defaults but exposure to subprime derivative contracts that they sold.

During the boom, the lenders were so confident that the loans they were making were good that they cashed-in even more by selling derivatives that would pay-off only in case of defaults.

In essence, the lenders were doubling down on subprime mortgages and on derivatives.

The hedge funds that stand to benefit have hire a big gun, Harvey Pitt, to defend their interests.

Given all that’s come to light, I don’t expect the housing making to stabilize until all of this gets cleaned up. For that to happen, the houses that get foreclosed in the process must come to market and be priced to sell.

I would not be surprised to see some major lenders go under.
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Here’s the Financial Times article:
http://www.ft.com/cms/s/ed2f76da-0fdb-11dc-a66f-000b5df10621.html

Hedge funds hit at subprime aid for homeowners

By Saskia Scholtes in New York

Published: June 1 2007 03:00 | Last updated: June 1 2007 03:00

Hedge funds are fighting bank decisions that help delinquent US mortgage borrowers remain in their homes, in a move that puts some of the country’s richest people in the position of arguing that some of its less well-off could be getting unfair breaks.

The dispute centres on derivatives contracts that pay money to investors when bonds backed by so-called “subprime” mortgage loans – which are extended to people with past credit problems – run into trouble.

The $1,200bn US subprime mortgage-bond market has been hit by rapidly escalating defaults in recent months, and hedge funds have been profitingfrom the crisis by buying such derivatives.

Some hedge funds say they are concerned that banks that both sell the derivatives contracts and handle mortgage payments could be involved in a form of market manipulation.

The funds claim banks are making concessions on the underlying mortgages – such as lowering the interest rate or extending the life of the loan – to avoid making good on derivatives contracts that pay off in cases of default.

The controversy pits the interests of hedge funds against those of stretched US mortgage borrowers, and politicians who want to help them keep their homes, underscoring the political dilemmas created by the rapid growth of the mortgage bond market.

A group of more than 25 funds has asked the International Swaps and Derivatives Association, the derivatives industry body, to act on their concerns, according to a letter seen by the Financial Times.

“ISDA should actively promote an industry solution that assures market participants that no one can engage in practices that are manipulative and prohibited by existing securities laws,”the funds said. The ISDA declined to comment.

The hedge fund group is led by Paulson & Co, which last year launched a specialist fund to bet on a downturn in the subprime market. The fund is up more than 90 per cent in the year to date. Paulson & Co declined to comment.

The hedge funds’ concerns centre on loan modifications that are often used to help overextended borrowers keep up with payments. In such cases, 40 per cent of the modified loans fall back into arrears within a year, credit analysts say. However, these changes do not automatically trigger write-downs on the mortgage bonds, which would result in a payment to purchasers of the credit-insurance derivatives.

One member of the group that wrote to ISDA said the hedge funds were not trying to force subprime borrowers from their homes – just to make sure that banks were keeping the interests of their trading desks and their mortgage arms separate.

“This is not about the politics of keeping borrowers in their homes or not,” said the person, who asked not be named. “We want to ensure that the dealers are not modifying loans based on their derivatives exposure, or trading the derivatives based on their economic interest in the underlying bonds – there should be a wall between the two.”

Harvey Pitt, former Securities and Exchange Commission chairman and a consultant hired to provide “strategic guidance” on the hedge fund group’s concerns, said that if banks extend favourable terms to borrowers purely to prevent derivatives losses “such transactions would be manipulative and actionable under the federal securities laws”.

Some banks’ exposure to derivatives contracts based on subprime mortgages could theoretically dwarf their exposure to the underlying mortgages.

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And here’s Harvey Pitt’s very circumspect answer to the article.
http://www.ft.com/cms/s/185fef64-1d39-11dc-9b58-000b5df10621.html