Could Hedge Fund Housing Losses Cause Economic Slump?

The decline of the U.S. housing market has now spread to the subprime mortgage market. Many homeowners who couldn't afford conventional mortgages took interest-only loans, which provided lower monthly payments. As home prices have declined, many have found their homes are no longer worth what they paid for them. At the same time, interest rates rose along with the Fed Funds rate. As a result, these homeowners cannot pay the mortgage, nor sell the home for a profit, and so they default.

As bad as that is for the banking industry, not to mention the individual homeowners, it may only be the tip of the iceberg. It appears that hedge funds have invested an unknown amount in these mortgage-backed securities, according to BusinessWeek. Unlike mutual funds, hedge funds are not as tightly regulated by the SEC, and so it is unknown how many funds will be affected by the defaults. Since hedge funds use sophisticated derivatives, the impact of any downturn will be magnified. This is because derivatives allow hedge funds to essentially borrow money to make investments, creating higher returns in a good market, and greater losses in a bad one.

Fear of such a downturn caused the Dow Jones Industrial Average to plummet 2% on Tuesday, the second largest drop in two years. If the market declines enough, it could cause an economic downturn. (Source: "The Mortgage Mess Spreads," BusinessWeek online, March 7, 2007; "Stocks Plummet on Subprime Lender Woes," Yahoo News, March 13, 2007)

See related articles:

• Downturn in Real Estate Could Threaten U.S. Economy
• How Do Hedge Funds Impact the Stock Market?
• Could the Stock Market Decline Cause a Recession?