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A second Australian hedge fund has been hit by the escalating subprime mortgage crisis gripping the United States.

The boutique company Absolute Capital has suspended two funds worth around $200 million that are exposed to defaults in the risky mortgages, and admits it is worried about the state of the debt market in the US.

Absolute's suspension comes a week after another fund, Basis Capital, told investors their investments were in jeopardy.

The local developments comes amid renewed fears that the US mortgage crisis will spill over into other parts of the world's biggest economy.

Absolute Capital describes itself as a specialised structured credit fund manager, playing the usual tactical game of balancing high risk with high return.

It has two funds worth around $200 million that are exposed to the crumbling subprime mortgage market in the United States.

In a letter to investors last night, Absolute said its portfolio was diversified and it had not engaged in risky end of the market.

Managing director Deon Joubert said although the subprime exposure was less than 5 per cent, the funds had to be closed to protect investors.

"Absolute Capital believes a temporary closure of the funds is the best defensive measure to protect the longer-term interests of our investors and to ensure equity amongst all investors as we manage any withdrawal requests, given the current illiquid nature of the funds' investments," he said in a letter.

But Mr Joubert warns Absolute investors that any rush to withdraw their money could be even more problematic, given the number of bigger players already unwinding their positions.

"Given the reduced market liquidity Absolute Capital believes the funds are not placed to adequately satisfy or price withdrawal requests," the letter said.

Absolute says the funds' performance is down 4 to 6 per cent for July, and the processing of withdrawal requests could be delayed until late October.

Despite the subprime exposure, Mr Joubert remains optimistic.

"We are expecting that markets will settle over the next few months, in which case investors in the funds may be able to benefit from these opportunities and improved market conditions," he said in the letter.

The suspension of Absolute follows a similar but higher-stakes story for Basis Capital, which has two funds worth more than $1 billion that are exposed.

Basis has hired the private equity group Blackstone to help defend a fire sale, and the global rating group Standard & Poors has been criticised for failing to detect the fund's fragility.

Distress in US

Meanwhile, Wall Street bounced back this morning after yesterday's heavy losses were fuelled by concerns that subprime defaults were spreading to more traditional mortgages.

But the signs of distress remain, with sales of existing homes falling for the fourth straight month, taking the US housing slump to its lowest level since 2002.

Real estate analyst Mike Larson agrees with yesterday's prediction from the major US mortgage lender Countrywide that subprime uncertainty means a recovery might not be seen until 2009.

"We've seen a real deterioration in the mortgage finance industry," he said.

"A lot more loans are going sour and a lot more lenders are cutting back on the types of loans they'll make.

"We'll probably see a continued weak market for the rest of this year and into next year with relatively weak sales and stagnant to falling home prices."

The mortgage instability in the US is being compounded in Australia by another collapse in the risky property sector.

South Australian private mortgage firm John West and Associates has been placed in voluntary administration with debts of almost $10 million.

CBC news

Would you like a mortgage that lends you more than the value of your house?

Would you like it structured so that your first payments are extra low?

If the mortgage weren't structured that way, would you be unable to afford the payments?

Are you convinced that real estate prices will continue to rise?

Do you have a poor credit history?

Congratulations if you answered "Yes" to most or all of those questions! You're an ideal target for a subprime mortgage lender.

Of course, there is a downside amid all the fine print, as hundreds of thousands of American consumers are now finding out. Mortgage delinquencies and foreclosures are way up. Dozens of companies that lent money to anyone with a pulse have gone belly up. And suddenly, some economists are starting to worry that the whole mess could send the U.S. economy into recession.

How did this happen?

What makes a mortgage "subprime"?

The term "subprime" isn't well known in Canada because most of our mortgage lending is "prime," or conventional. In the U.S., however, rapidly rising house prices and a poorly regulated industry combined to create a mortgage monster that is now busy running amok.

"Subprime" refers to the risk associated with a borrower, not to the interest rate being charged on the mortgage. Typically subprime mortgages are offered at interest rates above prime, to customers with below-average credit ratings. Subprime mortgage lenders in the U.S. tend to target lower-income Americans, the elderly, new immigrants, people with a proven record of not paying their debts on time — just about anyone who would have trouble getting a mortgage from a conventional lender such as a major bank.

Their pitch is irresistible and it unfolds along lines like this: "You want to buy your first house? We'll make it happen! And don't worry about a down payment. In fact, we'll even lend you more than the house is worth. We'll even charge you a super low rate [the "teaser"] during the first year or two to keep your payments low. Sure, the loan will eventually reset at prevailing rates, but since housing prices are rising by 20 per cent a year, all you have to do is refinance your house to keep your payments low!"

Needless to say, the subprime bubble soon burst. After enjoying a short period at low fixed rates, people with subprime "bargains" suddenly found their loans were being reset at rates that were in the double-digits. U.S. housing prices, which had been soaring, started falling. People with subprime mortgages found they could no longer count on the increasing value of their homes to refinance their way out of the mess.

By late 2006, one subprime loan in eight was in default across the U.S. Foreclosures were soaring. More than 20 subprime lenders were bankrupt. And the National Community Reinvestment Coalition estimated that as many as 1.5 million Americans could lose their homes by the time all the damage is done.

Could it happen in Canada?

Subprime mortgages are available in Canada. But it's a different story up here. For one thing, the subprime market share is much smaller in Canada. About 20 per cent of all U.S. mortgages are of the subprime variety in 2007. That compares to just five per cent in Canada, according to industry figures.

All high-ratio mortgages in Canada — those with less than 20 per cent down — must be secured by mortgage insurance, through, for example, the Canada Mortgage and Housing Corporation. In addition, Canadian financial institutions do not finance more than 100 per cent of a home's purchase price, and that value must be verified with a separate appraisal.

Canadian mortgage lenders have been scrambling to assure the population that there are major differences between the subprime markets in the two countries. "We have not seen the aggressive lending practices common south of the border," said Paul Grewal, chair of the Canadian Association of Accredited Mortgage Professionals. The association says Canadian underwriting practices are "more prudent."

Outside analysis backs up that assertion. Benjamin Tal, an economist with CIBC World Markets, noted recently that "only 22 per cent of subprime borrowers in Canada use variable rate mortgages — half the rate seen in the U.S." Tal also says there is no evidence linking the use of subprime lending in Canada with the increase in house prices. In the U.S., there is a "very high correlation," he says.

"Our view is that the price appreciation in the U.S. housing market over the past two years was, in many ways, artificial — boosted by aggressive lending and irresponsible borrowing."

Overall mortgage arrears in Canada are at just 0.5 per cent, the industry says, near record lows.

That doesn't mean there's nothing to worry about in Canada. A drop in Canadian housing prices and increases in interest rates would pose problems for borrowers. But with Canadian real estate showing fewer of the warning signs, with fewer subprime mortgages in this country, tighter borrowing restrictions and fewer mortgages at floating interest rates, the risks do seem to be considerably lower.

But the U.S. subprime meltdown has recently shown signs of spreading to the wider U.S. economy and into Canada. General Motors cancelled a shift at a truck plant in Oshawa, throwing 1,200 out of work, because sales of pickup trucks have plunged in the U.S. Most of Oshawa's production goes south of the border.

Stock markets in Canada and the U.S. began moving lower in the summer of 2007 as investors reacted to signs that lenders were beginning to tighten credit, boosting fears of a slowdown. Many Canadian companies reported having millions in cash tied up in normally safe short-term debt products that suddenly became illiquid as no one wanted to buy investments perceived as being risky.

Central banks on both sides of the border are watching closely for further signs of subprime fallout in the months ahead, as interest rates in many more U.S. subprime mortgages reset at higher levels.

HSBC to close US subprime mortgage unit

20 september 2007

NEW YORK (AFP) — HSBC Holdings, the British-based banking giant, announced Friday it will close its subprime mortgage subsidiary in the United States, saying it was "no longer sustainable."

HSBC Holdings's earnings have been heavily hit by its heavy exposure to the troubled US subprime mortgage market, where home loans are given to people with patchy credit histories.

HSBC said its closure of Decision One Mortgage will entail a goodwill charge of around 880 million dollars and a 65-million-dollar restructuring charge by the end of the year.

"This is a small part of our US business," said Michael Geoghegan, chief executive of HSBC Holdings plc.

"It's no longer sustainable and not the right place to allocate capital in the future. We said we would make tough decisions and we have done exactly that."

Decision One Mortgage, a unit of subsidiary HSBC Finance Corporation, originates non-prime mortgages through brokers. The bank said it will continue to manage Decision One's loan portfolio, which totals 349 million dollars.

HSBC was the largest provider of subprime loans in the US in 2006, according to Inside Mortgage Finance, a real-estate industry tracker, ahead of the US leaders in the domestic market, New Century Financial and Countrywide.

The HSBC decision comes as rising interest rates and falling house prices have triggered a spike in foreclosures by borrowers with already stretched finances.

The group said HSBC Finance will focus on originating and servicing loans through its consumer lending branch network under the HFC and Beneficial brands.

Approximately 750 Decision One employees will be affected by the closure, the group said.