What, me worry?

If subprime lending represents only about 13 percent of the $10.4 trillion U.S. mortgage market, and only 5 percent of subprime loans totaling $67 billion in loans are in foreclosure, what's the big deal? At least half those losses will be recovered when foreclosed properties are sold, so we're looking at losses of maybe $34 billion -- or less then 1 percent of the total market. The problems in subprime lending are playing havoc with the stock market in a way that's out of proportion to their real impact on the economy.

That's the argument economist Ben Stein made in an Aug. 12 New York Times column (watch him delivering the same message the following week on CBS Sunday Morning).

Mortgage broker and columnist Peter G. Miller offers a more in-depth analysis on DS News today, explaining how the use of derivatives can greatly magnify these losses for hedge funds and other investors.

Hedge funds -- and just about everybody with large amounts of capital to invest, including mortgage lenders -- use derivatives to manage risk. These are essentially bets, which companies cover like sports bookies. Interest rate and credit default swaps, for example, allow lenders to share risk (and potential profits) with others.

Whatever the outcome all their bets, their losses and gains on various derivates are supposed to balance out -- or leave them ahead of the game. Computer models can also be used to exploit tiny anomalies in the marketplace, Miller notes, allowing profits to be wrung out of what started out as a risk hedging strategy.

But derivatives are highly leveraged, meaning that a hedge fund like the infamous Long-Term Capital Management was, at the beginning of 1998, able to hold derivative contracts worth $1.3 trillion with just $4.8 billion in capital, Miller explains.

"If one hedge fund with $4.8 billion in capital can hold derivative contracts worth $1.3 trillion, then how much is held by 8,500 hedge funds as well as other investors?" Miller asks. "The worry is that huge investors have borrowed from banks and other financial sources and then placed many of their leveraged bets on the movement of mortgage-backed securities. With a growing volume of foreclosures the value of mortgage-backed securities are less than they were six months or a year ago, meaning once-profitable computer models are no longer on target."

The real fear among investors, RealtyTrac.com CEO Jim Saccacio tells Miller, "is not so much that we're having a subprime debacle, rather it's that rising foreclosure levels throughout the U.S. mortgage system will set in motion a series of bigger problems in related financial  instruments."

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