Hearts and the Link to Subprime Loans

In Hearts, a game in Windows, the objective of the game is to score as little points as possible. For banks, the objective of the game is to have as little risk as possible. Unless you are aiming to shoot the moon by collecting all the cards (everybody else gets 26 points each), you should try to get rid of the all the cards in the Hearts suit (each card is worth 1 point), and also the Queen of Spades, which is worth a whopping 13 points. You are allowed to exchange cards you do not wish to have at the first round.

To spread the risks, banks are just like the players who exchanged the cards. The risks are always there, but in order to make money, the banks swap the loans around, and then repackaged them. What exactly is subprime loan? Many people who would otherwise not be able to apply for loans could apply but at higher interest rates. Their creditworthiness is substandard, but these groups of people require a home to live in, so they are willing to accept the higher interest rates.

If they pay their loans promptly, they would be able to improve their creditworthiness, and then hopefully be able to refinance their loans at a better rate available only to people with good credit. Yet, many of them are merely paying the interest instead of servicing the initial loan to reduce the amount they need to pay.

In the past, the bank that gets the Queen of Spade would collapse. But with structured products, collaterised-debt obligations (CDOs) securities and other fancy terms, the dreaded Queen of Spade is cut up into many pieces, and instead of one deck of cards, thousands decks of cards are being played simultaneously all over the world. The threat becomes multiplied manifolds. At the same time, the players hope that the game will continue forever, without ending, so no group will ever be stuck with the bad loans.

Too bad, all games have to end, and the timing caught everyone by surprise. Apart from the Queen of Spade, the entire suit of Hearts is also all sliced up, and nobody knows how much he has lost. With this ambiguity, insecure investors are taking their money out, and the banks and other hedge funds have no choice but to find the money from the people they lent the money to, and these people are expected to cough out a huge sum of money, and if the value of their houses are lower than their original loans, they have to pay the difference. This causes the pyramid of stacked cards to fall, and the domino effect has spooked the entire world.

There was a slight respite in the European markets on Friday, but the Asian markets are badly hit, in part due to the sharp appreciation of the Yen. I wonder when the volatile times will end, and certainly not a bear market will emerge. If so, the Queen of Spade can get really badly mauled. So will all the subjects of the Queen. If only in real life, it’s as easy as starting over on a clean slate as the computer game when you are losing too badly.

This article is inspired by an article ‘The game is up’ in The Economist August 18th 2007.

Sarah Tan - SingaporeProfit.com