Friday, June 22, 2007

Bear Stearns and the housing market

Banks fear rout on risky US bonds

Mr McAdie said there was risk of a chain reaction through the
market for collateralised loan obligations (CLO), a risky debt security now being issued on a massive scale.

Fitch ratings estimates that $477bn of high-yield debt securities have been issued over the past three years, mostly B-grade junk bonds.

The two Bear Stearns funds, specialising in structured credit,
borrowed roughly $20bn to bet on risky bonds, though this has been cut by more than half. They targeted the lowest tranche of sub-prime mortgage debt, which can yield as much as 20pc but is highly vulnerable to rising default rates.

The property slump is likely to worsen as mortgage lenders tighten up dramatically, triggering a credit crunch at the lower end of the market. A sharp rise in 10-year yields over the past two months has compounded the crisis, raising the base cost of mortgage borrowing by roughly half a point.

Deadly ripples threaten subprime funds

Troubles at two Bear Stearns funds could trigger a selloff that deepens losses, hurts credit markets.

LONDON ( -- The fallout from problems at two Bear Stearns hedge funds that may be on the verge of collapse could roil the bond market and lead to a tightening of credit, analysts said Thursday.

The problems at the two funds, which bet heavily on securities
backed by subprime mortgages, are also affecting
stocks, which took a beating Wednesday as jitters about the possible effect on credit markets coursed through Wall Street. The Dow industrials, S&P 500 and Nasdaq all sank at least 1 percent Wednesday and opened lower Thursday, though stocks later recovered and ended with modest gains.

The declines at the two Bear Stearns Cos. funds - its
High-Grade Structured Credit Strategies Enhanced Leverage Fund and High Grade Structured Credit Strategies Fund - have revived fears about the subprime mortgage sector and triggered worries that worse is yet to come.

Given the timing of this news I would say we are still on track for bad news in July.
The problem with the Bear Stearns funds is they are heavily invested in CDOs (Collateralized Debt Obligations). That means in part, home Mortgages. The subprime market is where they placed those bets. That market pays higher interest on their loans, so it generates a nice return, until it doesn’t.

As we get closer to the middle of the Summer house selling season with little improvement to show for it, a lot of the mortgagees will find acceptance and I expect walk away or deliver their keys to the banks. It’s one way to stop the bleeding.
This will absolutely have an effect on CDOs, rippling through private equity funds and the Derivatives market. Last time I checked those players were leveraging $370 trillion or almost 3 times global GDP. That’s a lot of clams.

The key word however is leveraged. Any failing link in this chain of heavily leveraged debt could cause the whole house of cards to collapse, and I believe we might be witnessing the beginnings of that unwinding with the failure of these two funds. The next few weeks will tell if this thing is going to spread.


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