Subprime Mess Hits Wall Street Again
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What is now routinely called "the
subprime mortgage mess" is continuing to roil the U.S. economy and
last week it again caused major concern in the larger financial markets.
Bear Stearns announced on Friday that it was pledging as much as $3.2 billion
in loans to save one of its hedge funds that is in serious trouble because of
risky investments in the subprime mortgage market.
Two days earlier Yahoo News printed an article from Agence France Press (AFP)
which said that two of the big hedge funds managed by Bear Stearns were close
to being shut down as their mortgage-related bets went south. The funds were
identified by The Wall Street Journal as the High Grade Structured Credit
Strategies Enhanced Leverage Fund and the High Grade Structured Credit
Strategies Fund.
Hedge is a broad term applied to a variety of funds that try to reduce volatility
and risk and preserve capital and income under all market conditions. Funds
employ a variety of strategies such as selling short, arbitrage, investing in
currencies, and buying and selling undervalued securities.
According to The New York Times, the proposed bail-out by Bear Stearns is the
biggest rescue of a hedge fund since 1998 when Long-Term Capital
Management was saved by a group of over a dozen lenders which pledged 3.6 billion
to stabilize the fund.
The first fund (Credit Strategies Enhanced Leverage Fund) was started in 2004
and had posted 41 months of positive returns in excess of 12 percent a year.
However, under pressure from investors who wanted even higher returns, so in
August according to The New York Times the Structured Credit Enhanced Leveraged
Fund was started with $600 million in investments, and at least $6 billion in
money borrowed from banks and brokerage firms. Bear Stearns and a handful of
its top executives invested $40 million in the two funds, only a small part
of their total capitalization.
The two funds invested in collateralized debt obligations which invest in bonds
backed by hundreds of loans and other instruments. These debt obligations are
sliced into salable portions and marketed by Wall Street. Many of these obligations
have low yields but are easily traded and not terribly risky; others are risky
and don't trade often and so are difficult to value. The Times quoted
the Securities Industry and Financial Markets Association as stating that $316.4
billion in these obligations were issued in 2006, about 77 percent more than
in 2005.
Then, this past winter, as housing prices were beginning to fall and many of
the subprime mortgages began to suffer higher than usual rates of default, the
older of the two funds registered its first loss and by April
was down by 5 percent for the year while the new fund had lost twice that much.
Then, a short time later, Bear Stearns revalued some securities and informed
investors that the second fund may have lost more than twice what it had originally
said.
Both investors and banks that had lent money to the funds began trying to pull
money out but in May. Bear Stearns froze all redemption requests. Then in June
three major banks began demanding more cash to collateralize the loans they
had made. A couple of the lenders moved to sell assets and by last Wednesday
about $2 billion in securities were up for sale. Some collateral auctions scheduled
by banks have been cancelled and others resulted in the sale of only small portions
of the collateral offered.
In the midst of all of this, Reuters reported that hedge fund managers had
accused Bear Stearns of trying to manipulate the market by
propping up faltering mortgage-backed securities by purchasing individual mortgages
that were rapidly losing value.
On Friday Barclays Bank revealed it had some exposure to troubled hedge funds
that had invested in the subprime market but that losses won't impact
the bank's overall performance. The admission followed reports in several
British newspapers that Barclays had made loans of $300 million to the two Bear
Stearns funds.
The news of the fund bailouts hit the stock market hard and the Dow Jones industrial
average closed down 186 points on Friday, a decline of 126 points after the
Bear Stearns announcement was made public. The market had recovered a bit on
Monday and was up 110 points by mid-day.
The Friday announcement covers only one of the funds. Bear Stearns is reportedly
in negotiations with banks to rescue the newer and larger fund which has more
than $6 billion in loans and is reported to be invested in riskier positions.
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