Banks fear rout on risky US bonds

Terrific.

Credit markets across the world were braced for trouble last night after Merrill Lynch abandoned efforts to save two Bear Stearns hedge funds, forcing the sale of $850m (£426m) of sub-prime mortgage bonds and other assets for debt repayment.

“Junk bonds” re-entering finance lexicon is hardly a good omen.

The actual sub-prime market is worth around USD2tr, next to which this USD850m abandonment pales, which is more worrying still. In an age when debt is bought and sold like any other financial instrument, and who knows how much of the derivatives market is based upon hedging those instruments, the fall-out from this – if the structural problem in the sub-prime mortgages sector eats its way into the financial markets trading upon those mortgages – will be phenomenal. My recent post discussing housing slumps vs. housing crashes mostly goes out the window: this will be a crash.

At the moment, it may not. Bear Stearns has been doing this for the week. It has already off-loaded better assets, in a bid to avoid exactly this. To the extent that it satisfied Goldman Sachs and Bank of America already, and possibly also JP Morgan, it succeeded. Merrill Lynch is the fourth lender in line, and is the first to seize assets and try to dump them. So it could just be these funds, having raised USD1.5bn, made very bad bets, including sub-prime mortgage instruments, which have lost a tonne of value.

Or, it could be that loads of hedge funds have been doing mostly the same thing, and this will widen the exposure to junky assets considerably. From the Independent:

The number of sub-prime borrowers – Americans given high-priced home loans, despite being deemed a poor credit risk – who have got into arrears or had their homes repossessed has spiked to a record level, and the effects of rising defaults are rippling through the financial system.

The mortgages have been parcelled together with other investments into products called collateralised debt obligations (CDOs), which are sold on piece-by-piece to other investors. Their sheer complexity is such that their value is usually calculated using mathematical models rather than open-market prices.

Demand for new CDOs backed by sub-prime mortgages has already dried up. If the price existing assets fetch in an auction proves disappointing, hundreds of banks, hedge funds and other investors could discover they are sitting on losses they did not realise. Hank Paulson, US Treasury secretary, warned yesterday that there would continue to be “after-shocks”, but insisted they would be contained and would not damage the overall economy.

If he’s wrong (or hedging himself, to stabilise confidence, and is found out) the pressure extends back down to the mortgage lenders themselves and that will hit the sub-prime housing market (defined by me as houses bought with sub-prime mortgages), making it more likely to fall over. I wonder what Greenspan’s odds of a recession are now?

This will at least bring some of the heretofore very non-public activities of hedge funds out into a little more light. Collateralised Debt Obligations, for example, could do with a little more scrutiny, and the Securities and Exchange Commission has been given a heads-up already about people playing silly-buggers with these debts. Essentially the loans may be bad, but bonds have been created based partly on these loans, and investment banks want to save the bonds: so they’ll pay high prices for the bad loans. Merrill Lynch’s move is an example of an investment giving up on trying to save the bonds, and trying to offload the CDOs – essentially a packaged bundle of low risks and high risks, losses and gains.

If you read this and it seems like nothing is linearly straightforward or calculable, you’ve hit upon exactly the problem. CDOs don’t even have an ordinary market price. And hedge funds, playing for big hedge fund money, appear to be very heavily exposed. Fortune was writing concerns about this back in March.

It’s too confusing for me right at bed-time.

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