Another post about Bear Stearns

Google News says it has 385 articles about Bear Stearns at the moment. Which makes me less inclined to talk about it. Also I’m a health economist, who deliberately chose not to enter this world. I don’t know why this stuff is so fascinating to me. Probably for many of the reasons sports statistics are…

The story is Bear Stearns’ plan to bail out one those two near-dead hedge funds. We had seen the other day that Merrill Lynch, not playing the game of Goldman Sachs, Bank of America or JP Morgan, had seized assets for a fire sale. Why? Because Merrill Lynch took Collateralised Debt Obligations (CDOs) to sell – potentially setting up a run on the collateral(s) in question – sub-prime mortgages.

For ‘us’ (whoever ‘we’ are) this was the scary-ish part, because those are debts that equal houses, still, and we’d rather not have any more squeeze on sub-prime-mortgaged houses than we already have. For Bear Stearns (and other banks) a dump of the price of debts they all may own would be the scary part.

In the end Merrill backed out of the auction, like JP Morgan (investment banks are so shy – who knew?). Perhaps Bear Stearns got word to them that they’d cooked something up. Rather than face a market devaluation of assets to which Bear Stearns (and probably quite a few if not all of its peers) are exposed, the bank is pledging USD3.2bn to bail out the fund that gambled on them. Essentially it’s to buy out the creditors, to stop them seizing those CDOs:

Creditors extended $9 billion to the funds which made bets of more than $11 billion, a person familiar with the situation said. Lenders include Merrill, Lehman, JP Morgan Chase & Co., Goldman Sachs Group Inc., Citigroup and Cantor Fitzgerald LP, all in New York. Bank of America Corp., based in Charlotte, North Carolina, Barclays Plc in London and Frankfurt-based Deutsche Bank AG were the other lenders.

I also mentioned this in my previous post: the SEC has already been told to keep an eye out for investment banks over-valuing bonds in order to prevent a run on the underlying assets. In this case those assets are sub-prime mortgages – loans that are looking worse and worse. I don’t know what to draw parallels to first – junk bonds in the 80s or the entire Japanese banking sector in the 80s and 90s.

Since this is a straight loan, not a taking of equity, there’s a question over how funds that blew as much money as these can be reliably expected to turn around enough to cover those losses and USD3.2bn. Meanwhile we still know very little about exposure to the CDOs, especially those built around sub-prime lending. The Bloomberg article suggests pension funds bought into these as well – hopefully not by much. They aren’t doing well (I also didn’t know CDOs had been around for so long – although it makes sense that they came out of the 80s, with all the risky debt going around at the time).

The first CDOs were created at now-defunct Drexel Burnham Lambert Inc. in 1987. Sales reached $503 billion in 2006, a fivefold increase in three years. More than half of those issued last year contained mortgages made to people with poor credit, little loan history, or high debt, according to Moody’s Investors Service.

CDOs may have lost as much as $25 billion because of subprime defaults, Lehman Brothers analysts estimated in April.

Fitch Ratings warned today for the first time that it probably will downgrade some securities from CDOs containing bonds from 2006 of subprime second mortgages, the class of home loans that have been “experiencing the greatest stress.” Standard & Poor’s cut ratings on 45 bonds backed by subprime second mortgages.

So is Bear Stearns is taking a big risk to protect that collateral? All signs point to yes:

The risk of owning Bear Stearns’s corporate bonds also rose today. Five-year credit-default swaps based on $10 million of the bonds rose $2,200 to $48,000, according to composite prices from CMA Datavision. They touched a three-month high yesterday, trading at $49,000. An increase in the contracts, used to speculate on the company’s ability to repay its debt, signals deterioration in the perception of credit quality.

Suggesting that they at least have a lot more exposure to sub-prime mortgages than just the High-Grade Structured Credit Strategies Fund.

Meanwhile the Washington Post has a piece up discussing the market’s reactions. I liked this guy:

“I’m not sure this is the only mis-priced device that has been created,” said Marc Heilweil, president of Spectrum Advisory Services Inc. in Atlanta.

Really? I would have the shock of my bloody life if it was. Heilweil sounds like he took bear-ish positions anyway (probably why he sounds so sanguine). Discussion as well of Fed-watching (sad, when a country has no royal family), and some macro data out next week – sales of existing homes on Monday and new homes on Tuesday. I’ll definitely be back on the issue, then as will, I expect, the much better Big Picture.


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