The problem is very simple. We are having meltdowns in instruments that do not trade in the normal way.
If one of these funds go under, there is no way on knowing what, if anything the holders of the loan will get from selling these assets.
That’s why everyone freaked when Merril Lynch said that it would be selling off those assets from the Bear Sterns fund.
They are rated on face value, and the bids were coming in at far less than that.
When these sales occur, the assets necessarily get revalued at the auction price (willing sale, willing buyer), and suddenly hundreds of billions, if not trillions of dollars of funds become insolvent.
By Axel Merk
The US trade deficit with the rest of the world leapfrogged in recent days. Aside from goods and services, the United States is now importing “consensus-based crisis management” from Japan.
Out of fear that a cleanup of bad loans would trigger widespread defaults, Japanese banks got themselves deeper and deeper into trouble by hushing up the problems. We are talking about the crisis at Bear Sterns’ subprime hedge fund. The crisis shows that major adjustments on how the market prices risks are overdue; this may have negative implications for stocks, bonds, and commodities, as well as the US dollar.
Bear Sterns is a leading provider of services to hedge funds; it is also one of the largest originators of subprime-backed collateralized debt obligations. CDOs are what their name implies: a security backed by collateral. CDOs are created when mortgages with various risk profiles are grouped into different tranches or segments. Among others, Bear Sterns would create a CDO in a bundle according to a client’s specifications. Indeed, Bear Sterns would work with a rating agency, such as Moody’s, to obtain the desired rating (a practice likely to face more scrutiny as some allege that Moody’s no longer acts as an independent rating agency, but as a syndicator in the offering).
The explosive demand in this sector has attracted ever more creative structures. Investors should have grown concerned when dealmakers started suggesting that one can create a higher-grade security by grouping together a couple of lower-grade securities; it is rare that 1 + 1 = 3. As these instruments have grown more complex, the clients buying these instruments often do not have a full understanding of what they buy.
How do you make a best-seller better? You introduce leverage. Not only can leverage be introduced in the credit derivatives that define some of these securities, but brokers eager to attract hedge-fund business may also accept CDOs as collateral to lend money. The hedge fund now attracting so much attention is Bear Sterns’ High Grade Structured Credit Strategies Enhanced Leverage Fund, launched only 10 months ago. It shall be noted that Bear Sterns did not put much of its own money into the fund, but supplied many of the CDOs. A total of US$600 million in invested capital was boosted with borrowings of about $6 billion.
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In the brokerage industry, when a margin call is not met (when the borrower cannot provide sufficient collateral), the broker may seize the collateral and liquidate open positions. While a forced sale of the collateral may be painful for the borrower, it protects the system as a whole. Such forced sales happen all the time in the futures market, where positions are “marked to market” every day to evaluate the profitability and risk of open positions.
But the CDO market is not a regulated futures market; there is no daily market price that would allow one to assess the value of the collateral. The primary methods used to value CDOs are called “mark to market” and “mark to model”. In the more conservative “mark to market” approach, independent parties are asked to value the securities; as the name implies, the “mark to model” approach is more aggressive and uses a computed, theoretical value.
But because these instruments are sold in privately negotiated transactions, rather than a regulated and liquid market, neither valuation method is suitable in case of a forced liquidation.
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I’m not sure why, perhaps because it is not dependent on US realtors for ad revenues, the Asia times has been ahead of the game on this.
Banks ‘set to call in a swathe of loans
The United States faces a severe credit crunch as mounting losses on risky forms of debt catch up with the banks and force them to curb lending and call in existing loans, according to a report by Lombard Street Research.
Bear Stearns headquarters: Banks ‘set to call in a swathe of loans’
Bear Stearns headquarters in New YorkThe group said the fast-moving crisis at two Bear Stearns hedge funds had exposed the underlying rot in the US sub-prime mortgage market, and the vast nexus of collateralised debt obligations known as CDOs.
“Excess liquidity in the global system will be slashed,” it said. “Banks’ capital is about to be decimated, which will require calling in a swathe of loans. This is going to aggravate the US hard landing.”
Charles Dumas, the group’s global strategist, said the failed auction of assets seized from one of the Bear Stearns funds by Merrill Lynch had revealed the dark secret of the CDO debt market. The sale had to be called off after buyers took just $200m of the $850m mix.
“The banks were not prepared to bid over 85pc of face value for CDOs rated “A” or better,” he said.
“God knows how low the price would have dropped if they had kept on going. We hear buyers were lobbing bids at just 30pc.“We don’t know what the value of this debt is because the investment banks shut down the market in a cover-up so that nobody would know. There is $750bn of dubious paper out there in the form of CDOs held by banks that have a total capitalisation of $850bn.”
US property writer Paul Muolo described the Bearn Stearns crisis as the “subprime Chernobyl”, saying the bank had created a “cone of silence”.
Abandoned by fellow banks, Bear Stearns has now put up $3.2bn of its own money to rescue one of the funds, a quarter of its capital.
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The Mortgage Lender Implode-Meter that tracks the US housing markets claims that 86 major lenders have gone bankrupt or shut their doors since the crash began.
The latest are Aegis Lending, Oak Street Mortgage and The Mortgage Warehouse.
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Nouriel Roubini, economics professor at New York University, said there were now concerns about “systemic risk fall-out” from the Bear Stearns debacle as investors look more closely at the real value of CDOs.
FWIW, Roubini is a VERY sharp guy. He’s been well ahead of the market and the conventional wisdom again and again.
Goldman-issued subprime bonds lead downgrades-Citi
Mon Jun 25, 2007 1:50 PM ETNEW YORK, June 25 (Reuters) – Goldman Sachs Group Inc.
subprime mortgage bonds issued last year are being downgraded by rating companies at the fastest rate of any issuer, according to Citigroup Inc. research dated June 22. Nearly 70 of Goldman’s GSAMP-issued bonds, which include subprime loans from a variety of lenders, have been downgraded by Standard & Poor’s and Moody’s Investors Service in the year through June 15, with 60 of those issued in 2006, analysts at Citigroup Global Markets said in a weekly note.
Downgrades are accelerating on mortgage bonds backed by loans to the riskiest borrowers following an ongoing surge in delinquencies and foreclosures. Lenders loosened underwriting standards in the years through 2006, creating loans whose poor quality became apparent as the U.S. housing slump began.
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Goldman Sachs?
Seriously when these funds actually get a fair assessment, a lot of these banks will be insolvent.