Subprime fallout has Wall Street scrambling
Subprime fallout has Wall Street scramblingWall Street firms are trying to contain the subprime-mortgage fallout and reassure investors. Observers now expect a resolution to resemble a quick, brutal crash of the subprime market, a slow meltdown or a short-term blip.
Mutually Assured MayhemWall Street is on edge, scrambling to buck up Bear Stearns and avert a domino-effect debacle
On June 26 managers of Credit Suisse's (CS ) alternative investment group sent an e-mail to investors reassuring them that its portfolios "have minimal direct exposure" to subprime mortgages and "do not have any direct exposure" to the two Bear Stearns & Co. (BSC ) hedge funds that had nearly collapsed the week before. As that note was wending its way through the ether, other investors were quietly trying to sell their stakes in hedge funds full of subprime securities. Some were noting that Toronto bank CIBC holds many subprime bonds. Paris bank BNP Paribas (BNPQY ) was fending off questions about its investment in the Bear fund with heaviest losses.
It's white-knuckle time on Wall Street as firms try to prevent the subprime mess from spreading. The hedge fund blowup has suddenly thrown the world's biggest financial institutions into a game of brinkmanship that will end in one of three ways: a quick, brutal crash of the subprime mortgage market and possibly the broader corporate bond market; a slow, painful meltdown of one or both lasting many months; or a short-term blip that, over time, will be forgotten as conditions return to normal.
Disaster has been averted so far. But pressure continues to come from all sides. The decisions made by Wall Street's bankers, hedge fund managers, and bond raters over the next several weeks will determine which way the game plays out. One twitchy move by any of them could lead to mutually assured destruction.
ELBOW DEEPAt first the subprime mess looked more or less like a Bear Stearns problem. When its funds stumbled, it was Bear that put up a staggering $1.6 billion in loans to stanch the bleeding. It was Bear's stock that took the biggest hit of any brokerage house, falling some 3.2% in a day. And it was Bear that, as reported by BusinessWeek.com on June 25, drew the scrutiny of the Securities & Exchange Commission, which has opened up a preliminary investigation into what went wrong inside the 84-year-old firm led by CEO James E. Cayne.
Ordinarily, rivals wouldn't shed tears if Bear Stearns were suffering—they'd pounce on the weakness. But much of Wall Street is elbow-deep in the same troubled securities, all created during the height of the mortgage boom, that are now coming back to bite Bear. Last year, Wall Street churned out some $550 billion in so-called collateralized debt obligations (CDOs): complex bonds often backed by subprime loans that pay high yields in good times but are dangerous when the market gets rocky, as it is now. "This is not [only] a Bear Stearns problem," says Joseph R. Mason, associate professor of finance at Drexel University's LeBow College of Business.
A DOZEN PROBESCDOs are especially troublesome in a choppy market because they're illiquid— difficult not only to sell but even to value. Until now, accounting rules have let firms peg their CDOs at roughly the price they paid for them. But if the market sets new prices, then others must use those prices to value their holdings. What gives Wall Street nightmares is the possibility that Bear Stearns' struggling hedge funds, which once controlled $16 billion in assets, will be liquidated by their creditors. A shotgun sale of poorly performing securities would provide Wall Street with a true price for valuing the slumping assets. "Nobody wants to officially acknowledge the worthless nature of these products," says Peter Schiff, president of Euro Pacific Capital, a Darien (Conn.) money management firm. Indeed, SEC Chairman Christopher Cox, during a hearing on Capital Hill on June 26, disclosed that regulators have opened a dozen separate probes on the subprime market and the issue of CDO pricing, in addition to the Bear inquiry.
If Bear's holdings were auctioned off at, say, 60 cents on the dollar and other firms marked down their CDOs accordingly, losses would spread. Firms would start dumping their CDOs to get what they could for them. Thus would begin a quick, brutal crash.
That's one reason Wall Street firms such as Merrill Lynch (MER ), JPMorgan Chase (JPM ), Goldman Sach (GS )s, and Deutsche Bank (DB ), all of which had financed the funds in the first place, have been in no rush to liquidate them. A liquidation would have hurt everyone.
There's another force bearing down on CDO holders: credit rating agencies such as Moody's Investors Service (MCO ) and Standard & Poor's, which like BusinessWeek is a unit of The McGraw-Hill Companies (MHP ). If the ratings agencies were to downgrade the CDOs, it would force holders to mark down their values accordingly, potentially igniting the same sort of disaster scenario. That hasn't happened yet. "Our surveillance involves significant testing and analysis, and our long-term record is excellent," says an S&P spokesman. Noel Kirnon, head of global CDO ratings at Moody's, says the firm has a rigorous process for monitoring CDOs, and adds that deterioration in the underlying assets "has not exceeded expectations."
The wild card is institutional investors such as pension funds, university endowments, and foreign governments. If they get more nervous about the hedge funds they're invested in, they could start looking to cash out—as some have done already. If they rush for the exits, hedge funds will feel pressure to get out of CDOs, perhaps prompting a downward spiral.
The broader housing market also presents a potential threat. In Maricopa County, Ariz., which includes Phoenix, houses are entering foreclosure at a rate of more than 50 a day, according to Foreclosure.com, up 60% from last year, as recent buyers are hit by high payments and falling equity. The faster foreclosures rise, the more it may become apparent that the loans held by the CDOs are in trouble and the greater the risk of CDO downgrades.
In this high-stakes game, the risks to other lines of business are major. Already, concerns are growing that the Bear situation may be spilling over to junk bonds and leveraged loans—two red-hot markets that have kept leveraged buyouts booming and generated big profits for big banks. An index of leveraged loans has fallen 2% the past two weeks. Junk bonds are down as well. Steven C. Miller, managing director of Standard & Poor's LCD, a loan market research service, says that for the first time in two years, investment bankers have had to issue "bridge" or back-up financing for an LBO after running into difficulty selling junk bonds to fund the deal.
LBO firms are going back and offering investors higher yields and better protections to raise money for pending buyouts such as the one for retailer ServiceMaster Co. (SVM ), owner of Terminix and Merry Maids. "There's a much more sober view in the leveraged finance market right now," says Miller.
For all the pressure on CDOs, though, a crisis hasn't yet been touched off. Some observers are downplaying the significance of the hedge fund blowup to Bear Stearns' bottom line. Roger Freeman, an analyst at Lehman Brothers Inc. (LEH ), says in a June 26 research note that the matter will not have "a meaningful impact on Bear's earnings." Likewise, Miller of S&P LCD predicts that, for all the consternation over Bear, the LBO pace will only slow, not stop. CIBC, meanwhile, rejects suggestions that it could be the next firm to tumble. The assumptions about its subprime exposure "are simply not true," says bank spokesman Stephen Forbes. Paribas declined to comment.
Wall Street's strategy from here will be to try to maintain the status quo, putting out new fires quickly. "They are hoping to buy themselves as much time as possible," says James Melcher, founder of Balestra Capital, a hedge fund. "The game could work out if the top dozen firms get together to hold the market and gradually deflate it over time."
But the prospect of a meltdown is on everyone's mind. On June 26, UBS (UBS ) analysts held a conference call with money managers to review the Bear situation. "There's a search for contagion going on," says Douglas J. Lucas, a UBS analyst on the call. "I've talked to people from as far away as Australia." Everyone is watching to see who might blink.
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subprime, CDO, mortgage derivatives, CDS, ABXLabels: ABX, CDO, CDS, mortgage derivatives, subprime
Broker Dealer on Verge of Collapse from CDO Markdown
Indie B-D warns reps of dire finances By Bruce Kelly
June 21, 2007
Hammered by exposure to a risky type of mortgage-backed security, Brookstreet Securities Corp. of Irvine, Calif., yesterday told its 500 or so affiliated reps and advisers that "disaster" had struck, and that the firm could close if it doesn't come up with at least $5 million. And in an unsigned e-mail note to its advisers, the firm blamed its clearing firm, National Financial Services, and too many accounts on margin for its poor fortune.
"Today, the pricing system used by National Financial has reduced values in all Collateralized Mortgage Obligation," the e-mail said.
"Many of those accounts were on margin and suffered horrendous markdowns and unrealized as well as realized losses."
National Financial and the regulators expect Brookstreet to pay for realized liquidated losses and take a capital charge for unrealized (mark) to market losses. "
The e-mail continued, "It would take a capital infusion of at least $5,000,000 to keep the company in compliance with no additional guarantee that additional markdowns will no be forthcoming."
Brookstreet Securities is a mid-sized, independent-contractor broker-dealer, and in 2006 generated about $70 million in gross revenue, according to one industry observer who asked not to be named.
According to NASD records, the Brooks Family Trust owns more than 75% of the firm, with Stanley Brooks the trustee.
Although the message was unsigned, it contained a personal message to each adviser, potentially from Mr. Brooks.
"I have told many of you that you are always in danger of not being paid on your last check when working for any broker-dealer. I will try to get enough money from our account at NFS to complete our upcoming payrolls."
The note concluded with a plea: "All our family net worth is in the firm, please give me time to present a new plan."
Mr. Brooks did not immediately return a phone call on Thursday afternoon to comment.
Fidelity Investment, which owns National Financial, "can't comment specifically about Brookstreet's claims, but we are not responsible," a company spokesman said.
"National Financial has clear margin agreements in place and uses reputable firms to price securities held in brokerage accounts," the spokesman said.
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Hedge fund issues could cause economy to slow
Hedge fund issues could cause economy to slowWhile hedge fund failures are typically seen as a Wall Street problem, economists are forecasting that recent hedge fund meltdowns could impact Main Street and may even slow the U.S. economy. Turmoil in credit markets could push up borrowing costs for businesses and consumers and cause a ripple effect.
Hedge fund woes could hit Main StreetUpheaval in credit markets could hit consumer, business borrowing - and slow the economy; risk premiums already rising.
By Chris Isidore, CNNMoney.com senior writer
June 21 2007: 3:21 PM EDT
NEW YORK (CNNMoney.com) --
When Bear Stearns's hedge funds melted down this week because of too big a bet on subprime mortgages, it may have seemed like a Wall Street problem.
But numerous economists said the latest turmoil in the nation's credit markets could spill over to Main Street as well, raising borrowing costs for consumers and businesses alike - and possibly putting the brakes on the surprisingly resilient U.S. economy.
Subprime mortgages, made to home buyers with less than top credit ratings, have been skidding since early this year as delinquencies and foreclosure rates soared. Now problems with those mortgage loans have sparked a big headache for Bear Stearns (Charts, Fortune 500) and the Wall Street firms that lent it money to invest in subprime mortgages, such as Merrill Lynch (Charts, Fortune 500), JPMorgan Chase (Charts, Fortune 500) and Citigroup (Charts, Fortune 500).
But the problems threatening the credit markets could mean far more than just billions in possible losses for those firms. It could push rates higher for corporate debt, which has been relatively cheap even for companies with poor credit ratings.
Even if those companies don't fall behind in their debt payments the way many subprime borrowers have on their mortgages, the investors making money available for those riskier loans are now demanding a much higher premium than they had until just recently.
Deadly ripples threaten subprime funds That could choke off the supply of relatively cheap money that has kept the U.S. economy humming in recent years, putting a dent in everything from business investment to consumer spending.
"That's clearly high on my list of things to worry about," said David Wyss, chief economist at credit-rating agency Standard & Poor's. "I think it's healthy that pricing for risk changes. I think it's too loose now. But the transition could be painful. It depends on how fast it happens."
Wyss doesn't believe that the rise in borrowing costs for most companies will plunge the U.S. economy into recession - and many economists agree with him. They said there's enough underlying strength in the economy to keep it growing. But it will mean slow growth in the second half of this year rather than more normal "trend" growth of 3 percent a year or greater, said John Silvia, chief economist at Wachovia.
"I would think that that as you reprice risk, it will have a negative impact on economic growth going forward," said Silvia. "It will extend the workout in the housing market. And at the margin, they [higher rates] will crimp consumers and their spending."
Others see an even more drastic correction. Peter Schiff, president of Euro Pacific Capital, a brokerage firm specializing in overseas investments, said he had already been expecting a recession in late 2007. Now he believes the recession will come sooner, and hit harder, because of the problems with the Bear Stearns hedge funds.
"This is just another graveyard they can whistle by," he said, referring to Wall Street firms. "Eventually they're going to be overwhelmed. Interest rates are going to rise across the spectrum, and spreads are going to widen considerably."
That widening of the spreads - the difference between what it costs top borrowers and those deemed more risky - has already started. The spread between corporate debt that is not investment grade, popularly known as junk bonds, and a basket of U.S. government bonds was 2.89 percentage points on Thursday, according to Wyss, up from a record low of 2.65 percentage points on May 25.
Wyss said the spread had gotten too narrow and that a correction was likely even without the Bear Stearns problems. A more typical spread is close to four percentage points, and it was as high as 3.85 percentage points as recently as last September.
But he said an event in the credit market such as this week's meltdown typically sends spreads soaring. He noted the rise of roughly one percentage point in just two months in 2005 from a then record low in March following General Motors (Charts, Fortune 500) and Ford Motor (Charts, Fortune 500) debt being cut to junk bond status for the first time.
Full articlehedge funds, economics, capital markets, interest rates, bond yields, valuations, CDO, credit derivatives, derivatives, pooled securitiesLabels: bond yields, capital markets, CDO, credit derivatives, derivatives, economics, hedge funds, interest rates, pooled securities, valuations
Universities scoop up risky subprime debt from Bear Stearns Hedge Fund
Universities scoop up risky subprime debtUniversity endowments were among the most eager buyers of risky mortgage-backed securities being offloaded by Wall Street this week. "There's an opportunity out there to buy these loans at a discount," said Lou Morrell, vice president for investments and treasurer at Wake Forest University. Meanwhile, Bear Stearns continued to scramble to save two hedge funds hit hard by the subprime fallout, saying Thursday it took on $3.2 billion in loans to stop creditors from seizing assets of one of its money-losing hedge funds.
Bear Stearns Plans $3.2 Billion Hedge Fund Bailout (Update2)
By Jody Shenn and Yalman Onaran
June 22 (Bloomberg) --
Bear Stearns Cos. is proposing a $3.2 billion bailout of a money-losing hedge fund, the biggest rescue since 1998, to forestall creditors from seizing assets, people with knowledge of the proposal said.
The firm told lenders to the High-Grade Structured Credit Strategies Fund yesterday that it would assume their loans, said the people, who declined to be named because the plan is confidential. The New York-based firm made the offer after creditors including Merrill Lynch & Co., JPMorgan Chase & Co. and Lehman Brothers Holdings Inc. put some of their collateral up for sale to investors.
Bear Stearns increased efforts to salvage the fund, one of two that made bad bets on collateralized-debt obligations, as concern about a possible collapse sent stocks and bonds of financial companies lower. An agreement with creditors would prevent a fire sale of the collateral, while increasing the risk to Bear Stearns, the second-biggest underwriter of mortgage bonds.
``Bear needs to put this behind it as soon as possible,'' said Peter Goldman, who helps manage $600 million at Chicago Asset Management, including shares of Bear Stearns. ``The firm might take on some of the risk of the fund they didn't have before, but they're a bond shop and they wouldn't take on risk they shouldn't.''
The Bear Stearns fund lost about 10 percent of its value this year, while the related fund, the 10-month old High-Grade Structured Credit Strategies Enhanced Leverage Fund, lost about 20 percent, according to people familiar with the matter. Both funds are run by Ralph Cioffi, 51, a senior managing director.
Fastest-Growing
The funds speculated in highly-rated CDOs -- securities backed by bonds, loans, derivatives and other CDOs -- that were hurt in March and April as defaults on subprime mortgages to people with poor or limited credit histories increased. The fund also lost on opposite bets against home-loan bonds, which backed many of its CDOs.
Bear Stearns spokeswoman Elizabeth Ventura declined to comment. Lehman spokesman Randy Whitestone also declined to comment. Adam Castellani, a spokesman for JPMorgan couldn't immediately be reached when called after hours.
Investors from hedge funds to pension funds and foreign banks have snapped up CDOs as a new way to invest in debt, making it the fastest-growing market and pushing the amount outstanding to more than $1 trillion.
CDOs trade infrequently and holders rarely have comparable sales to use when valuing the securities on their books. Forced sales may have required investors to write down those values, potentially causing billions of dollars of losses.
Largest Since LTCM``The problem is not what we see happening, but what we don't see,'' said Joseph Mason, associate professor of finance at Drexel University in Philadelphia and co-author of an 84-page study this year on the CDO market. ``We don't know the price of these assets. We don't know which banks are exposed to this sector. These conditions are the classic conditions for financial crises across history.''
The bailout of the fund would be the largest since Long-Term Capital Management LP, which received $3.5 billion from 14 lenders in 1998. The Greenwich, Connecticut-based fund, run by John Meriwether, lost $4.6 billion.
In the case of Long-Term Capital, lenders agreed to take equity stakes in the fund after New York Federal Reserve President William McDonough called the heads of the firms together. They then sold assets over time to limit the impact of its collapse.
Bear Stearns's proposal doesn't involve taking equity. Instead, the firm would become a lender to the fund, its loan secured by the assets of the fund.
Bundling SecuritiesBankers and money managers bundle securities into a CDO, dividing it into pieces with credit ratings as high as AAA. The riskiest parts have no rating because they are first in line for any losses. Investors in this so-called equity portion expect to generate returns of more than 10 percent.
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.
Bear Stearns shares rose for the first time in four days yesterday after Merrill decided against selling all its collateral. The stock dropped $1.35, or 0.9 percent, to $144.46 at 10:58 a.m. in New York Stock Exchange composite trading.
Risk PerceptionsThe perceived risk of owning corporate bonds was little changed today after reaching the highest since September earlier this week. Contracts based on $10 million of debt in the CDX North America Crossover Index was quoted at about $169,000, after rising as high as $179,000 yesterday, according to Deutsche Bank AG.
The Bear Stearns funds had borrowed $9 billion and made bets of more than $11 billion, one of the people familiar with the situation said. The creditors include Merrill, Lehman, JPMorgan, Goldman Sachs Group Inc., Citigroup Inc. 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.
As the funds faltered, Merrill sought to protect itself by seizing the assets that were used as collateral for its loans. The firm was followed by JPMorgan, which offered some securities for sale before withdrawing its plan. Lehman put some securities up for sale, according to a person with knowledge of the situation.
The second fund had less money from investors though was more leveraged, meaning it had borrowed more relative to its assets. Talks with creditors to that fund are also underway, one person said.
To contact the reporter on this story: Jody Shenn in New York at
jshenn@bloomberg.net ; Yalman Onaran in New York at
yonaran@bloomberg.net .
video full articlehedge fund, bailout, high grade, CDO, collateralized debt obligations, university endowment, investment managers, mortgage backed securities, credit default swapsLabels: bailout, CDO, collateralized debt obligations, credit default swaps, hedge fund, high grade, investment managers, mortgage backed securities, university endowment
Hedge fund future bleak with Merrill sell-off
Hedge fund future bleak with Merrill sell-offMerrill Lynch's planned auction of about $800 million of bonds held by a money-losing Bear Stearns hedge fund could signal the end of a Bear Stearns effort to save the fund. The 10-month-old fun run by Bear Stearns senior managing director Ralph Cioffi has lost 20% this year and is under increasing pressure from creditors, including Merrill. Bear Stearns has attributed the falloff of the fund and a sister fund to the slump in the U.S. housing market.
Some Lenders Dislike Plan to Save Bear Stearns FundBy JULIE CRESWELL and VIKAS BAJAJ
An effort to save a troubled hedge fund at Bear Stearns hit a major hurdle yesterday when Merrill Lynch signaled that it would move forward with plans to auction $850 million in subprime securities that had been held as collateral.
While negotiations are continuing and the auction could be averted, the move signaled that some lenders in the High Grade Structured Credit Strategies Enhanced Leverage fund are not happy with some terms of the Bear Stearns bailout plan.
Executives at the bank have been scrambling to shore up the fund since three lenders — Merrill, Citigroup and JPMorgan Chase — asked the bank to put up more capital. The executives had offered to inject $1.5 billion in new loans into the fund, and a consortium of other banks, including Citigroup and Barclays, would infuse $500 million in new capital.
In return, the Wall Street banks and brokerage firms that had provided nearly $6 billion to the hedge fund would have had their own exposure reduced but would have had to agree not to demand more cash or collateral from the fund for a year, according to people briefed on the plan who were not authorized to speak for attribution.
If Merrill moves forward with an auction, it could make it much more difficult for Bear Stearns and the longtime portfolio manager of the fund, Ralph Cioffi, who has spent the last few days scrambling to try to bring in new money, to save the 10-month-old fund. If other lenders decide to follow Merrill’s lead and seize and sell assets, it could lead to the dissolution of the hedge fund.
Late yesterday, some people briefed on the plan said that one option might be for Bear Stearns to buy out Merrill’s stake. Representatives at Bear Stearns and Merrill declined to comment.
But if the assets — securities and bonds backed by subprime mortgages that can be difficult to value — are sold at prices well below where they are currently valued, the reverberations across Wall Street would be strong. Not only would Merrill be forced to post losses on its holdings, but other banks, hedge funds and investors owning similar securities would have to mark down the value of those holdings to new, lower prices.
“If we end up seeing these assets sold at significantly distressed prices, it will likely cause other funds to have to re-evaluate how effective and fair the values that they have been carrying these securities have been.” said Josh Rosner, a managing director at Graham Fisher, an investment research firm in New York.
The potential for a large ripple effect across the financial markets has been one reason many of the other lenders, even those unhappy with the terms of the bailout plan, stayed at the negotiating table with Bear Stearns, according to people briefed on the talks.
Started just last year, the Bear Stearns hedge fund was hit by a combination of bad bets on bonds backed by subprime mortgages as well as high levels of leverage. Investors originally put $600 million into the fund and another $6 billion was borrowed from the Wall Street banks.
Through the end of April, the fund had lost about 23 percent, prompting investors to try to redeem their investments. In May, the fund froze redemptions and soon faced margin calls from its banks.
While Bear Stearns has little exposure to the fate of the fund — the company and individual executives invested just $40 million in it — its stock nonetheless declined 2.2 percent, to $146.79. in the last two days.
Investors are probably concerned about how the outcome could affect the larger Bear Stearns business of underwriting and trading bonds backed by mortgages.
Full articleVideohedge funds, mortgage backed securities, CDO, CDS, credit derivatives, mortgage derivativesLabels: CDO, CDS, credit derivatives, hedge funds, mortgage backed securities, mortgage derivatives
With credit-derivatives backlog clearing, Fed eyes equity derivatives
With credit-derivatives backlog clearing, Fed eyes equity derivativesThe backlog of unconfirmed trades in the credit-derivatives market plunged 94% last year, following efforts by the Federal Reserve to persuade market participants to clean up their acts. Now the Fed is turning its attention to the backlog in equity derivatives.
full storycredit derivatives, CDS, CDO, confirmations, FEDLabels: CDO, CDS, confirmations, credit derivatives, FED, federal reserve
CDOs put the squeeze on bond investors
CDOs put the squeeze on bond investorsCollateralized debt obligations are pushing down the costs to protect against bond defaults. CDOs can return three times the rate of the underlying securities, and are "changing the economics of investing in corporate bonds," said the head of structured credit research at Barclays Capital in London.
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