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Mutually Assured Mayhem


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 DEEP

At 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 PROBES

CDOs 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.

Join a debate about whether the U.S. stock market is overheated.

By Matthew Goldstein, David Henry, and Mara Der Hovanesian, with Peter Coy in New York and Dawn Kopecki in Washington


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