Mutually Assured Mayhem

Posted by: Dean Foust on June 29, 2007

subprime2.jpgI’ve been remiss in not discussing the trouble in the subprime market this week—led by revelations last week that two Bear Stearns hedged funds that were invested in subprime mortgage debt were in deep trouble; while Bear agreed to invest $1.6 billion to shore up one of the funds, it so far hasn’t offered to bail out the other fund, which is acknowledges has suffered heavy losses. My BusinessWeek colleague Matt Goldstein has been on top of the story with these early dispatches (click here, here, here, and here), and Matt collaborated on a broader analysis in this week’s magazine with David Henry, Mara Der Hovanesian and others (which can be read by clicking here).

Given that hundreds of thousands, if not millions, of subprime loans are souring, what happens next? There seems to be a big game of…well, collusion, with all of the major Wall Street firms seemingly agreeing that they won’t write down the value of a tranche of subprime mortgages that they’re holding in a fund, since that would force all of the other firms to recognize similar losses in their holdings. A quirk of the accounting for asset-backed securities is that you can value bonds like these at their original value until there’s some triggering event that establishes a different valuation—say, a downgrade by one of the major credit-rating agencies, or writedowns by another investor holding the bonds.

casablanca.jpg
Bear Stearns wasn't necessarily being altruistic when it agreed to pump $1.6 billion into the troubled hedge fund. Bear Stearns just didn't want to have to acknowledge that the fund had suffered deep losses, which could trigger a domino-like tumble in valuations of subprime-backed bonds all up and down Wall Street. So what you have is a collective--and convenient--form of denial, a variation of the scene in Casablanca when Claude Raines' character scene Sounds like Casablanca when Captain Reynaud feigns shock that there is gambling going on. "Losses from subprime?? I'm shocked!! Shocked, I tell you!!" (In a curious move, a Citigroup analyst threw Bear Stearns a wet kiss today, raising his rating on Bear Stearns' bonds to "buy" from "hold."

Everyone on Wall Street knows that the bubble has popped and they're sitting on huge losses from subprime mortgages already in foreclosure or headed that way. The collective plan seems to be to let the air out of the balloon slowly--acknowledge and absorb the losses very slowly--and not quickly, which could create a contagion that spreads to the corporate bond market and beyond.




The Citigroup upgrade notwithstanding, I'm beginning to think that Bear's woes, which have already caused its stock to drop nearly 20% since January, will cost the firm its independence, certainly by the end of the year and perhaps by the end of summer (a view shared by Merrill Lynch analyst Guy Moszkowski). Bear Stearns is relatively small by Wall Street standards, and could prove to be a tasty morsel for a bank like Bank of America, which wants to beef up its investment banking businesses, or Wachovia--and probably couldn't pass on Bear if it's available for a sharp discount. But if Wall Street can maintain the myth that subprime is fine, then Bear may survive. The next six months will be worth watching.

Reader Comments

JanB

June 29, 2007 10:22 PM

Check out this beyond-excellent, honest commentary by Bill Gross of Pimco on the current unfoldings of the Bond Market--talk about hitting the nail on the head!!-great perspective and sense of humor Bill--if we can't laugh, then I guess we are gonna cry.........

www.pimco.com
From the homepage, click on Bill Gross Investment outlook July-2007
Bill...you are a GOD amongst men....
XOXO,
JanB

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BusinessWeek editors Chris Palmeri, Prashant Gopal and Peter Coy chronicle the highs and lows of the housing and mortgage markets on their Hot Property blog. In print and online, the Hot Property team first wrote about the potential downside of lenders pushing riskier, "option ARM" mortgages and the rise in mortgage fraud back in 2005—well ahead of many other media outlets. In 2008, Hot Property bloggers finished #1 in a ranking of the world's top 100 "most powerful property people" by the British real estate website Global edge. Hot Property was named among the 25 most influential real estate blogs of 2007 by Inman News.

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