25 June 2007

The subprime meltdown, continued | Bearish turns | Economist.com

The subprime meltdown, continued | Bearish turns | Economist.com: "“THEY kept pointing to the juicy yield, but our guys soon saw the paper for what it was: nuclear.” Thus one chief executive, recounting his investment firm's decision to spurn an offer of securities backed by subprime (low-quality) mortgages from Bear Stearns, a large investment bank. The radiation appears to have seeped out at its source, leaving two of Bear's own hedge funds terminally sick. Coming less than two months after UBS, a Swiss bank, closed a fund that had lost over $120m as the subprime market crumbled, the incident is a clear sign that concern is shifting from small, specialist lenders—dozens of which have gone bust—to the supposedly more sophisticated Wall Street firms that package, distribute and trade bonds tied to home loans.

Of the big securities houses, Bear is the most exposed to subprime. So no one was shocked when it announced a 10% fall in underlying profits for the latest quarter. But the fate of its year-old, unfortunately named High-Grade Structured Credit Strategies Enhanced Leverage Fund and its sister fund, the High-Grade Structured Credit Strategies Fund, has raised eyebrows. Run by Ralph Cioffi, an industry veteran, they were thought to be among the shrewdest actors in the mortgage-debt markets. Their downfall suggests that hedging at the highest levels is not as adept as it might be.

The enhanced-leverage fund lost 23% of its value in the first four months of the year as the subprime market collapsed, then stabilised, then fell again. The fund's problems were compounded by its borrowings, which were ten times bigger than its $600m in capital. This made it more vulnerable when things went wrong.

Last week Bear's funds, besieged by disgruntled investors, offloaded securities with a face value of at least $4 billion to free up capital. This fire sale was not enough for one creditor, Merrill Lynch, which seized collateral and threatened to auction it off to cover its losses.

Bear persuaded Merrill to stay its hand by agreeing to negotiate a rescue with a consortium of banks. At one point an injection of $500m in new capital looked possible, with Bear itself offering to lend an additional $1.5 billion. But the plan fell apart. On June 20th Merrill began hawking some of the funds' assets to other hedge funds, while other creditors, such as JP Morgan Chase and Deutsche Bank, worked with Bear to unwind their positions. But there were few buyers for the bank's subprime-backed debt, even the highest-rated paper.

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