3 July 2007


July 2, 2007 -- Shell-shocked mortgage bond traders who just closed the books on a surpassingly ugly June are eyeing the calendar warily, waiting for the next two weeks to bring the first word of just how much damage hedge funds sustained as a result of the subprime mortgage mess.

With a series of bad bets on subprime bonds and arcane structured securities triggering the near-collapse of two Bear Stearns hedge funds, wide swaths of the $6 trillion mortgage-backed bond market have sold off sharply. In turn, it is believed that many investors - especially hedge funds, which can borrow over a dozen times their capital base - have seen their already lackluster performance shellacked.

If the performance of subprime investors is as bad as expected, institutional hedge fund investors and the investment banks that loan funds money and clear their trades will be faced with investors' concerns over capital withdrawal, matched by the banks' need for better collateral and reduced exposure.

With a fear of lawsuits for breach of duty and a lack of faith in the quality of the loans backing the subprime mortgages, there could be little incentive to ride out the storm.

In 1994 and again in 1998, this cycle of fund redemptions and reduced leverage resulted in something akin to a panic in the mortgage market, triggering the closing of hedge funds and brutal losses for Wall Street firms.

Already there are some unsettling indications that the global retreat from risk is spreading and Cheyne Capital's Queen Walk fund, both were hit with significant losses as a result of exposure to the mortgage bond market. Late last week, two British mortgage funds, Cambridge Place's $900 million Caliber Global Investment fund and Cheyne Capital's Queen's Walk fund, announced plans to close.

The trading on Friday gave little indication that things will get any better in the near-term. The widely watched ABX index, a key gauge of the health of the asset-backed and subprime mortgage markets, began what one market player called "a collapse." One index, called the ABX 06-2 Single-A, saw its value drop four points Friday; as recently as two weeks ago, a move of one or two points was considered unusual.

Another looming crisis is the potential for widespread downgrades by rating agencies of arcane, illiquid securities called collateralized debt obligations - essentially bonds created from pieces of other bonds. With about $200 billion worth of CDOs backed by the bonds and loans of mortgage issuers - many of which have suffered bankruptcy or near-collapse - the market has avoided disaster only because of a loophole in valuation.

However, if the rating agencies begin downgrading CDOs, these securities could be re-valued, potentially sending their market prices down as much as 50 percent.

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