Subprime Mess Hits Wall Street Again

What is now routinely called "the subprime mortgage mess" is continuing to roil the U.S. economy and last week it again caused major concern in the larger financial markets.

Bear Stearns announced on Friday that it was pledging as much as $3.2 billion in loans to save one of its hedge funds that is in serious trouble because of risky investments in the subprime mortgage market.

Two days earlier Yahoo News printed an article from Agence France Press (AFP) which said that two of the big hedge funds managed by Bear Stearns were close to being shut down as their mortgage-related bets went south. The funds were identified by The Wall Street Journal as the High Grade Structured Credit Strategies Enhanced Leverage Fund and the High Grade Structured Credit Strategies Fund.

Hedge is a broad term applied to a variety of funds that try to reduce volatility and risk and preserve capital and income under all market conditions. Funds employ a variety of strategies such as selling short, arbitrage, investing in currencies, and buying and selling undervalued securities.

According to The New York Times, the proposed bail-out by Bear Stearns is the biggest rescue of a hedge fund since 1998 when Long-Term Capital Management was saved by a group of over a dozen lenders which pledged 3.6 billion to stabilize the fund.

The first fund (Credit Strategies Enhanced Leverage Fund) was started in 2004 and had posted 41 months of positive returns in excess of 12 percent a year. However, under pressure from investors who wanted even higher returns, so in August according to The New York Times the Structured Credit Enhanced Leveraged Fund was started with $600 million in investments, and at least $6 billion in money borrowed from banks and brokerage firms. Bear Stearns and a handful of its top executives invested $40 million in the two funds, only a small part of their total capitalization.

The two funds invested in collateralized debt obligations which invest in bonds backed by hundreds of loans and other instruments. These debt obligations are sliced into salable portions and marketed by Wall Street. Many of these obligations have low yields but are easily traded and not terribly risky; others are risky and don't trade often and so are difficult to value. The Times quoted the Securities Industry and Financial Markets Association as stating that $316.4 billion in these obligations were issued in 2006, about 77 percent more than in 2005.

Then, this past winter, as housing prices were beginning to fall and many of the subprime mortgages began to suffer higher than usual rates of default, the older of the two funds registered its first loss and by April was down by 5 percent for the year while the new fund had lost twice that much. Then, a short time later, Bear Stearns revalued some securities and informed investors that the second fund may have lost more than twice what it had originally said.

Both investors and banks that had lent money to the funds began trying to pull money out but in May. Bear Stearns froze all redemption requests. Then in June three major banks began demanding more cash to collateralize the loans they had made. A couple of the lenders moved to sell assets and by last Wednesday about $2 billion in securities were up for sale. Some collateral auctions scheduled by banks have been cancelled and others resulted in the sale of only small portions of the collateral offered.

In the midst of all of this, Reuters reported that hedge fund managers had accused Bear Stearns of trying to manipulate the market by propping up faltering mortgage-backed securities by purchasing individual mortgages that were rapidly losing value.

On Friday Barclays Bank revealed it had some exposure to troubled hedge funds that had invested in the subprime market but that losses won't impact the bank's overall performance. The admission followed reports in several British newspapers that Barclays had made loans of $300 million to the two Bear Stearns funds.

The news of the fund bailouts hit the stock market hard and the Dow Jones industrial average closed down 186 points on Friday, a decline of 126 points after the Bear Stearns announcement was made public. The market had recovered a bit on Monday and was up 110 points by mid-day.

The Friday announcement covers only one of the funds. Bear Stearns is reportedly in negotiations with banks to rescue the newer and larger fund which has more than $6 billion in loans and is reported to be invested in riskier positions.