The Bear Stearns Reporting Contest

Tanta at Calculated Risk:

Calculated Risk: The Bear Stearns Reporting Contest: It was a dark and stormy night; the rain fell in torrents--

The high-stakes game of brinksmanship began early yesterday on Wall Street, and continued throughout the day. Bankers traded telephone calls, frenetically negotiating the fate of two hedge funds. All wanted to avoid a fire sale in the troubled mortgage-securities market, but at the same time, not get stuck with an exploding liability that could result in steep losses. The day ended with deals that appeared to have forestalled a meltdown. But questions remained about how successful they were and whether they had merely delayed the inevitable...

except at occasional intervals, when it was checked by a violent gust of wind which swept up the streets

June 21 (Bloomberg) -- Merrill Lynch & Co.'s threat to sell $800 million of mortgage securities seized from Bear Stearns Cos. hedge funds is sending shudders across Wall Street. . . . "More than a Bear Stearns issue, it's an industry issue," said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York. Hintz was chief financial officer of Lehman Brothers Holdings Inc., the largest mortgage underwriter, for three years before becoming an analyst in 2001. "How many other hedge funds are holding similar, illiquid, esoteric securities? What are their true prices? What will happen if more blow up?"...

(for it is in London that our scene lies),

One mortgage investor said that while the CDO assets for sale carried high credit ratings, they were backed by such risky mortgages as to be "junk in investment-grade clothing"...

rattling along the housetops, and fiercely agitating the scanty flame of the lamps that struggled against the darkness.

The bottom line is that big losses in subprime investments are likely to make investors more reluctant to risk their money on these instruments in the future. That will make it harder for mortgage originators like banks to sell these types of loans in bundles to the bond markets, which will, in turn, reduce the availability of funds for subprime loans and make it much harder for subprime borrowers to obtain financing.

Nobody ever apologizes to Edward George Bulwer-Lytton. So I'm a contrarian. Herewith: apologies to Bulwer-Lytton.

UPDATE: Thank you, Outsider, for the perfect denoument to our overwrought little narrative:

"We're looking at somewhat immature markets that are going through a growth phase," Ralph Cioffi, senior managing director of Bear Stearns Asset Management, said at a bond conference in New York in February, Reuters reports. "There is a catharsis and a cleaning-out process."

Investors: If you can't tell who is having the catharsis, you're the catharsis.

FURTHER UPDATE: Every caprice needs a rondo. But Hugh Moore, partner of Guerite Advisors and a former executive at a subprime mortgage lending company, described the situation as a "slow train wreck."

"I wouldn't be at all surprised if we hear about more [hedge funds] blowing up in the coming months, as the subprime market meltdown continues," he said. "You've got $250 billion of subprime [adjustable-rate mortgages] that are going to reset this year. I don't think it's going to be systematic . . . but for those people who invested in those hedge funds, its certainly not going to be fun."

So what's it going to be for those subprime borrowers? Just another day at the circus?

Comments

[Ginger Yellow]

"The bottom line is that big losses in subprime investments are likely to make investors more reluctant to risk their money on these instruments in the future. That will make it harder for mortgage originators like banks to sell these types of loans in bundles to the bond markets, which will, in turn, reduce the availability of funds for subprime loans and make it much harder for subprime borrowers to obtain financing."

I'm struggling to understand why this is such a bad thing. The investors bought crap and they're getting burned. That's how it's supposed to happen. Nobody hid the quality of the loans from them.

There's a different argument to be had over CDOs and hedge funds (although again, if you're not willing to risk a loss, don't invest in a hedge fund), but for the subprime bonds themselves the market seems to be functioning as it should do. What I don't understand is why nobody's pointing their fingers at the rating agencies. They're the ones who said these deals were AAA investments while most economists were saying "housing bubble".

[Neal]

From Moodys.com

In a World of Short-Term Outlooks, Long-Term Opinions are Vital

In today's volatile markets, there is no shortage of financial commentators who are quick to respond to current events and to offer their short-term expectations. But most fixed-income market participants are also in for the long haul. Investors typically have long-term exposures to debt with maturities from several years to more than a century, while borrowers hope to maintain access to capital market funding for many years beyond their latest issue.

So Moody's takes a different perspective. We focus on the fundamental factors that will drive each rated entity's ability and willingness to meet its credit obligations over the long term.

As a rule of thumb, we look out over a time horizon of five-to-ten years at least through one full economic cycle. Moody's ratings do not ratchet up or down in response to short-term events such as quarterly earnings reports.

Rather, our emphasis is on a qualitative assessment of the "plausible crisis scenarios" that a rated borrower is likely to face and the fundamental investor protections that would enable management to continue to meet debt payments should the worst occur.

Moody's analysts look at each issuer's business and financial statistics. And they make extensive use of computer modeling techniques. But they spend most of their time sorting out the fundamental credit strengths and weaknesses unique to each entity and management team. Their aim is to understand the long-term risks specific to each borrower's industry, country, and region.

~Retrospective default studies provide the best measure of a rating agency's track record. Moody's annual default studies offer solid evidence that Moody's ratings have been highly reliable predictors of long-term credit risk and default.~

[Ginger Yellow]

Sure, but that's missing the point. I'm not talking about investors losing out from market value declines. Admittedly I'm much more in touch with the European market, but from what I understand there's serious potential for principal losses on subprime bonds rated well into investment grade. Considering that the US is not in a particularly stressed economic situation overall (various imbalances notwithstanding, there's no big recession), it's pretty bad for even BBB rated notes to take a principal hit. Moreover, Moody's and other rating agencies place a lot of emphasis on historical data when rating deals, yet they seem to have papered over the fact that the bubble in the US housing market since 2000 is unprecedented in its scale.

[Neal]

Obviously no one at Moodys read their PR and ran the subpriem mess through one full credit cycle or thought in 2006 that there was no top to the housing market.

But, just a few days ago in the new, there was a story that Bush personally intervened with the solicitor general of the US not to side with investors who were at the Supreme Court. The investors were trying to solidify the right to sue third parties that were complicit, negligent or covered-up financial misdeeds of public companies.

Their case was trying to get at rating agencies and stock analysts who rated stock as buy or hold up until the day the company collapsed. Just yeaterday in Congressional testimony Paulson reaffirmed Bush's position because "such suits would harm workers and the economy".

Such suits may be expected but don't look to the government to support them.

[Neal]

The issue to look at in the independence of the rating agencies is who pays Moodys and Fitch for their ratings. Its typically not the investor, its the offeror.

Its like the role of the appraiser in the hosue purchase market. Quite often in the recent past they were hired by the morgage broker who wanted to make the deal. Appraisers that did not support the mortgage amount were typically dropped from the process and more compliant appraisers were used more often.

[Hal]

Well the stock market had a very very short little reaction but pretty soon it was shooting up again. You just can't keep it down when it wants so badly to go up and up and up. Why it wants to needs explanation, but I haven't seen any.

[Ken Houghton]

Of course, the subprime borrowers could just go right on servicing their loans and the securities would still decline, if the assumptions of the security payments were overly optimistic.

It's not necessarily the way to bet, but there isn't necessarily a link between the current price of the security and what actually happens.

It's not the way to bet, but the subprime borrowers could survive quite well--or at least renegotiate their way to survival.

[ken]

This subprime angst is way overblown. It is the Y2K situation all over again.

Just like software engineers had prepared critical software systems for Y2K so too have financial engineers been preparing financial institutions for subprime resets.

I sometimes wonder if people who spend time blogging all the troubles they see coming really believe they have more foresight than the people who are paid the big bucks to actually run projections of various financial scenarios and then be prepared for them.

[Diana]

An aside: don't worry about apologizing to Edward Bulwer-Lytton. The apocryphal story about how he came to write those books is that he was a young aristocratic roue in London when his father revoked his handsome allowance, alleging that his son's escapades were ruining the family name.

Instead of mending his ways Edward said something to his father along the lines of, If you thought that what I was doing was maligning the family name, wait till you see what I'm going to do to it now, and proceeded to make a living by writing the very successful, very trashy Victorian potboilers for which he is famous.

And, as we all know, he did indeed make his family name infamous forever.

(The best of his books probably is The Last Days of Pompei. A very fun read, by the way.)

[howard]

ken, you are following the narrative arc here, right? you do understand that the smart guys at bear stearns screwed up big time? and that the guys making big bucks are not always the smartest guys in the room?

[christofay]

When did the word 'model' become some prominent?

[Slocum]

"So what's it going to be for those subprime borrowers? Just another day at the circus?"

I hope they'll get the good advice to either renegotiate or walk away than kill themselves trying to keep making payments on a house that's no longer worth as much as their mortgage balance. Having to move is wrenching, but most subprime borrowers put very little equity into their homes and have none now, so they won't lose much (if any) money by walking away.

[Barry]

"I sometimes wonder if people who spend time blogging all the troubles they see coming really believe they have more foresight than the people who are paid the big bucks to actually run projections of various financial scenarios and then be prepared for them."

Posted by: ken

Um, because the guys running the projections are not the guys making the 'big bucks'? The guys making the big bucks are the guys who hire and fire the scenario modelers.

As has been mentioned above, see Enron, Vast Financial Giants' complicity in.

Also, dotcom bubble, analysist talking it up until the fall couldn't be denied.

[ken]

Geez guys, get a grip.

Leveraging up is a risky proposition regardless of the underlying securities used.

So they made a big bet and lost. Big deal. Is this going to destroy the economy? Is this going to wreck havoc on financial institutions balance sheets all across America?

Get real. Securities based upon subprime are a small piece of the outstanding mortgage security market and mortgages are only one part of the debt market in general.

The era of subprime may be over but only those whose sole focus was in this sector will be seriously hurt. The subprime market just never got big enough to crowd out solid credits in most portfolios. At the worst it was sprinkled around pension funds, banks, endowments and the like in small percentages relative to their overall portfolios.

But more importantly, the loss to Bear Stearn and their investors will be the gain of those who are waiting to see these securites come to market so they can snap them up at deep deep discounts. Some people lose, some people win.

[the idler]

ken should watch less Larry Kudlow, and read more Nassim Taleb.

[howard]

ken has a new take, which is moderately improved but still not exactly on track, given that he's loading up on a different type of hyperbole.

Ken, here's the issue: leverage has been used in an unprecedented way in recent years, accompanied by an unprecedented expanion in derivatives and an unprecedented slicing and dicing of pieces of paper.

sure, it's possible that the pain from the subprime collapse will be localized and contained, although the rather desperate cries from the street about how awful it would be for everyone to have a market value against which to mark suggests that localized and contained might understate the matter.

and if it does understate the matter, then who knows what further implications might result? enough to "destroy the economy?" of course not: only people building weak arguments of straw go that far.

but enough to be noticed outside the exotic world of subprime mortgage funds? that's certainly a real possibility, and worth watching for.

[ken]

howard, the subprime issue is the just the latest issue for doom and gloomers to latch onto.

And speaking of straw. One of my points it that this whole issue is overblown. Most financial institutions are not going to be affected at all and most of those that will be affected the impact will be minor and even that impact has already been planned for (or is being planned for as we write).

The few institutions that made subprime a central part of their strategy will suffer, no doubt about that. But so what? Their loss will be others gain as their securities are sold off at deep discounts and are snatched up by others. This has been eagerly awaited by those who stayed away from subprime waiting the train wreck to arrive so they can sweep up what is left.

But even now I hear that Bear Stearns is trying to put together a 3.5 billion dollar effort to save its subprime securities from being liquidated. Pretty wise move if you ask me. Once you've taken your losses why give someone else all the gain?

[howard]

ken, let's try again, shall we? you know exactly what pieces of what paper are in what portfolios with what leverage where?

the only person making comments about "overblown" is you; what the rest of us are noting is that there is a real problem in one market with as yet unpredictable outcomes in another market. if you think that the wizards are ready, then i have some portfolio insurance i'd like to sell you: there have been no stress tests.

after all, the manager of the fund in question is reputed to be a pretty smart guy himself, and yet here he is, costing his bosses a nice piece of capital.

whether this will turn out to be a good use of capital by bear stearns for bear stearns remains to be seen, although it certainly is a good use of capital from the perspective of everyone who doesn't want to see positions marked to market.

[Arnie Pie]

Ken, to understand why this could have broader ramifications, it might help you to read up a little on leverage, risk and liquidity, among other things.

Here's a good place for you to start:

http://homepages.stmartin.edu/fac_staff/dstout/ECN101/index.htm