Best of the Week
Most Popular
1. Market Decline Will Lead To Pension Collapse, USD Devaluation, And NWO - Raymond_Matison
2.Uber’s Nightmare Has Just Started - Stephen_McBride
3.Stock Market Crash Black Swan Event Set Up Sept 12th? - Brad_Gudgeon
4.GDow Stock Market Trend Forecast Update - Nadeem_Walayat
5.Gold Significant Correction Has Started - Clive_Maund
6.British Pound GBP vs Brexit Chaos Timeline - Nadeem_Walayat
7.Cameco Crash, Uranium Sector Won’t Catch a break - Richard_Mills
8.Recession 2020 Forecast : The New Risks & New Profits Of A Grand Experiment - Dan_Amerman
9.Gold When Global Insanity Prevails - Michael Ballanger
10.UK General Election Forecast 2019 - Betting Market Odds - Nadeem_Walayat
Last 7 days
The Gold Stocks Correction and What Lays Ahead - 19th Oct 19
Gold during Global Monetary Ease - 19th Oct 19
US Treasury Bonds Pause Near Resistance Before The Next Rally - 18th Oct 19
The Biggest Housing Boom in US History Has Just Begun - 18th Oct 19
British Pound Brexit Chaos GBP Trend Forecast - 18th Oct 19
Stocks Don’t Care About Trump Impeachment - 17th Oct 19
Currencies Show A Shift to Safety And Maturity – What Does It Mean? - 17th Oct 19
Stock Market Future Projected Cycles - 17th Oct 19
Weekly SPX & Gold Price Cycle Report - 17th Oct 19
What Makes United Markets Capital Different From Other Online Brokers? - 17th Oct 19
Stock Market Dow Long-term Trend Analysis - 16th Oct 19
This Is Not a Money Printing Press - 16th Oct 19
Online Casino Operator LeoVegas is Optimistic about the Future - 16th Oct 19
Stock Market Dow Elliott Wave Analysis Forecast - Video - 16th Oct 19
$100 Silver Has Come And Gone - 16th Oct 19
Stock Market Roll Over Risk to New highs in S&P 500 - 16th Oct 19
10 Best Trading Schools and Courses for Students - 16th Oct 19
Dow Stock Market Short-term Trend Analysis - 15th Oct 19
The Many Aligning Signals in Gold - 15th Oct 19
Market Action Suggests Downside in Precious Metals - 15th Oct 19
US Major Stock Market Indexes Retest Critical Price Channel Resistance - 15th Oct 19
“Baghad Jerome” Powell Denies the Fed Is Using Financial Crisis Tools - 15th Oct 19
British Pound GBP Trend Analysis - 14th Oct 19
A Guide to Financing Your Next Car - 14th Oct 19
America's Ruling Class - Underestimating Them & Overestimating Us - 14th Oct 19
Stock Market Range Bound - 14th Oct 19
Gold, Silver Bonds - Inflation in the Offing? - 14th Oct 19
East-West Trade War: Never Take a Knife to a Gunfight - 14th Oct 19
Consider Precious Metals for Insurance First, Profit Second... - 14th Oct 19
Stock Market Dow Elliott Wave Analysis Forecast - 13th Oct 19
The Most Successful IPOs Have This One Thing in Common - 13th Oct 19
Precious Metals & Stock Market VIX Are Set To Launch Dramatically Higher - 13th Oct 19
Discovery Sport EGR Valve Gasket Problems - Land Rover Dealer Fix - 13th Oct 19
Stock Market US Presidential Cycle - Video - 12th Oct 19
Social Security Is Screwing Millennials - 12th Oct 19
Gold Gifts Traders With Another Rotation Below $1500 - 12th Oct 19
US Dollar Index Trend Analysis - 11th Oct 19
China Golden Week Sales Exceed Expectations - 11th Oct 19
Stock Market Short-term Consolidation Does Not change Secular Bullish Trend - 11th Oct 19
The Allure of Upswings in Silver Mining Stocks - 11th Oct 19
US Housing Market 2018-2019 and 2006-2007: Similarities & Differences - 11th Oct 19
Now Is the Time to Load Up on 5G Stocks - 11th Oct 19
Why the Law Can’t Protect Your Money - 11th Oct 19
Will Miami be the First U.S. Real Estate Bubble to Burst? - 11th Oct 19
How Online Casinos Maximise Profits - 11th Oct 19
3 Tips for Picking Junior Gold Stocks - 10th Oct 19
How Does Inflation Affect Exchange Rates? - 10th Oct 19
This Is the Best Time to Load Up on These 3 Value Stocks - 10th Oct 19
What Makes this Gold Market Rally Different From All Others - 10th Oct 19
Stock Market US Presidential Cycle - 9th Oct 19

Market Oracle FREE Newsletter

Stock Market Trend Forecast Oct - Dec 2019 by Nadeem Walayat

Bear Stearns and MBS Hedge Funds: What are the Real Risks Today?

Stock-Markets / Risk Analysis Jun 22, 2007 - 11:44 AM GMT

By: Paul_Tustain

Stock-Markets

"...What people don't fully appreciate is the extent to which our financial system has geared up over the last twenty years to finance the worldwide residential housing boom..."

MOST SIGNIFICANT MARKET EVENTS cause an immediate and substantial price reaction, which makes it hard to profit from them. But sometimes there's a sort of slumber, when the market gazes sleepily about itself not quite sure what to do.

We may be experiencing one of them now.


This week a major American investment bank called Bear Stearns was reported as having some serious trouble with a couple of hedge funds. It is difficult to be clear exactly what is going on, because this story involves lots of people and banks who have a vested interest in not being very open. I have been trying to find out the details.

It starts with the humble mortgage. Lots of people in the United States who have no money – they are called sub-prime borrowers – borrowed 100% of the value of a house right at the top of a housing market which has since fallen sharply.

The lenders, however, did not have to worry very much about the risk of default, because they rolled these mortgages into packages called Mortgage-Backed Securities, which they then sold. They got to be off-risk within a few weeks, because by then these MBS belonged to other financial organizations.

But it is not always easy to sell a package of these Mortgage-Backed Securities (MBS). The process of selling such a device demands that the credit quality is assessed – and because the underlying lender is marketing to sub-prime borrowers, the package of debt in the MBS is heavily composed of mortgages quite likely to go into default. So a credit ratings agency will give it a low credit score.

This makes it difficult to sell, which is where a bunch of smart investment bankers join in.

The investment bankers slice the MBS into several chunks or "tranches". These are known as Collateralized Debt Obligations, or CDOs for short. The idea is to create some higher risk assets and some much safer ones, slicing up the MBS into what are called equity, mezzanine and investment-grade bonds.

The equity takes the higher risk, and so it earns the higher return if things go well. But if things start to go wrong, the equity is lost first...and then the mezzanine. However, even if there's quite a high rate of failure in the higher risk end, the investment-grade bonds still get fully paid out. This persuades the credit ratings agencies to give them a respectable stamp of approval, thereby creating out of low-quality mortgages a respectable amount of highly-rated bonds.

In this way the bankers might, for example, convert a large package of MBS into perhaps 70% investment grade bonds, 15% mezzanine, and 15% equity. The original mortgage lender is in a hurry to get the whole MBS off its book, remember, selling the MBS into the financial markets. That way he replenishes his cash and can go out marketing more mortgages to more sub-prime borrowers.

The investment bank is well motivated to slice up the MBS, and it had better be good at selling all this debt on. It won't want to keep much – if any – of the newly created CDO tranches, since the bank earns its money primarily by distributing the MBS, rather than by taking risks with the chance of subprime mortgage borrowers not making their repayments on time.

It is relatively easy to sell the high-grade investment bonds. Stamped with an investment-grade rating, these bonds are sold off to mostly respectable investment institutions. But the mezzanine, and particularly the equity, are less easy to dispose of.

In effect the 30% of the mortgages in the original MBS which were deemed on a statistical basis to be likely to fail, are concentrated into what investment insiders call "Toxic Waste". How can these bonds be sold off?

Enter the hedge fund. Somehow, and possibly even using some its own money, a bank sets up a hedge fund whose objective is to trade in the high-risk CDO equity and mezzanine instruments. Let's say the bank puts up the first $10 million. The hedge fund then buys the equity tranche of the CDO from the bank.

With a bit of luck, and this is what happened over recent years, the housing market goes up. Now the equity is floating higher in the water, because there's a cushion of higher house prices preventing those original sub-prime borrowers from defaulting. This rather obscure equity instrument, which is not traded anywhere and is not liquid, appears to be worth more than it was at issue. It gets marked up in value, and much faster than the underlying houses, because all the price volatility is concentrated in this thin slice of CDO equity.

The hedge fund is now a performer! And that means it will be rewarded by further investment from outside. So what started as a vehicle with a little investment bank money can grow the funds it manages under its own steam – and that can make its managers very rich.

Next, and this is what hedge funds are all about, it will leverage its risk, too. The hedge fund goes out to a lending bank, holding its high-performing but illiquid toxic waste in its hand, and it asks to borrow money using the waste as collateral. The bank has access, whether directly or indirectly, to cheap money from Japan – where interest rates remain at just 0.5% – and so it has the prospect of lending for spectacular profits.

Now the MBS wheel is fully in motion. The hedge fund loses no time in marking up the value of its equity CDOs on the basis of rising house prices. There is an overwhelming pressure to do so, since the hedge fund's managers are rewarded based on performance – a figure which is far too easy to manipulate if your investments are illiquid and hard to value in the absence of an open market price.

The toxic waste gets marked up without the waste itself getting tested on an open market.

The lending bank sees the equity floating higher and higher in the water, and lends more and more cash against it to the hedge fund. Naturally – as with all collateral – it claims the right to sell if the underlying debt gets into trouble, but it certainly doesn't look like a real danger at this stage. The money lent by the bank against the equity goes back to the hedge fund, which buys more CDO equity from the investment bank, which buys more MBS from the mortgage lender, which provides more money to sub-prime borrowers, who then buy more houses, pushing prices higher again.

This appears to be the background to the Bear Stearns hedge fund problem today. Recently, US house prices have turned sharply down, so now the lending banks have asked for their money back and the hedge funds haven't got it. So the collateral needs to be sold. No problem, surely. It's in the books at a few billion dollars after all.

But with its concentration of risk, the equity slice has been hemorrhaging value. No-one is bidding. But that's not the full extent of the problem. There are so many similar hedge fund loans backed by questionable and illiquid securities at marked-up prices – untested by dealing on the open market – that the lending banks have stopped trying to sell for fear it will accelerate and exacerbate the problem into a full-grown systemic disaster, forcing every similar hedge fund out there to own up, catastrophically, to significant overvaluations in their CDO equity portfolios, too.

There is currently no market for this toxic waste. Everyone is taking a breather. All this came to light Thursday – and amazingly the US stock market went up. But it really could turn very nasty. Everyone with a hedge fund holding in any similar market is powerfully motivated to sell today.

What people don't fully appreciate is the extent to which our financial system has geared up over the last twenty years to finance the worldwide residential housing boom. Banks used to have to work quite hard finding profitable businesses to put their money into. But for twenty years now, those banks which concentrated on financing housing have left everyone else in their wake.

I was chatting to a senior financier recently from AIG – the biggest insurance company in the world. Even his business has come to be all about finding and assessing risk in housing finance. Everyone is up to their nostrils in this market.

What might happen? I expect the recent rises in bond rates are related to this developing problem. People better informed than me are starting to gather in cash, rather than lend it out. This could accelerate. The banking sector – whose profits have surfed this business and turned the banks into the pillars of the stock market indices – are going to be hit with some monster bad debts. Barclays bank has already owned up, but the debts it's admitting to are mushrooming, with early reports of $300m being replaced with ones later in the week suggesting more than $1 billion of losses. That hits the stock market with a double whammy - of falling bank stock prices and higher rates for everyone.

The quick deal might be to short Wall Street, which seemed to be wholly in a state of irrational denial as this story hit this week. If you do that today, and things start looking bad next week, consider sending some money to BullionVault to buy gold, too. Few places are better able to ride out the credit squeeze which could result than physical gold bullion owned outright – with no risk of default – in your name alone.

But on the other hand do not underestimate the skill of people including Ben Bernanke at the US Federal Reserve in underpinning the financial system at a time like this. They seem so often to get away with it. It would be interesting to know if Dr.Bernanke has chosen to cancel his social engagements this weekend.

By Paul Tustain

BullionVault.com

P.S: May I suggest that – after reading this note – you use News.google.com to search for "Bear Stearns hedge". Also check places like Wikipedia for terms such as "Collateralised Debt Obligation". You'll be better able to check my understanding. I tell you this so that you can decide for yourself if my summary stacks up, and if the risks could be as great as I fear they are.

Gold price chart, no delay | Gold prices live | Latest gold market news

Paul Tustain is director and founder of BullionVault – the world's fastest-growing gold ownership service, where you can buy gold today vaulted in Zurich on $3 spreads and 0.8% dealing fees.

(c) BullionVault.com 2007

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it.

Paul Tustain Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules