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Subprime Lenders Fallout - It's all hitting the fan!

Stock-Markets / Financial Crash Jul 20, 2007 - 08:38 AM GMT

By: Money_and_Markets


Mike Larson writes: It's all hitting the fan — right here, right now! The two Bear Stearns (BSC) hedge funds that Martin told you about in late June have reportedly been all but vaporized. Wiped out!

According to a July 18 New York Times story,

"Bear Stearns told clients in its two battered hedge funds late yesterday that their investments, worth an estimated $1.5 billion at the end of 2006, are almost entirely gone. In phone calls to anxious investors, Bear Stearns brokers reported yesterday that May and June had been devastating months for the portfolios.

"The more conservative fund, the High-Grade Structured Credit Strategies Fund, was down 91 percent by the end of June, investors were told. The High-Grade Structured Credit Strategies Enhanced Leverage Fund, which used extensive borrowings and assumed more risk, has no investor capital left, the firm said."

In plain English, here's what happened:

These funds invested in complicated mortgage securities …

They used extensive leverage, or borrowed money, to improve returns …

Then, delinquencies and foreclosures started surging, and the value of the underlying loans and bonds tied to them began sinking fast.

The end result is the financial carnage we're seeing today.

And Bear Stearns is far from alone. Several investment funds, including those operated or overseen by UBS AG, United Capital Markets Holdings, and Cambridge Place have reportedly suffered severe financial difficulties so far this year.

Ultimately, losses on subprime mortgage bonds alone may total as much as $90 billion, according to one estimate.

Losses on collateralized debt obligations (CDOs), investment vehicles created from slices of various mortgage-backed securities and asset-backed securities, may total billions more.

And This Problem Is Not Confined To a Few Hedge Funds, Either!

Just look at what happened this week at CIT Group (CIT) , a major commercial finance company. It shocked Wall Street by announcing a $127-million loss ($0.70 per share) in the second quarter. That sent its stock down more than 11% on Wednesday alone.

The reason? CIT is a big subprime lender, and it was forced to take a $495 million loss on its $10.6 billion book of home loan receivables.

CIT added that it was going to dump its subprime mortgage business. But who's it going to sell to? Everyone is turning tail and running from the industry!

Indeed, only a few days earlier, General Electric (GE) said it would put its WMC Mortgage business on the auction block. The unit lost $182 million in the second quarter, and $370 million in the first. It slashed its workforce by 70%!

Then there's a company called ACA Capital Holdings (ACA) . It sells credit derivatives, a type of insurance that's designed to protect bond investors from credit-related losses. Its shares have dropped off a cliff — they're down about 55% so far this year, amid fears about the company's exposure to derivatives on CDOs.

Meanwhile, News from the Housing Industry Keeps Getting Worse and Worse

Pulte Homes (PHM) became the latest builder to warn of big problems in its business. The third-largest home builder said orders plunged 20% from a year ago. And it's going to take as much as $770 million in pre-tax charges to write down the value of land and other assets on its books.

Meanwhile, the National Association of Home Builders released its latest monthly index data, which dropped four points in July to 24.

That was far worse than the 27 reading expected by economists … the third-lowest level on record … and the worst since January 1991. All three sub-indices — which measure present home sales, expectations for future sales, and current buyer traffic — fell, too.

Here's My Point: The Worst Is Not Over, So Protect Yourself!

I've been closely following the mortgage and housing markets for years. Since things started topping out in mid-2005, and the long slump got underway, I have heard two things almost every step of the way.

The first is that the worst is over and the bottom is in.

All along, I have maintained there is no evidence of that . And this week, even the Chairman of the Federal Reserve, Ben Bernanke, was forced to admit as much before Congress. He said,

"Although a leveling-off of home sales in the second half of 2006 suggested some tentative stabilization of housing demand, sales have softened further this year, leading the number of unsold new homes in builders' inventories to rise further relative to the pace of new home sales. Accordingly, construction of new homes has sunk further, with starts of new single-family houses thus far this year running 10 percent below the pace in the second half of last year."

The second thing I've consistently heard is that the problem is "well-contained."

Now, that's proving false as well. After all, it's clearly not just the home builders or the subprime mortgage lenders that are having problems.

It's some of the biggest corporations in the world (like the aforementioned GE). It's retailers like Home Depot (HD) and Lowe's (LOW) . It's construction supply firms that sell the stuff that goes into homes. It's the Wall Street investment houses that bundle and sell mortgage-backed securities and related bonds. It's the pension funds, the mutual funds, and the hedge funds that have invested in all this junk mortgage paper.

And as I demonstrated in a major white paper, "How Federal Regulators, Lenders, and Wall Street Created America's Housing Crisis; Nine Proposals for a Long-Term Recovery," many traditional banks and thrifts are also showing high levels of stress in their mortgage loan portfolios.

[Editor's Note: The paper focuses on the causes and consequences of the mortgage mess, as well as potential solutions for regulators and legislators to consider. If you missed our alert on Thursday, you can obtain a free copy of the report here .]

In sum, while the world certainly isn't coming to an end, this housing and mortgage problem is huge. Washington and Wall Street should stop sticking their collective heads in the sand, accept this fact, and start trying to find constructive ways out of the mess.

I suggest you continue sticking to the same basic themes I've been discussing for a while:

First, avoid stocks exposed to the doggy sectors I described above.

Second, hedge yourself against a falling dollar by investing overseas and buying contra-dollar investments.

Third, keep your fixed-income money in shorter-term, lower-risk debt. That means things like three-month or six-month Treasury bills rather than 10-year or 20-year junk bonds.

Until next time,

By Mike Larson

This investment news is brought to you by Money and Markets . Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit .

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