Last week, Bear Stearns, a major Wall Street investment bank, was required to extend a (secured) loan of $3.2 billion to a hedge fund investing largely in high yielding mortgage-backed securities and their derivatives like Collateralised Debt Obligations (CDOs), managed by it: earlier, lenders to the fund had started to sell the collateral they were holding as the fund could not meet margin calls.
This has affected the prices of all such securities. Bear has hitherto had a sterling reputation in the mortgage business, both as originator and packager of loans. It may be recalled that the earlier two major hedge fund losses were Long Term Capital Management (LTCM) in 1998, and Amaranth last year.
What went wrong? To understand that, one needs to take a look at the so-called sub-prime mortgage business in the US -- the term refers to loans to highly risky borrowers, many of them with no regular source of income.
Based on the assumption that housing prices will keep rising endlessly, lenders in the mortgage market were taking increasingly risky debt on their books. Zero down payment was becoming common; in many cases of so-called adjustable rate mortgages, initial interest rate was low -- in other cases, the EMI did not cover even interest (the difference got added to the principal).
Increasing existing loans to reflect higher house prices became the rule -- the assumption was that prices will keep rising indefinitely.
To give just one example, Financial Times reported some time back the case of a borrower with an income of less than $2,000, that too in disability payments from the government, who got 100 per cent finance to buy a property worth almost $900,000!
Clearly, 'irrational exuberance' had assumed gigantic proportions in the mortgage lending business, in a supposedly 'mature' market. Trouble was inevitable and may spread to the larger economy as rising house prices and mortgage loans have fuelled the US consumption boom for the last several years.
In some ways, it seems that mortgage lenders had become the marketing arms of investment banks whose principal interest was in structuring, repackaging and selling the debt to earn fees: such structured finance took the form of securities issued against pools of such mortgage loans (MBS -- mortgage backed securities), and their more complex derivatives like CDOs.
CDOs repackage underlying debt obligations into different tranches, or pools, with varying risk parameters -- and of course coupons: higher the risk, higher the coupon. The simple business of mortgage lending has become extremely complex in the United States.
The first signs of trouble in the sub-prime mortgage business came in February this year when HSBC's US unit reported large losses. This was followed by the bankruptcy of New Century Financial and dozens of other mortgage lenders.
Firms like UBS, GE Finance and GMAC (GM's finance subsidiary) also reported losses in the segment. With hedge funds actively competing with banks in the lending business, they were investing in such high coupon, risky mortgage securities -- they were confident that their own mathematical models were capable of pricing risks in a better fashion than the packager of the CDOs, or the rating companies.
The problem with complex securities is that there is not much secondary market trading, and such securities are often "marked to model" than "marked to market". Apart from the Bear funds, another casualty is a recently listed hedge fund in London; which has had to mark down some mortgage securities as much as 50 per cent!
One trigger for the collapse of the market was the suspension by Freddie Mac, the largest lender in the market, of fresh purchases of mortgage-backed securities. Prices started falling and when the Bear-managed hedge funds were unable to meet the margin calls, lenders started selling the CDOs held as collateral, putting further downward pressure on the prices. Hence the huge loan from Bear.
A few interesting corollaries are worth taking note of, and illustrative of how cutthroat finance business has become in today's 'developed' world. On the one hand, holders of mortgage-backed securities are suing the lenders for misrepresenting the risk in the loans at the time of securitisation.
Some hedge funds, who had shorted the bonds (or the index), are concerned that their bets would go wrong, or at least not be as profitable as they otherwise would be, if social and political pressures force the lenders to bail out the small, poor borrowers through lower interest rates or otherwise. (An estimated one in seven sub-prime borrowers faces foreclosure and tens of thousands may be thrown out of their houses.)
Other enterprising 'experts' in the real estate business have started organising seminars for individual Americans to teach them how to profit from the current mess in the sub-prime mortgage business, and the property that will be coming into the market as a consequence. The unacceptable face of capitalism?
Should all this matter to us? A housing slump could lead to a slowdown in consumer spending in the US, which has obvious implications for Asian economies.