by Tanta on 6/21/2007 01:17:00 PM

From Bloomberg, "Corporate Debt Risk Jumps on Concern Over Bear Stearns Funds":

June 21 (Bloomberg) -- The perceived risk of owning corporate debt rose worldwide on concern that the paralysis of two hedge funds run by Bear Stearns Cos. may cause a chain reaction that sparks losses for other hedge funds and the banks that finance them.

Credit-default swaps based on $10 million of debt in the CDX North America Crossover Index of 35 companies surged as much as $10,000 to a nine-month high of $179,000, according to Deutsche Bank AG. In Europe, the benchmark iTraxx Crossover Index of 50 European companies jumped as much as 16,000 euros ($21,400) to 216,000 euros, the biggest one-day rise in three months, according to Deutsche Bank.

Investors worry that the funds' problems are ``going to bleed through to other funds or dealers that are invested in other asset classes, which could result in further liquidations and forced-selling'' of assets beyond mortgage securities, said Matthew Mish, a credit strategist at Barclays Capital in New York.

So . . . all this "covenant-lite" paper was "perceived" to have your basic garden-variety normal risk until some BS hedge fund went to the edge over subprime-backed CDOs, and then all of a sudden it looked a touch wanton? Why, next thing you know someone will tell me it's cheaper to go naked long than to hedge this stuff . . .

by Tanta on 6/21/2007 07:40:00 AM

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?

EVEN FURTHER UPDATE: Because connoisseurs will not want to miss this one, courtesy of mp:

Two American so called hedge funds, with combined values a couple of weeks ago of north of 20 billion dollars, are teetering on the edge of collapse. Who's the culprit? Sub-prime loans, mortgages to people who really couldn't afford one, backed by houses whose price is deflating like a balloon in a shooting gallery. Enter the vultures.

"A balloon in a shooting gallery"? Vultures . . . eat bits of popped balloon? This image isn't working for me . . .

by Calculated Risk on 6/20/2007 11:52:00 PM

From the WSJ: Bears Woes Test Markets' Mettle

... word spread that several investment banks were having trouble finding buyers for subprime mortgage securities they pulled out of the teetering hedge funds at the Wall Street firm.
...
J.P. Morgan Chase & Co. ... was scheduled to begin an afternoon auction of collateral it held from the bear fund ... Minutes before the sales were to begin, the firm pulled back. Later, J.P. Morgan came to terms with Bear to eliminate its exposure to Bear's troubled hedge funds .... Some traders said the bank might have been forced to settle with Bear because the loans it had put up for sale would have fetched so little in the market.

Deutsche Bank AG and Merrill Lynch & Co., among others, remained in limbo ... Earlier in the day Deutsche quietly approached some market participants to gauge their interest in some of its collateral assets ...

Merrill also planned to sell collateral and stopped negotiating with Bear ... some of the early prices bandied about for Merrill's assets were relatively low. But when Merrill's auction took place late in the afternoon, it managed to sell some higher-quality assets at reasonably high prices ...

What a mess. No one knows what many of these securities are worth; some of them may be worthless.

The biggest risk is that this is just the "tip of the iceberg" and that other hedge funds are about to go under. Another risk, mentioned in the WSJ article, is that "$250 billion in junk bonds and corporate loans are slated to be sold to investors" over the next four to eight weeks as part of the recent LBO wave. If investors become skittish - and that Fitch Ratings notice I posted earlier today might scare a few of them too - those debt sales might be in trouble.

Even if this is just a bump in the road, at the least this probably means another round of credit tightening for the mortgage market, and more downward pressure on housing.

by Tanta on 6/20/2007 06:10:00 PM

Via Bloomberg, some excellent news from BOA:

June 20 (Bloomberg) -- The worst U.S. housing slump in 16 years will begin to ease in the next month or two, and job growth will lift home prices and spur construction early next year, Bank of America Corp. Chief Executive Officer Kenneth Lewis said.

``The drag stops in the next few months,'' Lewis said in an interview yesterday in New York. ``It's just about to be over. We're seeing the worst of it.'' . . .

``We do not see a recession,'' Lewis said. ``Because that drag stops, you'll see the economy begin to pick up in the third and fourth quarters.'

So much for those socialist girls at PIMCO with their "blood bath" nonsense.

(Thanks, JS!)

by Calculated Risk on 6/20/2007 04:37:00 PM

From Fitch Ratings: U.S. Leveraged Loan Covenant Decline Accelerating in 2007

The balance of power in the U.S. leveraged loan market continued to shift from creditor to borrower as protective covenant packages declined further during the first five months of 2007. The deterioration occurred amid vibrant and aggressive overall leveraged loan issuance.

• The percentage of leveraged loans containing a coverage covenant of any type dropped to 44.3% from 68.1% in 2006 and below the 1996–2006 average of 78.1%.

• The percentage of loans containing leverage covenants of any type fell to 51.1%, down from 69.6% in 2006 and below the 1996–2006 average of 72.8%.

• Along with the general demise of covenant packages has been the growth of specific “covenant-lite” loan issuance. In 2007 through May, $47 billion of “covenant-lite” transactions—those typically containing no financial covenants at all—have come to market; more than twice the level of covenant-lite issuance in all of 2006.

Overall lending is still "aggressive". And Fitch is worried:

In nearly any environment, such a radical deterioration in creditor protection would be cause for concern. Exacerbating the current trend, however, is that it is occurring amid an evermore aggressive rating mix of deals coming to market.
...
The near absence of corporate defaults appears to be a major factor behind the decline of key structural protections in the leveraged loan market. ... this lack of defaults is helping to create a self perpetuating and troubling pattern, whereby the low default rate enables deep speculative grade borrowers to get easy access to the loan and bond markets, and at increasingly favorable terms, as shown by the covenant trends discussed above. The result: nearterm defaults are avoided, which fosters some level of complacency and higher risk tolerance, ultimately allowing new issuance to take on even more aggressive characteristics. However, should economic growth soften more than anticipated or some other shock hit the market, the growing share of low quality loans and bonds ... will come under significant pressure. In other words, while defaults remain very low, risk in fact continues to move in the opposite direction.

by Calculated Risk on 6/20/2007 04:29:00 PM

From Dow Jones: Results From Sale Of Bear Assets May Not Be Clear On Wed (hat tip Brian)

While the deadline for a sale of Bear Stearns' ... hedge funds assets is not far, the results from the sale may not be clear until much later.

... Merrill Lynch & Co. (MER), which is circulating its list of $850 million of mostly highly-rated complex securities, may not be met...

That's because the securities - mostly collateralized debt obligations - on the auction block are extremely complicated, and it will take investors some time to assign what they believe is a fair value to these assets.

"At least a third of what is being shown is pretty esoteric stuff," said [Mark Adelson, managing director of fixed income research at Nomura Securities.] The bulk of collateral appearing on the bid lists are CDOs that are backed by a pool of mortgage bonds, and CDO squareds, which are CDOs of CDOs, similar in concept to a fund of funds, market participants said.

by Calculated Risk on 6/20/2007 10:27:00 AM

Reported on CNBC: JPMorgan Started Selling Stearns Hedge Fund Assets Tuesday Night

update: CNBC also reporting that Deutsche Bank and others are selling hedge fund assets.

by Calculated Risk on 6/19/2007 11:33:00 PM

More from the WSJ: Two Big Funds At Bear Stearns Face Shutdown

Two big hedge funds at Bear Stearns Cos. moved toward the brink of closing down ... as a bailout plan ... fell apart ...

The funds, which once controlled more than $20 billion in a combination of investor and lender money ... had invested heavily in various securities backed by subprime loans ...

... the funds had effectively paid down $2.25 billion of their $9 billion in outstanding credit. The first two lenders to exit their positions, Goldman Sachs Group Inc. and Bank of America Corp., agreed to unwind complicated transactions with Bear without dumping lots of bonds on the broader market. ...

By unwinding those loans in an orderly manner, rather than through a series of fire-sale auctions, Bear's fund managers ... could help stave off painful ripple effects in the broader market for mortgage-backed securities and related instruments. ...

Merrill, on the other hand ... opted to revive a planned auction for hundreds of millions of dollars worth of collateral from the Bear funds.

by Calculated Risk on 6/19/2007 06:18:00 PM

From the WSJ: Merrill Lynch To Dump Bear Stearns Fund's Assets

A day after managers of a troubled internal hedge fund at Bear Stearns Cos. presented lenders with a last-ditch plan to reinvigorate the fund with additional financing, creditor Merrill Lynch & Co. pushed forward with plans to sell hundreds of millions of dollars in collateral assets out of the fund, said traders late Tuesday.

Merrill has indicated plans to sell off at least $850 million worth of collateral assets, mostly mortgage-related securities, Wednesday afternoon, according to documents reviewed by the Wall Street Journal.

Brian sent me this link with the comment: "Look out below!"

Added: Bill Fleckenstein wrote the following today before the Merrill announcement (Fleck's site):

"I have to wonder why Wall Street is working overtime to rescue a $600 million fund. On the other hand, I think we all know the answer: In a liquidation scenario, lots of people fear what would happen to leveraged portfolios across Wall Street and the world if sales of some of the fund's paper were marked to
market.
...
I can't recall a fund of this size ever being bailed out. Liquidation is the usual outcome when a fund is down 25% to 30%, as this one supposedly is. Of course, it might be down a lot more if real prices were used.
...
Apparently, all sorts of games are being played and attempts being made to avoid marking mortgage slices-and-dices to market -- in addition to the fact that many funds aren't required to mark their positions to market until the ratings agencies say so."
Posted with permission.

First, it appears the fear will now become reality - assets will be sold. However Fleck appears to suggest that hedge funds aren't required to mark-to-market until the "rating agencies say so". We have seen a wave of downgrades recently, but overall the rating agencies have been slow to react to the subprime implosion. So if the hedge funds have to wait for the rating agencies, this will take some time to play out.

by Calculated Risk on 6/19/2007 09:37:00 AM

From the LA Times: Report from UCLA team skirts the R-word

"We suspect that the weakness in the housing market is finally spilling over into consumption spending," wrote senior economist David Shulman in the quarterly forecast being released today. "Retail sales appeared to stall in April and automobile sales have become decidedly weak.

"This is not a recession, but it is certainly close," Shulman said.

And on California housing:

In a separate report on the California economy, UCLA forecasters predicted home values would continue to fall slightly or remain flat in most parts of the state as many homeowners struggled to make higher payments on adjustable-rate mortgages.

"The pipeline of mortgage resets suggests it may be mid-2009 before California sees a normal housing market again," said the report by economist Ryan Ratcliff.

This fits with this Financial Times article: Bernanke hints at thinking on housing (hat tip Roubini)

Changes in house prices could have a bigger effect on consumption than the traditional “wealth effect” suggests, Ben Bernanke said on Friday in comments that offer some insight into how the Federal Reserve may think about the continuing problems in the US housing market.

The Federal Reserve chairman told a conference hosted by the Atlanta Fed that, in addition to making homeowners richer or poorer, changes in house prices might influence the cost and availability of credit to consumers.

This is because people with equity in their homes have more at stake in avoiding default. That, in turn, reduces the premium char-ged by lenders owing to their imperfect knowledge of their borrowers’ financial circumstances.

If this theory is correct, Mr Bernanke said, “changes in home values may affect household borrowing and spending by somewhat more than suggested by the conventional wealth effect”.