Interest Rate Roundup

Friday, June 22, 2007

More turmoil percolating in subprime

Some quick updates on the ongoing subprime/Bear Stearns/CDO debacle ...

* Bank of America is out with a note saying losses in U.S. mortgages could be just the "tip of the iceberg." Rising mortgage rates will make life tough for homeowners with adjustable rate debt -- with about $515 billion in ARMs facing higher payments this year and another $680 billion poised to reset in 2008.

* Things get curiouser and curiouser at Bear. The Wall Street Journal is reporting that the Everquest Financial initial public offering is getting yanked amid chaos in the subprime mortgage debt market. Bear owns 75% of Everquest, which was set up only last year to invest in the market for collateralized debt obligations, a complicated form of debt security.

* Speaking of Bear, Bloomberg is reporting today that the investment banking firm will assume $3.2 billion in loans to prevent other lenders from seizing and selling assets out of its struggling High-Grade Structured Credit Strategies Fund. Firms like Merrill Lynch, JPMorgan Chase and Lehman Brothers have been either grabbing collateral from the fund and holding or reselling it, or sending out signals they would do so down the road.

Bloomberg is calling this the biggest hedge fund bailout since Long-Term Capital Management blew up in 1998, citing the fact LTCM received $3.625 billion in bailout money.

So far, this mini-meltdown hasn't spread to the broader market. But the question in these situations is always: "Is this just smoke? Or is there fire out there?" Many folks are speculating that the reason Bear is so eager to help this fund out is to avoid a fire sale of fund assets. Such a sale would provide new market prices for all these esoteric, exotic securities, which are currently being carried on peoples' sheets at values estimated by models (values which likely don't reflect the reality that mortgage credit quality stinks)

My question is simple: If everyone knows this stuff is dreck, shouldn't firms just go ahead and write the value of their holdings down already? Sooner or later, someone is probably going to blink and start dumping in order to be the first person out the door. Anyone who's at the back of that seller's line is going to regret it. Alternatively, regulators could start applying pressure on firms to revalue their holdings at something resembling reality. Either way, it seems to me that Wall Street is just postponing write-downs that are all but inevitable.

Here's an analogy I thought up that might help you get your arms around what I'm saying: Say you're the CEO of a biotechnology firm. You have a promising new compound to treat a certain type of cancer. But there are some nasty side effects. You go before an FDA review panel to plead for regulatory approval, and your stock is halted until the outcome is known. Then your compound gets rejected.

You know that when the stock reopens, it could drop by 30%, 40%, or more. So what are you going to do? Beg the stock exchange to keep the trading halt on indefinitely? That might temporarily put off the day of reckoning. But it won't change a simple fact: It doesn't matter WHEN trading resumes, the result is going to be the same: Your stock is going to tank because your company has lost value.


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