Mortgage Losses Push Hedge Funds to Brink

By David Cho and Tomoeh Murakami Tse
Washington Post Staff Writers
Thursday, June 21, 2007

Two Bear Stearns hedge funds, worth more than $20 billion, teetered near collapse yesterday after absorbing major losses from investments in the subprime mortgage industry.

The troubled funds, which lost a key financial backer yesterday, are the latest sign that the problems in the subprime mortgage industry are spreading across the financial markets. If the hedge funds fold and their holdings are sold off at a discount, the value of similar assets owned by other banks, hedge funds and investors also could fall.

That ripple effect worried financial markets yesterday. The Standard & Poor's 500-stock index dropped 1.4 percent, its steepest decline in two weeks. The Dow Jones industrial average lost 1.1 percent.

The yield on the 10-year Treasury note, which affects rates on mortgages and corporate loans, rose to 5.14 percent yesterday from 5.09 percent the previous day.

Bear Stearns, a major investment bank, is the biggest hedge fund broker. The unraveling of two of its funds is "at best an embarrassment for [the firm], and at worst, it threatens to have a ripple effect on valuations across the subprime sector," Kathleen Shanley, an analyst at Gimme Credit, wrote in a report released this week.

Wall Street has developed an intricate relationship with the mortgage industry. Many financial firms buy massive pools of loans from lenders, repackage them as bonds called mortgage-backed securities, and sell them to hedge funds and other investors for a profit. Hedge funds make money off these securities by turning them into complex investment tools called derivatives and selling them to other investors.

The rise of such financial partners has empowered the lending industry to sell riskier loans, including those considered subprime, which are mortgages made to people with blemished credit histories. Since 2000, more than $1.8 trillion of securities backed by subprime mortgages have been created, according to Inside Mortgage Finance.

When housing prices started falling, many subprime borrowers stopped making monthly payments. Default rates on loans made last year soared to levels not seen since the late 1990s. That caused a drop in the value of subprime-mortgage-related securities and bonds.

Bear Stearns's 10-month-old High Grade Structured Credit Strategies Enhanced Leverage Fund, which made huge bets in the subprime market, dropped about 20 percent this year. A related fund sustained slightly smaller declines.

As the losses mounted, the managers scrambled to save the funds and contain the fallout. But at least one backer, Merrill Lynch, decided to pull out.

Merrill Lynch yesterday began auctioning off about $800 million worth of assets held as collateral for the loans it made to the hedge funds. The fund managers at Bear Stearns made a last-ditch effort to avoid the auction but were not able to stop it.

Securities and Exchange Commission Chairman Christopher Cox said the agency was tracking the turmoil at Bear Stearns. "Our concerns are with any potential systemic fallout,'' Cox told Bloomberg News in an interview yesterday. "So far, so good on that score.''

The President's Working Group on Financial Markets, which was created after a major hedge fund collapsed in the late 1990s, said in February that the current system for preventing market turmoil is "working well."

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."

The unraveling of the Bear Stearns hedge funds is the latest in a series of problems that have surfaced in the subprime mortgage industry. Last month, another hedge fund run by an arm of the Swiss bank UBS said it would shut down after losing big in the mortgage market.

Friday, Moody's Investors Service downgraded 131 bonds backed by subprime mortgages. Those bonds were issued in 2006.

Tse reported from New York. Staff writer Nell Henderson contributed to this report.


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