Over the last six months, the financial markets have seen the problems in the housing market bleed into financial institutions' activities. These events are the first in what is sure to be a 12-18 month period of problems in the mortgage financing market.
The first round of mortgage problems at the lender level started in late 2006 when a number of subprime mortgage lenders went bankrupt, sold their portfolios or had their lines of credit cut-off effectively shutting down their respective operations. These lenders "imploded" because of the high delinquency rate in subprime mortgages. As delinquencies increased, Wall Street firms that purchased subprime loans for securitizations cut-off funding. As a result of the loss of funding, subprime mortgage lenders closed their doors. Currently, 86 major US lenders have "imploded" according to the mortgage lender implode-o-meter.
The next sign of mortgage related financial problems came out in the FDIC"s Quarterly Banking Profile. The report noted on page 1, "Reflecting an erosion in asset quality, provisions for loan losses totaled $9.2 billion in the first quarter [of 2007], an increase of $3.2 billion (54.6%) from a year earlier." The reason for the loan-loss provision increases was an across the board increase in delinquencies and charge offs which increased 48.4% from year ago levels. The report noted on page 2 that "Net charge-offs of 1-4 family residential mortgage loans were up by $268 million (93.2%) [from year ago levels]."
This week we had a potential problem at a Bear Stearns Hedge Fund the invested in subprime mortgages. Bloomberg noted:
Bear Stearns Cos. offered $3.2 billion in loans to bail out one of its failing hedge funds, the biggest rescue since 1998, after creditors started seizing assets and investors demanded their money back.
Bear Stearns offered to salvage the fund, one of two that made bad bets on collateralized-debt obligations, after creditors including Merrill Lynch & Co. took the funds' CDOs as collateral and started selling them in auctions. An agreement with creditors would prevent a fire sale of the collateral, and help stem a plunge in prices, while potentially increasing the risk to Bear Stearns, the second-biggest underwriter of mortgage bonds.
The Bear Stearns fund lost about 10 percent of its value this year, while the related fund, the 10-month old High-Grade Structured Credit Strategies Enhanced Leverage Fund, lost about 20 percent, according to people familiar with the matter. Both funds are run by Ralph Cioffi, 51, a senior managing director.
The Bear Stearns situation is somewhat unique because of the fund's incredibly high degree of leverage -- as in a 9 to 1 ratio. Other funds that made similar investments in similar securities will obviously have losses, but if the amount of leverage (or loans) is smaller the problems will be less pronounced.
One of the main issues with the Bear Stearns Fund is "collateralized debt obligations" or CDOs. These are risk management derivatives that can get a bit complicated. Here is a link to Wikipedia's CDO page which provides a good overall view of these investments.
CDOs have been around for about 15-20 years in various incarnations and are designed to diversify risk. However, they have never actually been tested by a real market problem. That does not mean they won't work as advertised. It simply means they haven't gone through a rough period in the market. It looks like they will soon get tested and we'll have to wait and see how they perform.
Let me add a few words of very important caution. Because we have about 18 months of adjustable rate mortgage resets, these above-mentioned problems will continue for about 18-24/28 months. However, this is not Armageddon. It is a period of heightened stress in the financial system. There will be casualties -- and probably more than a few minor ones. However, I think any predictions of a complete meltdown are very overblown. The US financial system is incredibly resilient and is able to withstand serious economic shocks. That does not mean it will be easy; just not a meltdown.
For economic commentary and analysis, please go to my blog, the Bonddad Blog.