Bear Stearns announces that another of its hedge funds is in danger - 1-Aug-07 - Generational Dynamics

The first two hedge funds were heavily invested in CDOs (collateralized debt obligations) related to subprime mortgages. Subprime mortgage loans are the riskiest group, given to home purchasers with poor credit ratings. Furthermore, these two hedge funds were heavily leveraged (similar to buying stocks on margin), meaning that a small drop in the value of the CDOs in its portfolio would be multiplied several times over. (In case you're wondering why anyone would do that, it's because a small increase in the value of the CDOs would be multiplied many times over, as well.)

But this third hedge fund is NOT leveraged, according to the investment firm. Furthermore, its securities are NOT related to subprime mortgage loans, but rather to higher rated Alt-A and prime mortgages. Alt-A mortgage loans are given to home purchasers who have good credit ratings, but are unable to document their incomes (if they're self-employed, for example), and prime mortgage loans are given to the most creditworthy borrowers.

The fact that this hedge fund is also in trouble shows how the contagion is spreading. (Think of my analogy the other day of termites destroying a house from within.) It's NOT just subprime mortgages; it's NOT just leveraged hedge funds. Everything is vulnerable.

Financial pundit Jim Cramer explained that there's no distinction between prime and subprime, because the value of real estate is falling. Here's a partial transcript of Jim Cramer's controversial interview, where he recommends that people "walk away" from their homes, and default on their mortgages:

"This [New York's financial district] is the only area of the country - this square mile - where real estate is up year on year. It's down year on year everywhere else. It's really remarkable. The real issue is the 2/28 mortgage loan -- you're going to hear a lot about this -- the first two years low interest rates, almost no interest rates, almost undocumented. They all reset -- the big bulge of reset will be October of this year to February of next year. Most the of the people who took these mortgages can't pay them.

[[Just to explain: the 2/28 mortgage is the ARM (adjustable rate mortgage) where you pay a teaser rate for 2 years, and then the interest rate adjusts so that for the next 28 years your monthly payment is several times higher.]]

I'm looking for 100% default on the 2/28. The bears are looking for 50% -- I'm saying that they're foolish and way too optimistic.

Now where are these 2/28 loans concentrated? Largely in Florida, in Phoenix, in Las Vegas, in the southland of California, the northern part, Sacramento, but most importantly the "inland empire."

We need to plow over the inland empire, because there are too many homes, and the homebuilders have too much inventory, and the people who have made these loans - I think that everything that was written from May 2006 to the end of the year is worthless.

[[I.e., he's saying that every mortgage loan granted from May to Dec of last year is worthless.]]

By the way, I'm not distinguishing any more between subprime and prime. That's a meaningless distinction. When your house drops 20% in value, then it doesn't matter if you're subprime or prime. It's better to walk away, even if you're wealthy.

You don't want to lose your credit card, and you don't want to lose your car. Your house is fungible. It's smart to walk away. You see the economic decision now weighs on walking away from your home. It's actually a good thing.

I know that sounds a little bit counter-intuitive. But if your house declines 20% in value, it's really important to sell it, to walk away from it. ...

There's no area of the country that's doing well. There's a small area in Baltimore that's probably about a mile or two square that's doing well. And south of Manhattan in NY is doing well. ...

All the major homebuilders have indicated that other than a little bit of square feet in Baltimore, and the south of Manhattan, there are no areas that are appreciating in this country. None.

What's so odd is that the average home appreciated 1% in 2006. I'm calling for a dramatic decline in home values, based again on the number of homes that continue to be built, and the inability to seell, and now the new found end of the 2/28, the end of all of these products that made it -- the teaser rates are gone.

Now, once again I'm going to emphasize -- if the Federal Reserve were to cut interest rates by one full point, what you would have is that things would just reverse dramatically, and everything would go up in value. So it really is just a stroke of the pen for the Fed.

[[The above paragraph is total nonsense. Reducing interest rates 1% would have no effect, and may cause investors to panic further.]]

But until then we're going to be in what I now believe is a total crisis.

The only guys writing honestly about it are Moodys.com, but I also find that duplicitous, since Moody's was so far behind on the mortgages.

[[He's referring to "Moody's joins S&P in downgrading mortgage-based securities."]]

As usual, Cramer is being dramatic and controversial, but his reasoning makes sense:

Now, this reasoning actually makes sense. Of course, the figure won't be 100%. There are many people who love their homes and are willing to pay the increased mortgage rates; there are many people who will stay out of a sense of moral obligation. But his logic makes sense that if your home value is far less than the amount of the mortgage loan -- and that's going to happen widely by the end of the year -- then forgetting moral obligations and as a purely financial decision, it makes sense to walk away.

The biggest financial news in the last couple of days is what's happened to American Home Mortgage Investments. American Home does not deal in subprime mortgages, but even so, the value of the company's assets has been dropping like a stone.

American Home had promised last month to pay a dividend to its stockholders, but suddenly reversed itself late on Friday of last week. Then, on Monday, the company announced that it didn't have the money to meet its margin calls. This caused investors to panic, and the value of the stock fell from $10.47 per share to $1.04 per share.

The market as a whole followed suit, and the market fell 1-1.5% on Tuesday. As of this writing, around noon in Asia, the Asian markets are down 2-3%.

Generational Dynamics Web Log for 1-Aug-07
Bear Stearns announces that another of its hedge funds is in danger

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Generational Dynamics Web Log for 1-Aug-07 Bear Stearns announces that another of its hedge funds is in danger

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Generational Dynamics Web Log for 1-Aug-07
Bear Stearns announces that another of its hedge funds is in danger