Two Bear Stearns Cos. hedge funds that invested heavily in securities backed by subprime mortgage loans are close to being shut down as a rescue plan is falling apart, The Wall Street Journal Online reported on Wednesday.
Late last week, the fund sold off at least $4 billion of mortgage securities, to help pay for client redemptions and expected margin calls.
That would mean heavy losses for the investment bank and lots of buzz on the New York financial scene. That's bad for Bear Stearns, but for the average person, what's the big deal?
In this case, the problem is that the fund invested heavily in bonds backed by risky mortgages and its dissolution could have implications far beyond the confines of Wall Street — all the way down to home buyers on Main Street.
Some questions and answers about what the fund is, why it is in trouble and what its demise might mean for homeowners and investors.
Q: What does this Bear Stearns hedge fund do?
A: Like any hedge fund, its goal is to generate outsized returns using complicated investment strategies that are typically risky.
This one, called High-Grade Structured Credit Strategies Enhanced Leverage Fund, was started 10 months ago and invested mostly in securities related to risky mortgages, known as subprime loans. It is estimated to hold invested capital of more than $600 million and total borrowings of about $6 billion, although specific figures are not available.
Q: So does the fund own individual mortgages? Could it own my mortgage?
A: No. The fund invests in things like bonds that are backed by individual mortgages. Banks and other mortgage originators make the loans to consumers, package groups of similar mortgages together and sell them to investors in a process called securitization.
Q: What went wrong with the Enhanced Leverage fund?
A: The fund reportedly lost 23 percent of its value in the first four months of the year. The specific reasons are not clear, but starting earlier this year, there was a sharp increase in the number of delinquencies and defaults on loans made to borrowers with spotty credit histories. Bonds backed by these subprime mortgages lost much of their value, before stabilizing somewhat in April and May.
The decline led one big investor, Wall Street bank Merrill Lynch & Co., to ask for its money back. When Bear Stearns balked, Merrill Lynch requested its collateral for the loan — in this case at least $800 million in bonds backed by subprime loans.
Q: Why is that a problem for a $6 billion fund?
A: Because the bonds Merrill took have high ratings, leaving the fund with a higher percentage of risky investments. And if an investor as prominent as Merrill wants out, it is possible that other financiers will come calling for their money.
"Merrill takes the more liquid assets to get its money back," said Axel Merk, manager of the Merk Hard Currency Fund. Others investors may follow suit, and they, too, would get highly rated assets. "And when you get rid of the more liquid assets, what's left is toxic waste," Merk said.
Q: What would the fund's collapse mean for the broader market?
A: It will likely not lead to any major correction, but could signal the start of a shift in how the market values risk.
During the recent bull run, lenders have charged a historically low premium to borrow money to make risky investments. As more of these securities falter, lenders will start asking for more in return.
That would lead to higher volatility, or more ups and downs in the prices of securities. As securities get more volatile, investors typically reduce their exposure to risk.
Q: What does all this mean to potential home buyers?
A: 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.
"It means you will be much, much worse off this year than last year if you are a subprime borrower," Cecala said.