Anatomy of a meltdown.

Author:England, Robert Stowe
Position:Evaluation of subprime crises

The subprime meltdown spilled over into other financial markets over the summer. Investors fled the private-label residential mortgage-backed securities market, shutting it down in early August. Facing margin calls, falling asset values, no buyers for non-agency bonds and no buyers for mortgages originated for the private-label market, mortgage companies large and small scrambled to survive.


There's got to be a morning after," goes the theme song from the 1972 disaster flick The Poseidon Adventure. Many mortgage company executives had to share that sentiment as August 2007 finally drew to a close. [??] Like passengers on the Poseidon, a fictional luxury liner hit by a tidal wave triggered by an underwater earthquake, mortgage lenders and Wall Street mortgage financiers now know more than they would like to about being caught up in a disaster outside of their control. [??] The underwater earthquake that first rattled the foundations of the mortgage industry came in the form of sharply higher delinquencies and defaults from a book of poorly underwritten subprime loans from the fourth quarter of 2005 through the first quarter of 2007. [??]


A liquidity squeeze by warehouse lenders imposed on subprime companies was the first visible shock wave from this earthquake. It toppled many independent subprime lenders earlier this year. Most of the survivors were acquired by major financial companies. By Aug. 31, the crisis prompted a response from President Bush, who unveiled a proposal to use the Federal Housing Administration (FHA) to rescue some stranded subprime borrowers facing higher mortgage payments due to resets.

Shock wave No. 2: Bear Stearns

Following the first shock wave from the subprime meltdown in late winter and early spring, a second--even more powerful--wave hit in June, upending two hedge funds invested in investment-grade tranches of subprime residential mortgage-backed securities (RMBS) managed by the investment arm of Bears Stearns & Co. Inc., New York. The trouble began after Bear Stearns' Enhanced Leveraged Fund, which had $638 million in investor capital and $11.15 billion in gross long positions, lost 23 percent of its value between January and April, with most of that in April.

A chronology of the major events in the summer's market meltdown can be seen in the sidebar, "Timeline."

Bear Stearns had earlier reported a much smaller loss in April of 6.5 percent, but restated the April loss to 19 percent on June 7. BusinessWeek reported that banks began marking down the value of the mortgage bonds held by the hedge fund, which required Bear Stearns to put up more collateral, which precipitated the crisis.

News of the sharp decline in the value of the hedge fund prompted a flurry of redemptions from investors and a series of margin calls from creditors. To meet the redemptions and margin calls, Bear Stearns sold $8 billion in assets from its less-leveraged High-Grade Fund to generate cash, according to The Wall Street Journal. The High-Grade Fund had $925 million in investor capital and $9.7 billion in gross long positions.

"The sheer size of the asset sales suggests investors or lenders have asked for some or all of their money back," reported Stephen Foley in the June 15 issue of London newspaper The Independent. The internal struggle to salvage the Enhanced Leveraged Fund went public when Bear Stearns suspended redemption payments to investors in the fund.

On June 15, a major creditor--New York-based Merrill Lynch & Co.--ran out of patience and said it would sell $400 million of its collateral held against the loans it had made to the Enhanced Leveraged Fund. Bear Stearns persuaded Merrill Lynch to wait until it had time to hear its proposal for recapitalizing the funds the following Monday, June 18. Bear Stearns told Merrill Lynch it was injecting $500 million of equity and providing $1.5 billion in credit from the parent company, according to The Wall Street Journal. Merrill Lynch was unimpressed, and decided to raise the ante by announcing it would sell at auction the next day at least $850 million worth of collateral assets, mostly mortgage-related securities.

On June 22, more than a week after the crisis went public, Bear Stearns released a statement announcing a $3.2 billion deal to rescue the less-leveraged High-Grade Fund. At the same time, the firm revealed it was in the process of de-leveraging the Enhanced Leveraged Fund, presumably to salvage it.

A hopeful Bear Stearns Chairman James E. Cayne seemed convinced the crisis was over. "By providing the secured financing facility, we believe we have helped stabilize and reduce uncertainty in the marketplace," Cayne said. "We believe the repurchase agreements are adequately collateralized, and we do not expect any material adverse effect on our business as a result of providing this secured financing."

Weakness across the mortgage markets

Bear Stearns' reassurances proved less than convincing to market observers. "The public unwillingness of the broker-dealer to assume the hedge funds' debts for ... two weeks fueled lively speculation about the severity of the losses by them and the prospects that other hedge funds may have incurred similar losses," says Michael Young-blood, managing director of asset-backed securities (ABS) research at FBR Investment Management Inc., Arlington, Virginia.

Market fears were enhanced June 25 when London-based Cheyne Capital Management (UK) LLP announced it was writing off 400 million euros from one of its hedge funds, Queen's Walk Investment Ltd., which had invested 4.2 percent of its portfolio in U.S. subprime RMBS. Events at Bear Stearns and Cheyne Capital raised more speculation that the U.S. subprime meltdown had "contaminated" the primary and secondary markets for subprime mortgage-backed securities (MBS).

Youngblood says that until the speculation is abated, to expect elevated volatility in the MBS market and related derivative instruments.

The slow-motion train wreck at Bear Stearns ultimately careened off the tracks, despite the best of intentions and the intense and costly efforts of the firm. In a July 17 "Dear Client" letter obtained by Mortgage Banking, Bear Stearns revealed that "preliminary estimates show there is effectively no value left for investors in the Enhanced [Leveraged] Fund and only 9 cents on the dollar for investors in the High-Grade Fund as of June 30, 2007."

The letter told investors the funds had lost value due to "unprecedented declines" in the valuations of a number of highly rated (AA and AAA) securities. "In light of these returns, we will seek the orderly wind-down of the funds over time," the letter stated.

The funds' losses were magnified due to their high leverage. The Enhanced Leveraged Fund, for example, borrowed nearly 20 times its $699 million investment capital. The woes for the High-Grade Fund, despite its lower leverage, were compounded when assets were sold off at fire-sale prices. On July 31, the two funds filed for bankruptcy protection.

The swift evaporation of $3 billion into the black hole of Bear Stearns' two hedge funds revealed to the markets the soft underbelly of private-label subprime mortgage bonds. Private-label residential mortgage-backed securities had since 2005 become the dominant source of funding for securitized mortgages, when private-label issuance rose to $1.19 trillion, or 55 percent of the $2.16 of total residential mortgage-backed securities, according to data collected by Inside Mortgage Finance. Historically, mortgage issuance has been dominated by the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, and by Ginnie Mae. Prime agency conventional, conforming mortgages (with balances no higher than $417,000), however, have not been significantly affected by the subprime contagion during the market implosion.

It was soon clear the subprime contagion was far from over, as United Capital Markets Holdings Inc., San Francisco, announced July 3 it was temporarily suspending investor redemptions in four of its Horizon hedge funds tied to subprime mortgage-backed securities. The Horizon funds cut their leverage and sold "a large amount" of cash securities in the market, according to a company statement. United Capital suspended trading in the synthetic structured finance markets completely, due to high volatility in the markets, the company reported.

Shock wave No. 3: Credit agency downgrades

Downgrades of hundreds of classes of residential mortgage-backed securities by the credit-rating agencies became the third wave to hit the mortgage industry and the financial markets. The actions began when New York-based Moody's Investors Service announced it was downgrading 399 subprime RMBS and was placing an additional 32 on negative watch. Moody's also downgraded 52 subprime second-lien RMBS.

On July 11, Moody's placed 184 classes of collateralized debt obligations (CDOs) on negative review because of their exposure to the subprime RMBS the agency had downgraded the prior day. On July 10, New York-based Standard & Poor's (S & P) announced it had placed on watch 612 classes of subprime RMBS totaling $7.35 billion. Then, on July 12, S & P downgraded 498 classes of the 612 it had put on watch, and left 26 classes on negative watch. A few days later, New York-based Fitch Ratings Ltd. placed 170 subprime RMBS and 19 related CDOs on negative watch.

"These actions are unprecedented," stated the July 14 issue of FBR Investment Management's newsletter, Structured Finance Insights. "Never before has either S & P or Moody's downgraded or placed on watch so many classes of RMBS--a grand total of 1,095."

The newsletter further reported that S & P's and Moody's combined downgrades affected 652 subprime RMBS totaling $7.4 billion, or 1.03 percent of subprime RMBS outstanding as of April 2007, if one takes into account duplicates. According to FBR's analysis, issuers owned directly or indirectly by...

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