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Mortgages Give Wall St. New Worries

Late in 2005 some large lenders ended up bankrupt after cracks started to appear in the subprime mortgage market. The cracks are now looming large down Wall Street, with funds that invested in these loans now beginning to have difficulties.

Experts expect to see problems unfolding slowly over the next year to year and a half, and consumers who have poor or subprime credit will have extended misery as the housing downturn bites deeper.

The effects on Wall Street could be even harder, with financial institutions and funds force to admit significant losses, which might have been hidden in complicated investments that would be hard to unravel. A knock-on effect could also be a restriction on certain types of mortgage lending.

Recently Bear Stearns, a force in mortgage bonds, had to use some of its own capital to bolster two hedge funds after requests from three lenders – Merrill Lynch, Citigroup and JPMorgan Chase.

It appears that Bear Stearns Asset Management have assured creditors that they had secured $500m new capital from a group including Barclays (UK) and Citigroup. Prior to that the fund sold $3.6bn of high-grade securities that were backed by subprime mortgages. Whether the new capital will deter Merrill Lynch from seizing and auctioning $400m of the funds’ assets remains to be seen.

The situation is being monitored closely as, if one fund unravels, many others could follow suit.

Bear Stearns’s High-Grade Structured Credit Strategies Enhanced Leverage fund fell 23% in the twelve months to April 2007. It had borrowed around $6bn from Wall Street banks and brokerage firms. As losses were signaled, many investors wanted to get their money out, but these were frozen in May.

Up to now problems have been slow to come to light in the housing market, but as it moves slower than the stock market and subprime mortgages are packaged in securities designed to withstand high default rates, the true impact has yet to be felt. This is not going to blow up overnight as the processes involved take much longer to manifest themselves as problems.

The riskiest part of mortgage bonds are collateralized debt obligations (CDOs) and these are held by a relatively small group of investors. CDO values are hard to determine, but large financial institutions were willing to gamble on subprime bonds and CDOs without attempting a valuation. Many assets were invested simply based on credit ratings.

Last year’s lax attitude to mortgage loans is now hardening and investors want more comprehensive reviews now. Bonds are increasingly being downgraded by ratings agencies, who are watching others for further downgrades too. Activity if being pushed by delinquency rates among borrowers, their property values and how much the structure of a bond can protects its investors. Experts suggest that most investors in bonds that are backed by mortgages will have protection as long as losses remain no higher than 10%.

CDOs are different as they are invested in the highest risk area of mortgage bonds – and with a lot of borrowed money. Securities are continually being revalued at the moment.

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