Ya Got Yer Winners

Bloomberg (09.20.07):

"Goldman Sachs Group Inc. reported the third-best profit in its 138-year history after betting against the mortgage bonds that roiled credit markets and left Bear Stearns Cos. with its biggest earnings decline in more than a decade.

The world's largest securities firm said net income rose 79 percent in the third quarter to $2.85 billion, or $6.13 a share, beating the highest analyst estimate by more than 20 percent.

Goldman Net Tops Estimates; Bear's Drops 61 Percent

And ya got yer losers. "Earnings at Bear Stearns fell 61 percent to $171 million, or $1.16 a share."

Don't Ask; Don't Tell

Reuters (06.23.07):

"It was Wall Street's version of hide and seek this week as some of the world's largest investment banks remained tight-lipped on the likely fall in price of some complex securities that may soon infect global debt and equity markets.

In the past week the stock market lost ground, the bond market saw prices bounce around, and investors were left with the sinking feeling that things could get worse as credit worries undermined the $1 trillion market for collateralized debt obligations (CDOs)."

Wall Street circles wagons on risky securities

"The losses suffered by two funds containing these complex securities, many tied to risky mortgage loans, sent Bear Stearns Cos. executives scrambling to re-finance the funds this week."

"But the large and sophisticated investors in these funds did not run for the hills. Instead, they went silent." Case in point: last week, Merrill, Lynch and JPMorgan freaked out, and moved to dump a bunch of these things. Cooler heads prevailed, however, and the liquidation sales were kinda, sorta canceled. Why?

No one is sure what kind of prices these CDOs would fetch on the open market. We'd bet they'd bring a lot less than the value on the books. Considering how much of this crappy paper the big banks are holding as collateral, a panicked fire sale would be very, very bad. How bad? Collapse, crash and burn bad.

"If word of the exact nature of the losses became public, it would have forced many other funds to revalue their holdings and perhaps lose money, setting off a domino effect that could rattle markets globally."

Perhaps?

"'Wall Street is now engineering a way to pretend that nearly worthless subprime bonds are maintaining' their original values, said Peter Schiff, president of Euro Pacific Capital, a broker-dealer based in Darien, Connecticut."

Maybe not worthless, but worth a lot less than they once were. Bloomberg (06.21.07):

"Not since 1994 have mortgages at banks with past due payments been so high, according to first-quarter data compiled by the Federal Deposit Insurance Corp., the agency that insures deposits at 8,650 U.S. banks. Lehman analysts estimated in April that the collateral backing CDOs had fallen by $25 billion."

Merrill Sells Portion of $850 Million Bear Funds

And the best is yet to come. Bloomberg (06.22.07):

"Losses in the U.S. mortgage market may be the 'tip of the iceberg' as borrowers fail to keep up with rising payments on billions worth of adjustable-rate loans in coming months, Bank of America Corp. analysts said.

Homeowners with about $515 billion on adjustable-rate home loans will pay more this year, and another $680 billion worth of mortgages will reset next year, analysts led by Robert Lacoursiere wrote in a research note today."

Bank of America Report Sees Worse Mortgage Defaults

"More than 70 percent of the total was granted to subprime borrowers, people with the riskiest credit records, they said."

Tick, Tock

Oh well. It was fun while it lasted. NYTimes (06.23.07):

"Bear Stearns Companies, the investment bank, pledged up to $3.2 billion in loans yesterday to bail out one of its hedge funds that was collapsing because of bad bets on subprime mortgages.

It is the biggest rescue of a hedge fund since 1998 when more than a dozen lenders provided $3.6 billion to save Long-Term Capital Management."

$3.2 Billion Move by Bear Stearns to Rescue Fund

"The crisis this week from the near collapse of two hedge funds managed by Bear Stearns stems directly from the slumping housing market and the fallout from loose lending practices that showered money on people with weak, or subprime, credit, leaving many of them struggling to stay in their homes.

Why are these guys in such a pickle? In a nutshell, a bunch of big-assed banks (Merrill, Lehman, JPMorgan, Goldman Sachs, Citigroup, Bank of America Corp., Barclays and Deutsche Bank) loaned a lot of money ($9 billion!) to these guys to help 'em get going. For collateral, they took back a bunch of fancy paper known as collateralized debt obligations, aka CDOs. Though CDOs can make you a lot of money (which bankers really, really like), they can be a bit, uhhh, volatile (which bankers really, really hate). Bloomberg (06.22.07):

"The funds speculated in highly rated CDOs -- securities backed by bonds, loans, derivatives and other CDOs -- that were hurt in March and April as defaults on subprime mortgages to people with poor or limited credit histories increased. The fund also lost on opposite bets against home-loan bonds, which backed many of its CDOs."

Bear Stearns Plans $3.2 Billion Hedge Fund Bailout

That and nobody really knows what the hell these things are worth. "Some CDOs are so rarely traded that their owners can't tell whether they are worth 50 cents or 90 cents on the dollar, said Scott Simon, who owns CDOs among his $200 billion of mortgage-and asset-backed bond investments at Newport Beach, California-based Pacific Investment Management Co."

This has our jolly bankers scared shitless. What's a poor creditor to do? Business Week (06.22.07):

"The big fear is that a mass liquidation of those poor-performing bonds, called collateralized debt obligations (CDOs), will force hedge funds and banks with similar CDOs in their portfolios to mark down their values.

A mass reduction in CDO values could cause other banks and hedge funds to report sizable losses and scare off institutional investors. In a worst-case scenario, it could prompt lenders to get more protective and stop making loans of all sorts, not just to subprime borrowers."

Bear Stearns to the Rescue—Sort Of

Bear Stearns says not to worry, all bets are covered: "Bear Stearns Chief Financial Officer Sam Molinaro, said the firm's line of credit, known as a repurchase agreement, is 'adequately secured.'"

Some are less convinced. "'The problem is not what we see happening, but what we don't see,' said Joseph Mason, associate professor of finance at Drexel University in Philadelphia and co-author of an 84-page study this year on the CDO market. 'We don't know the price of these assets. We don't know which banks are exposed to this sector. These conditions are the classic conditions for financial crises across history.'"

And it ain't over yet, folks. "Bear Stearns averted a meltdown this time, but if delinquencies and defaults on subprime loans surge, Wall Street firms, hedge funds and pension funds could be left holding billions of dollars in bonds and securities backed by loans that are quickly losing their value."

Think it's dicey for 'em now? There's plenty more trouble where that came from. "The firm is, meanwhile, negotiating with banks to rescue the second, larger fund started last August, which has more than $6 billion in loans and reportedly holds far riskier investments. Those negotiations were continuing yesterday, and it was unclear whether they would be successful."

Bubble, Bubble, Toil and Trouble

Bloomberg's attention was captured by the housing market this afternoon. Four of the top six stories as of 4:45P CDT:

• U.S. Stocks Tumble, Led By Financials as Mortgage Slump Worsens

• U.S. Subprime Mortgage Delinquencies Reach Four-Year High of 13.33 Percent

• Accredited Home, New Century Shares Plunge After Lenders Demand More Cash

• GMAC Reports Fourth-Quarter Loss at ResCap Mortgage Unit on Loan Reserves

This is what's got 'em all nervous. Bloomberg (03.13.07):

"Bond investors rattled by mounting losses in subprime U.S. mortgages say trouble is brewing in collateralized debt obligations, the same securities that fueled the boom in leveraged buyouts and cut-rate finance."

Sales of CDOs, which package loans, bonds and derivatives into new securities, rose by almost half to $918 billion last year, according to data compiled by JPMorgan Chase & Co.

CDOs May Bring Subprime-Like Bust for LBOs, Junk Debt

"CDOs were first set up in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc., the home of one-time junk bond king Michael Milken. Junk, or high-yield, debt are rated below Baa3 by Moody's and BBB- by Standard & Poor's."

"Bankers bundle what is often speculative-grade securities into a CDO, dividing it into pieces with credit ratings as high as AAA."

In other words, there's a lot of this stuff out there, and a lot of it contains varying amounts of subprime loans. As the expected default rate of the skanky loans begins to exceed original allowances, these guys are gonna freak.

Then you'll see some hell breaking loose.