The problem is very simple. We are having meltdowns in instruments that do not trade in the normal way.

If one of these funds go under, there is no way on knowing what, if anything the holders of the loan will get from selling these assets.

That’s why everyone freaked when Merril Lynch said that it would be selling off those assets from the Bear Sterns fund.

They are rated on face value, and the bids were coming in at far less than that.

When these sales occur, the assets necessarily get revalued at the auction price (willing sale, willing buyer), and suddenly hundreds of billions, if not trillions of dollars of funds become insolvent.

When hedge funds implode

By Axel Merk

The US trade deficit with the rest of the world leapfrogged in recent days. Aside from goods and services, the United States is now importing “consensus-based crisis management” from Japan.

Out of fear that a cleanup of bad loans would trigger widespread defaults, Japanese banks got themselves deeper and deeper into trouble by hushing up the problems. We are talking about the crisis at Bear Sterns’ subprime hedge fund. The crisis shows that major adjustments on how the market prices risks are overdue; this may have negative implications for stocks, bonds, and commodities, as well as the US dollar.

Bear Sterns is a leading provider of services to hedge funds; it is also one of the largest originators of subprime-backed collateralized debt obligations. CDOs are what their name implies: a security backed by collateral. CDOs are created when mortgages with various risk profiles are grouped into different tranches or segments. Among others, Bear Sterns would create a CDO in a bundle according to a client’s specifications. Indeed, Bear Sterns would work with a rating agency, such as Moody’s, to obtain the desired rating (a practice likely to face more scrutiny as some allege that Moody’s no longer acts as an independent rating agency, but as a syndicator in the offering).

The explosive demand in this sector has attracted ever more creative structures. Investors should have grown concerned when dealmakers started suggesting that one can create a higher-grade security by grouping together a couple of lower-grade securities; it is rare that 1 + 1 = 3. As these instruments have grown more complex, the clients buying these instruments often do not have a full understanding of what they buy.

How do you make a best-seller better? You introduce leverage. Not only can leverage be introduced in the credit derivatives that define some of these securities, but brokers eager to attract hedge-fund business may also accept CDOs as collateral to lend money. The hedge fund now attracting so much attention is Bear Sterns’ High Grade Structured Credit Strategies Enhanced Leverage Fund, launched only 10 months ago. It shall be noted that Bear Sterns did not put much of its own money into the fund, but supplied many of the CDOs. A total of US$600 million in invested capital was boosted with borrowings of about $6 billion.

…

In the brokerage industry, when a margin call is not met (when the borrower cannot provide sufficient collateral), the broker may seize the collateral and liquidate open positions. While a forced sale of the collateral may be painful for the borrower, it protects the system as a whole. Such forced sales happen all the time in the futures market, where positions are “marked to market” every day to evaluate the profitability and risk of open positions.

But the CDO market is not a regulated futures market; there is no daily market price that would allow one to assess the value of the collateral. The primary methods used to value CDOs are called “mark to market” and “mark to model”. In the more conservative “mark to market” approach, independent parties are asked to value the securities; as the name implies, the “mark to model” approach is more aggressive and uses a computed, theoretical value.

But because these instruments are sold in privately negotiated transactions, rather than a regulated and liquid market, neither valuation method is suitable in case of a forced liquidation.

…

I’m not sure why, perhaps because it is not dependent on US realtors for ad revenues, the Asia times has been ahead of the game on this.

Banks ‘set to call in a swathe of loans

The United States faces a severe credit crunch as mounting losses on risky forms of debt catch up with the banks and force them to curb lending and call in existing loans, according to a report by Lombard Street Research.

Bear Stearns headquarters: Banks ‘set to call in a swathe of loans’
Bear Stearns headquarters in New York

The group said the fast-moving crisis at two Bear Stearns hedge funds had exposed the underlying rot in the US sub-prime mortgage market, and the vast nexus of collateralised debt obligations known as CDOs.

“Excess liquidity in the global system will be slashed,” it said. “Banks’ capital is about to be decimated, which will require calling in a swathe of loans. This is going to aggravate the US hard landing.”

Charles Dumas, the group’s global strategist, said the failed auction of assets seized from one of the Bear Stearns funds by Merrill Lynch had revealed the dark secret of the CDO debt market. The sale had to be called off after buyers took just $200m of the $850m mix.

“The banks were not prepared to bid over 85pc of face value for CDOs rated “A” or better,” he said.

“God knows how low the price would have dropped if they had kept on going. We hear buyers were lobbing bids at just 30pc.

“We don’t know what the value of this debt is because the investment banks shut down the market in a cover-up so that nobody would know. There is $750bn of dubious paper out there in the form of CDOs held by banks that have a total capitalisation of $850bn.”

US property writer Paul Muolo described the Bearn Stearns crisis as the “subprime Chernobyl”, saying the bank had created a “cone of silence”.

Abandoned by fellow banks, Bear Stearns has now put up $3.2bn of its own money to rescue one of the funds, a quarter of its capital.

…

The Mortgage Lender Implode-Meter that tracks the US housing markets claims that 86 major lenders have gone bankrupt or shut their doors since the crash began.

The latest are Aegis Lending, Oak Street Mortgage and The Mortgage Warehouse.

….

Nouriel Roubini, economics professor at New York University, said there were now concerns about “systemic risk fall-out” from the Bear Stearns debacle as investors look more closely at the real value of CDOs.

FWIW, Roubini is a VERY sharp guy. He’s been well ahead of the market and the conventional wisdom again and again.

Goldman-issued subprime bonds lead downgrades-Citi
Mon Jun 25, 2007 1:50 PM ET

NEW YORK, June 25 (Reuters) – Goldman Sachs Group Inc. subprime mortgage bonds issued last year are being downgraded by rating companies at the fastest rate of any issuer, according to Citigroup Inc. research dated June 22.

Nearly 70 of Goldman’s GSAMP-issued bonds, which include subprime loans from a variety of lenders, have been downgraded by Standard & Poor’s and Moody’s Investors Service in the year through June 15, with 60 of those issued in 2006, analysts at Citigroup Global Markets said in a weekly note.

Downgrades are accelerating on mortgage bonds backed by loans to the riskiest borrowers following an ongoing surge in delinquencies and foreclosures. Lenders loosened underwriting standards in the years through 2006, creating loans whose poor quality became apparent as the U.S. housing slump began.
…

Goldman Sachs?

Seriously when these funds actually get a fair assessment, a lot of these banks will be insolvent.

I’ve post dated this a bit, because I think that it is a wonderful picture, and really shows where this all comes from.

The source of this picture is the Irvine Housing Blog’s Article, Houses Should Not Be a Commodity, which I found care of Peter Viles’s LA Land Blog.

It is accompanied by well written descriptions of the stages, which are analogous to the stages of grief.

About the only thing I differ with this at all is that I believe that the overshoot on the downside will be much worse. It may not be recorded in house sales though, as the market is likely to become largely illiquid, so you will simply be stuck with your home and mortgage debt.

In the Irvine blog, the basic point is that when housing simply becomes a traded commodity, it does far more harm than good. It creates wild swings in prices driven by speculators, that alternately price people out of, or wipe out, people attempting to obtain a stable necessity.

Speculation in the housing market gets you here: Image from the Irvine blog.

He has a somehwat more informative picture too:

This scary picture is an artifact as housing as volatile speculatively traded commodity. People use sophisticated instruments to buy into a speculative bubble, because of the desire to purchase a rapidly appreciating comodity, and for fear of permanently being priced out if they do not purchase immediately.

Note that existing home sales lag 1-2 months behind new home sales, because the latter is recorded when the offer is accepted, and the former when the property closes.

Also note that new home sales do not include cancellations, which are not a part of the stats generally.
New home sales fall more than expected in May.

May reading shows ongoing slump at start of key selling season; prices fall; April sales revised lower.
By Chris Isidore, CNNMoney.com senior writer
June 26 2007: 11:10 AM EDT

NEW YORK (CNNMoney.com) — New home sales posted a surprising drop at the start of the crucial spring selling season in May – the latest sign that the battered housing market could have a ways to go before hitting bottom.

The pace of new home sales fell 1.6 percent to an annual rate of 915,000 last month, the Census Bureau reported, from April’s 930,000 pace, which itself was revised lower. Economists surveyed by Briefing.com had forecast a rate of 925,000.

While sales picked up from the early part of the year, they tumbled 15.8 percent from May 2006 – marking the 18th straight month of year-over-year declines.

Their participation made it too difficult for them to lie.

The way the current market is, they need a significant information asymmetry to make any money at all.

Realtor groups may quit statewide reports

By STEPHEN FRATER and MICHAEL POLLICK

STAFF WRITERS
stephen.frater@heraldtribune.com
michael.pollick@heraldtribune.com
The Naples Area Board of Realtors has long wanted to report that city’s results undiluted by lower-priced and worse-performing neighbors.

In fact, for the past few months, the board has refused to submit its sales and price numbers to the Florida Association of Realtors for its comprehensive monthly reports.

Marla Martin, an FAR spokeswoman, said the Naples board — representing the wealthiest median home sales prices in Florida — had raised issues with the state association relating to the presentation of the board’s sales and price data.

Martin said there have been recent meetings about the matter, and she expected some resolution soon.

Observers say that Naples’ strong, expensive but medium-small market does not want to be lumped into any other database because it could drag down the statistics.

With much the same sentiment, the Sarasota Association of Realtors would prefer to be judged only within the boundaries of its Multiple Listing Service, and it issues a monthly release timed to coincide with the FAR’s monthly statistics.

But it is uncertain where the group sets the MLS boundaries.

..

It appears to me that this will be far worse than is currently envisioned by the mainstream financial press.

Of note, the 2nd story uses the “d word”, Depression.

Worries rise as fund crashes

Bear Stearns pledges $3.2 billion to shore up mortgage investments.
By E. Scott Reckard and Kathy M. Kristof
Times Staff Writers

June 23, 2007

Anxiety intensified Friday about the toll the sub-prime mortgage meltdown is taking on the financial industry at large, as Bear Stearns Cos. pledged to lend $3.2 billion to rescue a hedge fund battered by rising defaults on home loans. The jitters sent stocks tumbling across the board.

“We know that these holdings are not unique to Bear Stearns,” said Drexel University professor Joseph R. Mason, co-author of a recent study warning of dangers in securities backed by home loans to high-risk borrowers. “It would be hard to find a Wall Street firm that hasn’t created similar funds.”

The hedge fund, which is managed by a Bear Stearns division, had taken in nearly $7 billion — $600 million raised from investors plus 10 times that sum borrowed from Wall Street firms. Such a great amount of leverage would sharply boost any profit generated — as well as any loss incurred. The fund invested mostly in bonds that paid generous yields and were backed by sub-prime mortgages.

But as the nation’s housing market soured, setting off a wave of defaults on sub-prime loans, the securities held by the fund lost substantial value, although exactly how much hasn’t been disclosed. The borrowing by the fund magnified the losses.

…

And then we have this from one of the most respected financial bodies in the world.

BIS warns of Great Depression dangers from credit spree

By Ambrose Evans-Pritchard
Last Updated: 9:02am BST 25/06/2007

The Bank for International Settlements, the world’s most prestigious financial body, has warned that years of loose monetary policy has fuelled a dangerous credit bubble, leaving the global economy more vulnerable to another 1930s-style slump than generally understood.

“Virtually nobody foresaw the Great Depression of the 1930s, or the crises which affected Japan and Southeast Asia in the early and late 1990s. In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a ‘new era’ had arrived”, said the bank.

The BIS, the ultimate bank of central bankers, pointed to a confluence a worrying signs, citing mass issuance of new-fangled credit instruments, soaring levels of household debt, extreme appetite for risk shown by investors, and entrenched imbalances in the world currency system.

“Behind each set of concerns lurks the common factor of highly accommodating financial conditions. Tail events affecting the global economy might at some point have much higher costs than is commonly supposed,” it said.

The BIS said China may have repeated the disastrous errors made by Japan in the 1980s when Tokyo let rip with excess liquidity.

“The Chinese economy seems to be demonstrating very similar, disquieting symptoms,” it said, citing ballooning credit, an asset boom, and “massive investments” in heavy industry.

Some 40pc of China’s state-owned enterprises are loss-making, exposing the banking system to likely stress in a downturn.

It said China’s growth was “unstable, unbalance, uncoordinated and unsustainable”, borrowing a line from Chinese premier Wen Jiabao

In a thinly-veiled rebuke to the US Federal Reserve, the BIS said central banks were starting to doubt the wisdom of letting asset bubbles build up on the assumption that they could safely be “cleaned up” afterwards – which was more or less the strategy pursued by former Fed chief Alan Greenspan after the dotcom bust.

…

The bank said it was far from clear whether the US would be able to shrug off the consequences of its latest imbalances, citing a current account deficit running at 6.5pc of GDP, a rise in US external liabilities by over $4 trillion from 2001 to 2005, and an unprecedented drop in the savings rate. “The dollar clearly remains vulnerable to a sudden loss of private sector confidence,” it said.

Mr. Toscano is a numerate and concise real estate expert who writes about the housing market in southern California, particularly San Diego and Environs. Check out his page.

The graphs are from the post linked to below.

May Foreclosure Activity

This is the ratio of notices of defaults, and notices of trustee sale. It’s as bad as it was in the early 1990s at it’s worst, and it’s still on the way down.

This is a shorter time series graph, with the NOD/NOT to sales ratio.
It shows that foreclosures are up relative to sales.

Go to the link to see more.

BTW, he has the funniest footnote ever in his post:

As shown by this article, no one actually knows how much these collateralized debt obligations are actually worth.

What happens if the $800 million of securities sells for $700 million? What if they sell for $400 million? What if they sell for less?

A number of funds, and possibly firms, could become insolvent over night.

Bear Stearns Fund Collapse Sends Shock Through CDOs

By Mark Pittman

June 21 (Bloomberg) — Merrill Lynch & Co.’s threat to sell $800 million of mortgage securities seized from Bear Stearns Cos. hedge funds is sending shudders across Wall Street.

A sale would give banks, brokerages and investors the one thing they want to avoid: a real price on the bonds in the fund that could serve as a benchmark. The securities are known as collateralized debt obligations, which exceed $1 trillion and comprise the fastest-growing part of the bond market.

Because there is little trading in the securities, prices may not reflect the highest rate of mortgage delinquencies in 13 years. An auction that confirms concerns that CDOs are overvalued may spark a chain reaction of writedowns that causes billions of dollars in losses for everyone from hedge funds to pension funds to foreign banks. Bear Stearns, the second-biggest mortgage bond underwriter, also is the biggest broker to hedge funds.

“More than a Bear Stearns issue, it’s an industry issue,” said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York. Hintz was chief financial officer of Lehman Brothers Holdings Inc., the largest mortgage underwriter, for three years before becoming an analyst in 2001. “How many other hedge funds are holding similar, illiquid, esoteric securities? What are their true prices? What will happen if more blow up?”

…

The crash is here, it’s just not yet being reported on by the papers, because realtors buy too many ads.

Rate Rise Pushes Housing, Economy to `Blood Bath’
By Kathleen M. Howley

June 20 (Bloomberg) — The worst is yet to come for the U.S. housing market.

The jump in 30-year mortgage rates by more than a half a percentage point to 6.74 percent in the past five weeks is putting a crimp on borrowers with the best credit just as a crackdown in subprime lending standards limits the pool of qualified buyers. The national median home price is poised for its first annual decline since the Great Depression, and the supply of unsold homes is at a record 4.2 million, according to the National Association of Realtors.

“It’s a blood bath,” said Mark Kiesel, executive vice president of Newport Beach, California-based Pacific Investment Management Co., the manager of $668 billion in bond funds. “We’re talking about a two- to three-year downturn that will take a whole host of characters with it, from job creation to consumer confidence. Eventually it will take the stock market and corporate profit.”

…..

The increase in mortgage rates meant an 8% decrease in buying power in about a month.

Mortgage Woes `Tip of Iceberg,’ Bank of America Says

By Sebastian Boyd

June 22 (Bloomberg) — Losses in the U.S. mortgage market may be the “tip of the iceberg,” Bank of America Corp. analysts said today in a note for clients.

Higher interest rates have yet to affect many home owners who took out adjustable-rate mortgages, the Charlotte, North Carolina-based bank said. Interest payments on about $900 billion of the riskiest subprime home-loans are due to increase this year and next, the analysts wrote.

Bear Stearns Cos., the second-biggest underwriter of mortgage bonds, plans to assume $3.2 billion of loans to stop creditors from taking over assets of one of its hedge funds, people with knowledge of the proposal said. Concern about the collapse of the funds, which made bad bets on mortgage-backed securities, sent bonds and stocks of finance companies lower.

“The demise of two Bear Stearns managed leveraged mortgage funds could be the tipping point of a broader fallout from subprime mortgage credit deterioration,” wrote Bank of America analysts led by Robert Lacoursiere in New York.

…

This is where the housing crash infects the rest of the financial markets.

You have to remember that this is going on when interest rates are about a percent above historic lows.

We have a crash, the only question is when it becomes a panic.

Foreclosure Rate Hits Historic High

By Dina ElBoghdady and Nancy Trejos
Washington Post Staff Writers
Friday, June 15, 2007; D01

The percentage of U.S. mortgages entering foreclosure in the first three months of the year was the highest in more than 50 years, according to the Mortgage Bankers Association.

As the association released its numbers, the Federal Reserve held a hearing to determine whether regulators could do anything to crack down on abusive lending practices, which have exacerbated the problem

The problems arose last year as the housing market softened, driving down home prices and making it more difficult for cash-strapped borrowers to sell their homes or refinance their way out of trouble.

The most dramatic fallout took place in the subprime market, which caters to people with blemished credit or other factors that make them a risk to lenders.

Those borrowers entered foreclosure at a rate of 2.43 percent, up from 2 percent the previous quarter. The percentages seem small, but they are far above norms, particularly in a healthy economy. The concern is that the mortgage industry’s troubles could damage the economy if they are not contained.

For more credit-worthy, prime borrowers, foreclosures rose slightly, to 0.25 percent, in the first quarter from 0.24 percent in the previous one.

New foreclosures for prime and subprime borrowers combined hit record highs. They rose to 0.58 percent on a seasonally adjusted basis, compared with 0.54 percent in the previous quarter and 0.41 percent a year earlier.

The high translates into about 254,591 mortgages, or one in 172 loans, the association said.

The problems weren’t uniformly spread around the country. Doug Duncan, chief economist for the mortgage bankers group, said the rate of new foreclosures would have dropped had it not been for big jumps in California, Florida, Nevada and Arizona. He said high rates in Ohio, Michigan and Indiana also drove up the overall percentage of loans in foreclosure.

Some who track the industry say the worst is yet to come.

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