As suspected here last week, long-term interest rates have stabilized: the all-powerful 10-year T-note is in a broad range below 5.2 percent, and mortgages are at 6.75 percent to 6.88 percent.
Everyone assumes the 10-year T-note will make a run through 5.25 percent, and mortgages will climb to 7 percent, but I don’t think we will stay that high unless there is worse news on inflation or the global economy runs away from the central banks.
In the last week, the mortgage market has been glued to the demise of two Bear Stearns mortgage investment “hedge” funds. Their rise and demise tells the whole crazy mortgage credit story, abounds in black humor, and presages the untidy conclusion of an interval of excessive leverage in all markets.
The funds were created only 10 months ago, the larger fund named in ultimate hubris, High Grade Structured Credit Strategies Enhanced Leverage Fund. Bear raised $1.5 billion in capital, mostly from institutions, and then its geniuses borrowed to establish about $30 billion in mortgage derivative positions (short and long, some offsetting, about one-third of the position in tranches of CDOs made up of tranches of other CDOs, black boxes within black boxes.). The lenders were the usual suspects, clones of Bear: Merrill, Morgan-Chase, Barclays, Goldman, Deutschebank, Citi, and BofA, some with better security than others.
By May, Bear had lost the capital, and to meet margin calls sold the high-quality assets, then forbade investors to withdraw, and by last week faced a creditor mob threatening to seize the remaining derivatives and liquidate the two funds altogether.
Then it got worse. After much huffing, the creditors realized that a fire sale was not such a hot idea, because they all have clients invested in the same stuff that Bear has, and gazillions more in loans out to each other secured by that same stuff. If Bear’s trash sold for thirty cents on the buck, then that would be the value of their trash and the collateral securing their other loans. On Monday Bear’s lenders were talking about injecting their own money into the funds to prop them up, and all week long lurched back and forth between a collateral scramble and a negotiated workout.
In some ways, it was a routine end to a bad idea. But, look again.
In the 2000-2006 Wall Street-backed extension of mortgage credit on suicidal terms, I had assumed normal Wall Street operations: if you’ve got a client who is desperate for yield and self-deceptive about risk, sell them what they want, and caveat emptor. The Securities and Exchange Commission protects widows and orphans; institutions are on their own. You may not cheat other institutions, but you have no duty whatsoever to save them from themselves.
The stunning thing in this Bear fiasco: Bear and all its lenders are the insiders in the suicidal mortgage credit game. These are the guys who offered to buy mortgage trash from Main Street in any quantity, designed bizarre structures to satisfy their co-dependent, credit-rating agencies, and sold them to feed the insatiable global demand for yield. Insiders entered the market for mortgage trash in the fall of 2006 when several million civilians knew that you might as well juggle nitroglycerine.
It never occurred to me that the insiders didn’t know what they were doing. They were so drunk on money and power that they didn’t know their incompetence.
As of this morning, rumor has it that Bear is offering a self-rescue injection of $3.2 billion (double the initial capital), theoretically for pride. I believe that there is more going on. It is a serious accusation, but the Street for months has appeared to be in a conspiracy of silence, working to conceal the real value of $1.5 trillion in bad mortgage ideas created from 2004 to 2006, abetted by the glacial pace at S&P and Moody’s to acknowledge their massive rating error. The Federal Reserve is just as silent, which may preserve calm for a time, but transparency is the only antidote to episodes like this one.
Consequences for “A” mortgage paper are likely to be beneficial, as frightened money moves to quality, but credit standards will be tight. The Bear adventure could catalyze a leverage meltdown in other markets, likewise beneficial to quality loans.
Lou Barnes is a mortgage broker and nationally syndicated columnist based in Boulder, Colo. He can be reached at firstname.lastname@example.org.
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