Subprime Crisis Deepens as Bear Stearns Funds Wiped Out, Ratings Fall

The "Greatest Economic Boom Ever" looks a little less great this morning. 

You'll recall how experts rushed to assure us that the little problem in subprime lending was "contained". Of course, no one knew how much of a problem it would be. Subprime was like a stray puppy; you couldn't know how big it would get when it grew up...or how much damage it would do to the furniture.

Well, over the last 10 days, the little mutt has been more trouble than a Japanese earthquake...hitting containers of CDO waste and knocking the lids off.

What began as a problem for borrowers has turned into a problem for lenders, too.

The slump in the housing market has made it tough for borrowers to sell or refinance. Or, from another perspective, it has made it hard for people to buy houses; yesterday's news tells us that homebuilders are so depressed that their wives are hiding their hunting rifles. They have not been in such a funk for 16 years, say the reports. And the people who finance the homebuilders are not feeling so good either.  Countrywide Financial Corporation, one of the nation's biggest mortgage lenders, says conditions "became increasingly challenging" in the second quarter.

Meanwhile, the homeowners are often stuck - with a nice house, but no way to pay for it. Finally, the long arm of the law stretches out and takes their house away from them. But that is hardly the end of the story. It is only the beginning. Because then the mortgage goes unpaid...and the whole bunch of dodgy sausages that were packaged up as Collateralized Debt Obligations begins to stink. 

"Up until now, hedge funds have been creating a great deal of the miraculous 'liquidity' sloshing around the globe," offers Dan Amoss.

"By buying the highly leveraged equity and mezzanine tranches of CDOs, they've greatly strengthened the buying power that's been bidding up the prices - and lowering the yields - of risky debt instruments. George Soros' theory of reflexivity was at work during the financing stage of the housing bubble; now it's working in reverse to 'de'- finance the housing bubble."

"Indigestion tends to lower an appetite, and institutional investors' appetite for junk bonds is spoiling just as Wall Street tries to serve them heaps of acidic securities," continues Dan.

"While CDOs have shifted risk away from the banking system by linking borrowers with lenders from around the world, they have not lessened default risk; they've merely transferred it to unsuspecting lenders that are just beginning to push back."

Last week, all three rating agencies - Moody's (ASX:MCO), Standard and Poor's, and Fitch - announced downgrades of subprime linked debt. And this week, Bear Stearns (ASX:BSC) said investors in one of its hedge funds that bought CDOs on a leveraged basis would get none of their money back. They were wiped out, said the letter reported by Bloomberg, buying Triple-A bonds. Just how subprime CDOs, suspicious byproducts of a disreputable industry, came to be rated AAA is a story worth telling, but today we will stick to the news. Bear went on to say that while investors in one of its two endangered funds had been wiped out, investors in the other fund could breathe a sigh of relief - they had only lost 91% of their money.

As this news made it up and down the street, the indexes that measure confidence in collateralised debt dropped. "All but one of the 15 ABX indexes fell to a record low," says the Bloomberg news. In the words of one trader, offers for CDOs are going "no bid."

These losses, declines, and reverses were "unprecedented," as Bear put it. But then, they always are.

Bill Bonner
The Daily Reckoning Australia

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