Subprime Debt: Merrill Lynch Couldn’t Find Bear Stearns Buyer

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Last week we mentioned Merrill Lynch (NYSE:MER) doing its impersonation of Michael Jackson, dangling the US mortgage baby outside its hotel window—and utterly freaking out the entire stock market in the process. Upon further review, it appears that Merrill didn’t have a change of heart about selling the mortgage debt. It just couldn’t find any buyers.

London’s Independent newspaper reports that “the fast-moving crisis at two Bear Stearns (NYSE:BSC) 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.” Charles Dumas, the global strategist at Lombard Street Research said that Merrill didn’t make good on its threat to sell the collateral it had seized from a hedge fund at Bear Stearns because it couldn’t. “The sale had to be called off after buyers took just US$200 million (AU$238 million) of the US$850 million mix….We hear buyers were lobbing bids at just 30 per cent [of face value],” the Independent reports.

Officials in Wall Street and New York keep reassuring us that the subprime meltdown is contained, as if it were a small brush fire in the back-yard. This meltdown, however, seems more toxic to us, largely because pieces of mortgage-backed debt have been thinly sliced and widely distributed. The key to the whole thing may be the ratings agencies, Fitch, Moody’s (NYSE:MCO) and Standard and Poor’s.

If any or all of the ratings agencies reconsider the credit-quality of bond offerings containing slices of subprime debt, it could force many owners of that debt to sell. Pension funds in particular either prefer or are only allowed to buy triple A quality debt. Any re-rating of the subprime market would force many of these large bond-holders to sell.

“Sell to whom?” is the question. As Merrill’s aborted action last week showed, there are a lot of would-be sellers of subprime debt…but not so many buyers. The fancy name for such an imbalance is a “liquidity contraction”. No matter what you call it, it means falling prices for debt all over the world, and higher interest rates…a much dreaded global credit crunch.

If the credit crunch is in proportion to the excess that preceded it, this will not be a case of just throwing the mortgage-debt baby out with the junk-bond bathwater. This might be one of those rare market events in which the entire bathtub – high-risk debt as a socially acceptable asset class – is thrown out the window to the street below. But don’t worry, and don’t look up. The sky isn’t falling…yet.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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