When Banks Blink...through Crocodile Tears - The Subprime Circus

Oh me Miserum……”look how much money we will lose on irresponsible borrowers letting homes go to foreclosure?’

Nothing could be further from the truth. The music stopped and Wall Street hot shots got caught holding the bag. Bear Stearns has anted up $3.2 Billion to save a hedge fund and give comfort to all of the other investment banks they borrowed money from to fund their Mortgage Backed Securities hedge play.

The Bear Stearns hedge fund managers went wrong on three scores: 1. not truly understanding the nature of the under lying investment. 2. Investing with “no (or little) money down!” 3. Then compounding the error by listening to the media rather than truly understanding the market and the real versus perceived risk of market losses.

Bear Stearns has two funds: The first High-Grade Structured Credit Fund— the one bailed out last week— has done well since 2004, posting 41 months of positive returns of about 1 percent to 1.5 percent a month. Ever hungry investors wanted more which required more aggressive bets on riskier mortgage-related securities and significantly higher levels of borrowed money, or leverage, to bolster returns. In August 2006 Bear Stearns started High-Grade Structured Credit Enhanced Leveraged Fund with $600 million in investments from wealthy individual clients of Bear Stearns. At least $6 billion was borrowed from banks and other brokerage firms. Initially Bear Stearns and top executives only invested $40 million in both funds.

When the media started trumpeting the real estate market "collapse" and the subprime circus started, these investors and lenders got nervous and asked for their money back. Bear Stearns blinked and put $3.2 billion into the first fund.

As backgound: June 25^th 2007, The Mortgage Bankers Association reported that .62% of all residential real estate loans were in delinquency or default. That is point 62 of 1 percent! So most of the loans in these MBS portfolios are performing as agreed. Honest people diligently paying their monthly mortgages do not make good newspaper headlines.

Now here is the humor: The subprime market is a perfect example of a how misunderstood real estate is. Banks lend money on the basis of balancing property value (real estate as security,) personal credit (the borrower’s ability to repay) and fee income (how much can we make?) Many institutions got way too aggressive in this space and pushed fee income over ability to repay.

But now look at most lenders’ real exposure:

1. The property is the first security. When mortgage payments stop they can seize it and sell it and recover loan monies.

2. When a foreclosure sale occurs on the property subject to the loan, the borrower paid Personal Mortgage Insurance often exists to cover any shortfall between the home sale price and loan repayment amount. This is if loan orginators (sellers) did not intentionally "game the securitizaton system" by placing a less than 80% LTV first mortgage and a 20% second trust deed to consciously avoid PMI.
   

3. Many loan originators (brokers and banks) typically have “buy back” covenants in their sale of these mortgage packages into the secondary market to funds like those run by Bear Stearns. If the loan goes bad the originator will buy it back.

4. Then these hedge funds in turn borrowed money from many sources to fund these MBS under stringent loan call terms, hence their stress.

Subprime Strife? - These banks and lenders blinked. Now the same smart money has a new appetite for this distressed paper. Yes, a theatrical blink through crocodile tears!

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