Make no mistake: this week, as last week, is all about the blow up of the two Bear Stearns hedge funds heavily invested in subprime mortgage backed securities.
And The Wall Street Journal, as usual, is to be commended for its superb coverage of the story, its implications and its corollaries.
I highly recommend the following five front page Wall Street Journal stories for those of you who want to understand what’s going on (please e-mail me and I’ll send you a link if you don’t have a subscription).
(1) “Bear Stearns Bails Out Fund With Big Loan: Injection of $3.2 Billion Caps Days of Drama; Subprime Sector Fears”, Saturday June 23, 2007 (subscription required)
This story covers the blowup of the two Bear Stearns hedge funds, High Grade Structured Credit Strategies and High Grade Structured Credit Strategies Enhanced Leverage, heavily invested in subprime mortgage backed securities.
Included is an excellent history of the funds as well as an account of the days leading up to and including the current crisis.
(2) “How Wall Street Stoked The Mortgage Meltdown: Lehman and Others Transformed the Market For Riskiest Borrowers”, Wednesday June 27, 2007 (subscription required)
This article is truly fasinating reading:
A generation ago, housing finance was different. Bankers took in deposits, lent that money to home buyers and collected interest and principal until the mortgages were paid. Wall Street wasn’t much involved.
Now it plays a central role. Wall Street firms provide working capital that allows thousands or mortgage firms to make loans. After lenders sign up consumers for home loans, investment banks pool the income streams from these loans into bonds known as mortgage backed securities. The banks sell them to yield hungry investors around the world.
An excellent graphical depiction of how it works can be seen here.
The article concentrates on industry leader Lehman Brothers, which packaged and sold more than $50 billion worth of subprime mortgage backed securities in both 2005 and 2006 (graphic).
That amounts to about 10% of the total industry for the last two years which has packaged and sold about $1 trilllion worth of subprime mortgage backed securities in just those two years (graphic).
This article is truly fascinating and mind blowing and if you want to understand the blow up in subprime mortgages and how its effects will ripple out and be felt throughout the investment community you must read it.
(3) “Behind Buyout Surge, A Debt Market Booms: CLOs Spark Worries Of Volatility and Risk; Loan Standards Loosen”, Tuesday June 26, 2007 (subscription required)
CLOs (Collateralized Loan Obligations) are the analagous instrument to mortgage backed securities (called CDOs or Collateralized Debt Obligations) for corporate loans. When corporations borrow money they can either issue bonds to the public at large or they can borrow from a bank who can then either keep the loan on its books or sell it to investors as CLOs.
The volume of collateralized loan obligations packaged and sold in the US has been about $100 billion the last two years – as compared with $500 billion for subprime mortgage backed securities (see above).
CLOs have been extraordinarily important in financing the leveraged buyout (i.e. private equity) boom that has been such a boon for stocks the last few years. According to the article, more than half of the loans behind last year’s record wave of buyouts were pareceled out to investors as CLOs.
One of the reasons subprime mortgages got so out of hand was that the lenders making the loans didn’t have that much interest in their quality as they were selling them to investment banks to be packaged and sold as CDOs rather than holding them on their own books as they used to. The Bear Stearns hedge funds, and everyone else, invested in these CDOs are now finding this out the hard way.
The same thing applies in the case of CLOs:
‘The banks making the loans don’t have a continuing interest in how the loans play out because they don’t have much money at risk. There’s been a progressive detioration of underwriting standards.’
– Dan Fuss, Vice Chairman Loomis Sayles
The article interestingly contrasts the financing for KKR’s legendary acquisition of RJR Nabisco (memorialized in the wonderful Barbarians at the Gate: The Fall of RJR Nabisco – read my review here) with the financing for its more recent acquisition of Sungard Data Systems.
Back then, banks lent them the money and kept the loans on their books – encouraging them to be careful in scrutinizing the deal.
In the Sungard acquisition, banks provided a bridge loan of $5 billion but had lined up more than 150 buyers of CLOs to take on $3 billion of the loans within 2 weeks: “Within days, the Sungard loan exposure was spread over thousands of different institutions around the globe.” The banks, as with the subprime mortgage underwriters, don’t seem to have the same incentive to scrutinize the deal under this system.
(4) “Market’s Jitters Stir Some Fears For Buyout Boom: Takeover-Related Debt Gets Chilly Reception; Hearing ‘Wake-Up Call'”, Thursday June 28, 2007 (subscription required)
CLOs are a big pillar of loan demand. If they slow down, borrowing will get a lot more difficult for companies.
– Steven Miller, Manager Director S&P
This article details the lack of interest by junk bond and CLO investors in buying the debt for the LBO of U.S. Foodservice, the nation’s 2nd largest food distributor:
Tuesday evening, a group of Wall Street underwriters cancelled a $1.55 billion bond offering and a $2 billion sale of corporate loans for US Foodservice after failing to find enough investors to take on the debt. The banks had to provide the $3.6 billion debt on their own via a ‘bridge’ loan….
‘We didn’t think investors were being compensated for the risk’, said Andrew Cestone, head of the high yield team at Evergreen Investments.
Should investors continue to shy away from junk bonds and CLOs we could indeed be seeing the end of the private equity frenzy – with the attendant consequences for the stock market.