Wall Street played role in creating subprime troubles

NEW YORK — Some on Wall Street want to blame the little guy for the latest hedge-fund mess. People with shoddy credit histories couldn't pay their mortgages so that pushed some funds to the brink of collapse and sent shock waves through financial markets.

Talk about a cop-out — that shifts blame away from the Wall Street firms and banks that had a hand in creating the subprime-mortgage mess but aren't taking responsibility for it.

Not only did the banks and firms encourage lending to borrowers with shaky credit so they would have lots of loans they could package and sell, but Wall Street then started hedge funds that used borrowed funds to leverage the bets on the mortgage markets many times over.

When things were going well, they made out big. But since the rise in subprime-mortgage defaults, it's a different story.

Bear Stearns is the most glaring example. The investment firm decided to build on its expertise in the subprime-mortgage securitization business by creating funds tied to that corner of the lending market.

Two of its funds produced strong returns, for a while at least. Its High-Grade Structured Credit, started in 2004, had tallied 40 months without a decline, before it turned the other way this spring. Given its success, Bear Stearns launched the High-Grade Structured Credit Strategies Enhanced Leverage Fund last August.

The rosy picture began to erode this year as home-loan borrowers began defaulting at an unexpectedly fast pace amid higher interest rates and a slowing housing market, which knocked down the value of the assets underlying those bonds.

Investors, seeing that situation unravel, started cashing out, until Bear Stearns froze all redemptions starting in May — signaling to the market that there was trouble. Its lenders — which included many of its investment-banking rivals — began to demand more collateral.

Bear Stearns found itself in a tough spot as the funds neared collapse. Not only was its reputation on the line, but fears grew that lenders would force a fire sale of those assets at lowball prices.

If that happened, the effect could have been widespread since it would have triggered a revaluation at much-lower prices of assets underlying all such securities in the market.

Fund bailout

Once its Wall Street peers declined to help rescue the funds, Bear Stearns had to act to avoid market mayhem. It is bailing out one of the funds with $1.6 billion in secured loans.

This crisis may look as though it has been averted for now, but there still is reason to worry. For one, the newer Bear fund still is in trouble. Bear Stearns also certainly wasn't alone in making such bets on the mortgage market; it's just the only one that publicly melted down so far.

It also shouldn't be forgotten that many of these firms are unusually linked, a point not lost on investment strategist Ed Yardeni.

"Wall Street firms and money-center banks financed the leveraging up of hedge funds that purchased the exotic and illiquid fixed-income securities produced by the very same Wall Street firms and money-center banks," he said in a note to clients.

He notes a similar situation in the late 1990s dot-com boom when technology companies boosted their sales by lending their customers money to buy their products. That, of course, didn't get most of them very far for long.

Standards shot up

Given the already apparent fallout in the subprime mortgage market, lending standards have shot up and the market for such investments has deteriorated. But that won't erase what's already out there, which is ugly and could get worse.

The demise of the Bear Stearns funds could be just the "tipping point of a broader fallout from subprime-mortgage deterioration that would lead to cascading deleveraging and ultimately ending with higher rates to new mortgage borrowers," according to a new report by Bank of America analyst Robert Lacoursiere.

He notes that mortgage borrowers are in a weaker position than in previous cycles because they have less of an equity cushion, devote higher levels of income to debt servicing and face higher interest rates in the upcoming waves of mortgage-rate resets. At the same time, a softening U.S. housing market makes repayment by sales an unlikely option.

Homeowners with about $515 billion on adjustable-rate home loans will pay more this year, and another $680 billion worth of mortgages will reset next year, Lacoursiere said. Of those ARMs, he estimates that 78 percent this year are subprime loans.

No doubt that many subprime borrowers shouldn't have been allowed to borrow money, but they still shouldn't be faulted for creating this mess. Doors were opened to them because Wall Street firms and the banks welcomed the business they brought, for their own greedy purposes.