Another Shoe

It has never been clear to us common folk what mortgage-backed securities look like when Wall Street sells them. A pessimist would say something like, "Those guys would sell ANYTHING regardless of its investment merit."  One trick seems to be to come up with a clever name, like Bear Stearns High-Grade Structured Credit Strategies fund.  Do you know what that means? Neither do I.  High-Grade is a nice sounding name but high-grade compared with what? And what is a structured credit strategy?

What it means is whatever it says in the prospectus that was given to investors, and that may not have much similarity with its name. A relatively small specialty in the legal profession creates these many-paged documents that the average investor never reads.  Even professional investors are probably relying more on what the salesman tells him about the safety of the product than in specific wording in the prospectus. Yet, when the fund heads south and investors want to sue to get their losses covered, you can bet the Wall Street firm will say, "This was properly disclosed in the prospectus."

Then comes along the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund. What this means is that the fund can go borrow more money than just what investors put into the fund and buy more mortgages.  Word has it that these kinds of funds routinely borrow $9 for every $1 in equity. That means that a fund can start out with $100 million in investor money, borrow $900 million and buy $1 billion in mortgages.

Now let's assume for the moment that each mortgage does not exceed 90% loan-to-value, more conservative than the 100% financing widely available.  That means that the equity behind those mortgages is only $100 million. It doesn’t take a rocket scientist to tell that a modest decline in property values and an increase in the foreclosure rate can destroy most of the equity in the fund. 

And then there's that $900 million of money that some lender probably wants back. Depending on what the credit agreement says, the lenders might have some ability to step in and TAKE enough mortgages to cover its loans, and that may mean the investors get wiped out.

At this point, Bear Stearns has indicated that it will put $3.2 billion (gag!!) into the first fund mentioned, hoping to stave off collapse. But it looks as if the leveraged fund investors are on their own and that they will suffer significant losses.

That's another shoe, and I think that there are still others around.

Stay tuned.

For more information, check out http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=aYDTeHYnV3ms