Bear Stearns' Funds in Trouble!

Stock markets across the world had an attack of the jitters last week, led by the US. On Friday, the Dow Jones lost more than 100 points, to close down at 13,360. One of the key worries is the condition of two hedge funds ran by investment bank Bear Stearns.

The funds both invested in securities related to the US subprime mortgage market - the elephant in the global economy’s living room that all the participants are desperately trying to ignore in the hope that it will just go away. So what exactly is the problem, & could this be the start of something bigger?

Two of Bear Stearns’ hedge funds - the High-Grade Structured Credit Fund & the High-Grade Structured Credit Enhanced Leverage Fund - are experiencing problems. In essence, the funds made some bad bets on the US housing market, & now they’ve run into trouble. Other banks that had loaned the funds money to make those bets now want it back, but they don’t have it.

The troubles emerged when Bear Stearns stopped investors in the second fund (the ‘enhanced leverage’ one) from pulling money out - which is, as Bloomberg put it, “the first sign of an impending collapse.” So naturally, “the investment banks who had lent money to the Bear Stearns hedge funds said – ‘We want our money back. And if we can’t get our money back right away, we may seize collateral & sell it,'”.

Some of the banks reached deals with Bear Stearns, but others - including Merrill Lynch - began selling assets, or are at least considering doing so. Bear Stearns seems to have saved the first fund for the moment, by putting up $3.2bn of its own money to bail it out, but it looks like the second will be wound down.

The idea the funds might collapse certainly has some analysts worried. The demise of two Bear Stearns managed Leveraged Mortgage Funds could be the tipping point of a broader fallout from subprime mortgage credit deterioration that would lead to cascading de-leveraging & ultimately end with higher rates to new mortgage borrowers.

So how would this happen? Well, derivatives are complicated beasts, but like most things in finance, the basic concepts aren’t that difficult to get your head around. The big problem with the Bear Stearns funds is that a lot of the assets they have are of dubious quality & are illiquid - in other words, they don’t change hands very often. That means that no one is entirely sure of how much those assets are actually worth. And that situation is made worse by the fact that in the wake of the subprime mortgage collapse, they are probably worth much less than they were when everyone in America still believed that house prices could only go up.

The problem is not what we see happening but what we don’t see! We don’t know the price of these assets. We don’t know which banks are exposed to this sector. These conditions are classic conditions for financial crises across history.

If Bear Stearns has to sell off its assets, it will probably reveal that they are worth much less than anyone had thought. And that means that anyone else who has invested in similar assets could see huge writedowns on their value – it could also lead to a sharp rise in the number of people trying to rush out of the market.

In any case, even if the two funds go down without much of a wider impact, it shows that the problems caused by the troubled US housing market are a long way from being over. Many analysts & authority figures are keen to point to a bottom in the market, or suggest that the impact will be restricted to a very small portion of the population - the poor, basically, who should never have been able to get hold of these home loans in the first place.

But house prices in the US are already falling, while lending standards are tightening. That has an impact on everybody. With the savings rate well into negative territory, where it has been for a long time, US consumers (not just the 'poor’ ones) have been relying on being able to borrow money against the ever-increasing value of their homes for a long time, particularly as wage growth hasn‘t been enough to provide much of a boost to the average person’s standard of living.

Now they can’t do that anymore. So if you can’t borrow more money, then you either have to cut back on your spending, or you have to earn more. And one of the easiest ways to earn more is to demand more from your employer. And why shouldn’t employees ask for more? After all, we’re always hearing about how the global economy is in a ‘sweet spot’ & that times have never been so good & that corporate profits are at record levels compared to employees’ wages - why shouldn’t the workers demand a bigger slice of that?

Of course, the problem with that is that higher wage demands tend to drive up inflation. That puts pressure on interest rates to rise too, & that makes debt servicing even harder. As the US economic 'miracles’ have been built on cheap debt, its absence is likely to kick the legs from under them.

Yesterday the Bank for International Settlements (the BIS, or the ‘central banker’s central bank’ as it’s also known) warned of the consequences as borrowing becomes more expensive. “Given the key role that a benign credit environment has been playing in boosting the performance of the financial sector over the past years, a turn in the credit cycle represents a significant risk to its outlook.”

So Bear Stearns may live to fight another day - but the more testing times for the global economy are just beginning.

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