Financial 'Katrina' begins to blow

For some days now, banks and finance houses have been watching the unfolding crisis at major investment bank Bear Stearns, as it tries to limit the fallout from the failure of two of its hedge funds. Like many such investors, Bear Stearns had a lot of products riding on the back of property-related debt, and, notably, the US "subprime" mortgage market. Subprime refers to the practice of making loans to borrowers who do not qualify for market interest rates because of problems with their credit history.

The two failed funds have grand titles: the High-Grade Structured Credit Strategies Enhanced Leverage Fund, and the High-Grade Structured Credit Strategies Fund. These meant-to-be reassuring names hide a high risk reality. In the trade, such products offered are based on credit with a quality rating politely referred to as "junk", or less politely, "nuclear" or "toxic" waste. The buyer gets the possibility of high returns, but runs the risk of getting little or none of his principal back. The "enhanced leverage" fund was worst hit because, as its name implies, the underlying capital represented only 10%, the rest being borrowed from other sources.

As we have discussed previously, the housing market in the US has been in decline for many months. It is leading the way down not just for the American economy but, behind the misleading appearance of continued worldwide growth, is having a major impact on the rest of the global economy. Subprime mortgages are the most risky ones where the homeowners are at least able to make the monthly payments. The rate of default has been accelerating, and many of the lenders have been forced into bankruptcy. This is a problem for the so-called securities houses like Bear Stearns which despite its reputation as one of the shrewdest actors in the mortgage market, with the best set of controls in place, finds its funds failing, and its customers and creditors scrambling to sell.

As the swirling clouds of credit and debt that have swelled the markets in hedge funds, and more recently private equity, have ballooned in recent years, it could only have been a matter of time before the iron law of value began to make itself felt. There is much speculation about the extent of the impact on the rest of the world’s financial markets. One of Bear Stearn’s investors put it like this: "They didn’t realise this was Katrina, they thought it was just another storm." According to The Economist "perhaps the most worrying thing for financial institutions holding mortgage-backed paper is not the subprime market itself, but the unnerving parallels with an even bigger one to which they are also exposed: leveraged loans to companies. As Daniel Arbess of Xerion Capital Partners points out, corporate lending's giddy leverage echoes the high loan-to-value ratios in subprime; … subprime, says Mr Arbess, might well be ‘a dress rehearsal for something bigger and scarier’."

Gerry Gold, economics editor