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A Sub-Prime Ripple?

Will the problems at a Bear Stearns hedge fund spread to the rest of the economy?

12:00 AM, Jun 26, 2007 • By IRWIN M. STELZER
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IF YOU ARE one of those people who doesn't mind worrying, really worrying, think of the High Grade Structured Leveraged Credit Strategies Enhanced Leverage Fund. The hedge fund, run by Bear Stearns, is struggling to raise cash so that it can avoid passing into the dustbin of history. Like another Bear Stearns fund that holds similar assets but is not so heavily leveraged, the fund's assets consist in good part of bonds backed by sub-prime mortgages, loans made to borrowers whose histories or incomes make them less-than-good risks. Rising default and late-payment rates have called the value of these mortgages into question, prompting the banks that lent the fund $6 billion to demand repayment of their loans. Since the fund has only $600 million in investors' capital, Bear Stearns has no way of repaying its creditors, and at this writing is scrambling to obtain new loans and new equity capital. In short, the fund finds itself in a position not very different from that of tiny sub-prime borrowers, only on a larger scale.

This might merely be a matter of no concern to policymakers: bad luck for well-informed and well-heeled investors and lenders such as Barclays PLC, Merrill Lynch, and Citigroup who underestimated the risk involved in investing in this fund. But there might be collateral damage which affects innocent bystanders. If the assets that underlie the fund, now being auctioned off, bring only knock-down prices, similar assets now valued in the trillions, might also be revalued sharply downward. That would hit the earnings of several big banks, reducing their willingness and ability to lend, possibly contributing to the slowing effect on the economy of falling home sales. If very early reports that some of the items in the portfolio are selling for ten-cents-on-the-dollar prove to be true, some banks, endowment funds, and others will have a lot of explaining to do. To calm markets and preserve its reputation in the bond market, in which it is a major player, late last week Bear Stearns bailed out the sister fund by agreeing to lend it up to $3.2 billion. But the highly leveraged fund remains, as the jargon goes, "troubled."

But before being becoming consumed with worry, know two things. The financial markets have so far reacted with an indifferent shrug. And the people on top of this situation do not see any such systemic risk in the economy's future. I base that on talks with key government officials who are paid to watch these things. A composite of that information looks something like this:

The problem of defaults and repossessions is not a trivial one, but neither is it likely to bring down the economy. The mortgage-market turmoil has several causes. The recent rise in interest rates caused monthly payments on adjustable-rate mortgages to rise to levels that many sub-prime borrowers cannot meet. Most of the problems are concentrated in the "rust belt" states, where workers in industries suffering from a combination of mismanagement, rapacious trade unions, and imports are finding it difficult to keep their mortgage payments current. Since any candidate who hopes to capture the White House must carry these states, attention must be paid. Also, disproportionate numbers of the troubled borrowers are black, adding to the political heat generated by the defaults. Most important, key policymakers believe in the social value of widespread home ownership, and are eager to keep credit markets open to sub-prime borrowers, many of whom prove to be good credit risks.

Still, there is a feeling in some political and pundit circles that if a borrower takes on debt he cannot repay, and his house is forfeit, that is his problem, and not society's. And if lenders are foolish enough not to inquire into the borrowers' ability to carry the loans, they deserve the losses they will inevitably face.

Unfortunately, life is not so simple. Since defaults and repossessions are concentrated in relatively few areas, the sprouting of for-sale signs on the repossessed properties drives down the values of the houses owned by families who are able to meet their mortgage obligations. In addition, families in arrears often reduce expenditures on maintenance, creating eye-sores that adversely affect a neighborhood's appearance and the value of properties owned by solvent homeowners.

Such circumstances can breed social problems such as higher crime rates, truancy, and neighborhood slovenliness. Which is why Freddie Mac chairman and CEO Richard Syron told Congress that his organization, which benefits from an inferred government guarantee of its securities, feels it part of its reciprocal obligation to "to develop more consumer-friendly sub-prime products that will provide stable financing alternatives going forward."