Friday, June 15, 2007

Mortgage Defaults, Hedge Funds and Market Liquidity

From the WSJ:

Mr. Cioffi, 51 years old, has been at Bear for 22 years and is a mortgage-market veteran. But his riskier fund lost nearly one-fourth of its value in the first four months of this year. In recent days, lenders led by Goldman Sachs Group Inc. and Bank of America Corp. began making margin calls on the fund, requesting additional cash or collateral.

Yesterday, seeking to raise the cash, Mr. Cioffi's funds auctioned off nearly $4 billion in some of their highest-quality mortgage bonds. The auction went smoothly, but now Mr. Cioffi's funds are left holding riskier investments that could be harder to sell. Wall Street was watching the sale closely yesterday, fearing the market could soon be flooded with low-quality mortgage securities in the weeks to come.

Mr. Cioffi didn't return a call for comment.

Whether the Bear sale raised enough money to meet redemption requests and margin calls -- requests from lenders for additional cash or collateral -- remains to be seen. Late yesterday, a number of creditors for the two funds met with its managers, but the outcome of the meeting wasn't known.

This leads to a lot of very important points.

1.) Mortgage market 101: Mortgage lenders makes loans to individuals. After the lender closes the loan, they usually sell to loan to an investment bank. The investment bank than pools loans with similar characteristics into mortgage-backed securities, which are then sold to various investment institutions. Everything is fine so long as all the players in this chain of events are able to move product at a profit. Once that profit disappears, the players disappear and mortgage liquidity dries up. Then it becomes harder to make loans, which further lowers housing demand.

2.) One of the main concerns with hedge funds is they don't have any reporting requirements: no one simply knows what assets they hold, or what the value of those assets are. Because there are a lot of hedge funds out there right now, there could be a ton of portfolios that have large mortgage losses that no one knows about.

3.) This situation reminds me of the S&L problem in the 1980s. At first there were no problems. Then a few problems started to come into light. Then the damn broke.

4.) So far, the mortgage market has been very resilient. It has taken a ton of really bad hits and survived really well. However, every system has limits to how much stress it can tolerate. Is the mortgage market approaching that limit? There's no way to tell.