reality-based educator

For a while now we have heard from the Federal Reserve that the subprime mortgage mess is "well-contained" and that while it probably will hurt a few investors with the bad luck to own bonds backed by defaulting mortgages, the American economy as a whole should not be terribly affected. But then today we learned this from the Wall Street Journal:

Investors in two troubled Bear Stearns Cos. hedge funds that made big bets on subprime mortgages have been practically wiped out, the Wall Street firm said yesterday, in more evidence of the turmoil in this corner of the bond market.

Bear said one of its funds was worth nothing and another worth less than a 10th of its value from a few months ago after its subprime trades went bad, according to a letter Bear circulated and to people briefed by the firm. The Wall Street investment bank -- known for its bond-trading savvy -- has had to put up $1.6 billion in rescue financing.

...

The revelations marked another anxious day for subprime investors. As a market index that tracks the performance of subprime bonds hit new lows, signs emerged that the pain experienced by Bear's hedge-fund investors is being felt by investors around the world.

Wall Street firms yesterday circulated at least a dozen lists of subprime-related bonds they planned to hastily sell to investors. Some of the assets were from a fund managed by Basis Capital, a large hedge-fund manager based in Australia, and were put on the block by Citigroup Inc. and J.P. Morgan Chase & Co., according to people familiar with the matter.

Basis Yield Alpha Fund last week informed its investors it had lost around 14% in June. Another fund, called Basis Pac-Rim Fund, was down 9.2% that month. Basis said the declines came after bond dealers abruptly marked down the value of the securities, which it said were "otherwise fundamentally sound."

Investors are struggling to place values on assets tied to subprime home loans. Because some of these instruments aren't actively traded, investors worry that they are holding securities on their books at values that are no longer accurate.

...

Last week, Moody's Investors Service and Standard and Poor's, the two big credit-rating services, knocked down their assessments on hundreds of mostly lower-rated subprime-backed bonds.

Delinquencies and defaults have been rising on subprime mortgages -- which are taken out by borrowers with shaky credit backgrounds. Some of these mortgages were subject to fraudulent loan documentation when they were written.

The problems haven't filtered into the stock market, which hit new records yesterday. But the mortgage-bond market is filled with uncertainty, and investors show signs of aversion to risky corporate bonds, too.

"Right now things are starting to come unglued," said Charles Gradante, co-founder of hedge-fund consultant Hennessee Group.

The net value of assets in Bear's highly indebted fund, High-Grade Structured Credit Strategies Enhanced Leverage Fund, is wiped out, according to people familiar with the matter, who were briefed on the contents of a late-afternoon call with brokers. The net value of assets in its other, larger, less-leveraged fund is roughly 9% of the value at the end of March, these people said. The net-asset value represents the value of an investor's holdings after debts have been paid.

When terms like "coming unglued" and "wiped out" are being used to describe the problems with hedge funds related to the subprime mortgage market, can Fed Chairman Ben Bernanke still say with a straight face that concerns are "well-contained?"

If he were honest, probably not.

And yet he's not, so he will say concerns are "well-contained."

And investors will act like they believe him.

This is a slow moving train wreck, because it takes a while for homeowners who have defaulted on their mortgages to have their homes foreclosed. sop they will get away with this for a while.

But with so many ARMs readjusting over the next two years and with inflation on the rise and interest rates either stagnant or rising, there looks to be little relief for defaulting borrowers and homeowners.

And thus there will be a lot more stories about hedge funds backed by subprime mortgages that are now essentially worthless.

I wonder which hedge fund my teachers pension is invested in and when I will learn that it has been "wiped out?"

UPDATE: Actually, Bernanke admits the fall-out from the subprime mortgage mess is no longer well-contained. Nonetheless, he says overall "Don't Worry, Keep Buying..."

"However, conditions in the subprime mortgage sector have deteriorated significantly, reflecting mounting delinquency rates on adjustable-rate loans. In recent weeks, we have also seen increased concerns among investors about credit risk on some other types of financial instruments. Credit spreads on lower-quality corporate debt have widened somewhat, and terms for some leveraged business loans have tightened. Even after their recent rise, however, credit spreads remain near the low end of their historical ranges, and financing activity in the bond and business loan markets has remained fairly brisk."

So, not well-contained, but still, all is well.