September 30, 2007

The credit crisis sparked by rising loan defaults in the sub-prime mortgage market is spreading like a contagion to other asset classes, causing volatility in the stock market and continuing to wreak havoc on hedge funds that made bets on complex debt securities.

The turmoil has mostly affected U.S. hedge funds with exposure to collateralized debt obligations (CDOs) -- financial products that pool and securitize different kinds of corporate bonds, mortgages and derivatives. CDOs -- which are sold to investors worldwide, including pension funds and insurance companies -- are carved up into different risk layers, called tranches, based on the returns they offer and their likelihood to absorb losses should there be defaults.

The CDO market has been among the fastest-growing segments of the fixed-income markets and had a market value of $2 trillion in 2006, prior to the current crisis, according to estimates by Celent. Sales of CDOs last year reached $503 billion -- representing a five-fold increase in three years, according to published reports -- more than half of which contained sub-prime mortgages.

Many CDOs hold residential mortgage-backed securities (RMBSs) -- bonds created by pooling residential mortgages. Pooling the mortgages and selling the RMBSs to various investors is supposed to distribute the risk. However, rising delinquency rates by homeowners have impacted the cash flows to the CDOs and caused their values to plummet.

Bear's Bad Bets

The credit crisis began in late June when reports surfaced that two hedge funds managed by Bear Stearns Asset Management (BSAM) had suffered severe losses from investing in CDOs tied to loans in the sub-prime mortgage market. The two funds, the High-Grade Structured Credit Strategies Fund and the High-Grade Structured Credit Strategies Enhanced Leverage Fund, borrowed money to invest in the CDOs so they could magnify their returns. Bear Stearns reportedly raised more than $600 million from investors for the Enhanced Leverage Fund and threw in $35 million of its own capital.

Then Bear Stearns went out to the Street -- to investment banks including Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers, JPMorgan and Bank of America -- to borrow money to buy more CDOs. But Bear Stearns made a bad bet on the mortgage market as default rates from borrowers with shaky credit histories started climbing in February. "[The BSAM funds] had a loss in April [and] suspended redemptions in May," notes Ed Rombach, derivatives market analyst at Thomson Financial. "They couldn't calculate the losses because these instruments don't trade often. They are really theoretical prices."