Answers About Bear Stearns’ Mortgage Exposures

Yesterday, I wondered

what the connection was between the weak subprime-mortgage market, on the one

hand, and some weakness in the second-quarter results from Bear Stearns and

Goldman Sachs, on the other.

Today, Kate

Kelly and Serena Ng of the WSJ try to answer some of those questions, although

their article is a bit confusing. It starts off by talking about a Bear Stearns

hedge fund, which has indeed taken a serious bath in subprime mortgages, but

which hasn’t had a significant effect on Bear’s bottom line. Later on, they

seem to continue to elide the difference between the performance of managed

funds and the banks’ operating results:

Both Goldman and Bear yesterday sounded one common chord: that continued

troubles in the mortgage market remain a big worry.

With the sort of weakness investors are seeing in the subprime market, "there’s

no hedging strategy you’re going to be able to employ that’s going to completely

immunize you," said Sam Molinaro, Bear’s chief financial officer, in

an interview. Investors have made big profits on subprime loans in recent

years, and losses on risky mortgage loans "are to be expected,"

he added. "While you don’t like to have them, it’s a fact of life in

the business."

In a call with reporters, Goldman finance chief David Viniar was even blunter.

"I don’t think we’ve seen the bottom" of the subprime problems,

he said.

Bear, which is known for its tough risk controls, has so far been unable to

navigate its way out of the turmoil. This raises the specter that other Wall

Street funds are sitting on big losses that could crop up in the days and

weeks ahead.

I do understand that banks generally make more money in bull markets than in

bear markets. But what exactly are the losses being talked about by Bear’s Molinaro,

here? Are they losses for the bank, or losses for investors? And the same question

can be asked of those hypothetical "Wall Street funds" which might

be sitting on large losses.

To the rescue comes my favorite informant on matters subprime, who sent me

an email yesterday explaining a lot of this. (He hasn’t given me permission

to use his name yet, so for the time being he’ll remain anonymous.) Firstly,

he explains why the subprime losses are showing up in the banks’ second-quarter

results, rather than their first-quarter results.

The reason is that the subprime meltdown didn’t really happen until the end

of the banks’ first quarter, which ended in February. So in a large part of

their first quarter they continued to make money by securitizing and trading

subprime mortgages, as well as by lending money to subprime originators. Then,

when the bottom fell out of the market in February, volatility spiked upwards,

and banks generally make money in times of high volatility. So what they lost

in terms of securitization and lending revenues they made up for on the trading

floor.

In the second quarter, however, volatility fell back down, but there was much

less activity on the lending and securitization fronts. Which means the banks

were hit on both fronts, and there was no way for them to make money in the

subprime sector. Unless and until subprime wakes up again, it’s unlikely to

be a source of much profit for banks. And of course if a sector was providing

large profits and now provides very little in the way of profits, then that

means the bank’s profits are falling. In journalists’ shorthand, this often

equates to "losses" in the sector: the important thing is not whether

profits are greater than zero or not, but rather whether they’re going up or

going down.

The sector is still alive: the same WSJ story reports that Merrill Lynch yesterday

launched a $1.6 billion bond issue backed by subprime mortgages, which "generated

significant investor interest". But such deals were certainly much more

common a year ago than they are now. And with long-term interest rates rising,

consumers’ appetite for new housing debt is sure to be constrained.

Banks such as Bear Stearns and Lehman Brothers have made a lot of money in

recent years from the mortgage sector in general and the subprime part of it

in particular. For the foreseeable future, they’re going to have to look elsewhere

for those profits.

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