This one by is reader cursed…
The Bear Sterns hedge fund melt down has yet to be felt
I believe the Bear Sterns hedge fund melt down will have a far reaching impact, and it will directly affect the price of homes as well as all other asset classes.
The troubled Bear Sterns hedge funds contained collateralized debt obligations (CDO’s) that have been vastly overvalued, and they have leveraged to the hilt based on overvalued CDO’s. The rest of the investment banks in London and New York are likely also upside down on some of their positions.
In the late 80’s Drexel Burnham Lambert, home of the infamous junk bond king Michael Milken, started the CDO’s, although they did not really catch on till the last few years. Basically local banks sell the mortgages they originate to an investment bank, which repackages the mortgages into separate investment categories. The big investment banks sell these to one another, and then borrow huge sums against the supposed value of the CDO’s.
The problem is that few anticipated the high rate of home owners defaulting on their mortgage payments. Bear Sterns quickly infused their fund with a few billion dollars, but is seeking help with a larger fund. When they tried to sell some of the CDO’s on the open market the sale was quickly withdrawn, because nobody wanted to buy them.
There are about a trillion dollars of CDO’s floating around the big investment banks, so this is huge, and over the next couple of years about a trillion dollars of ARM’s will be reset upwards in the face of falling home values. Fannie Mae and Freddy Mac’s accounting shenanigans do not engender confidence, and I suspect that they too hold over valued assets.
The big investment banks are desperately hoping that this will not grow into a full blown crises, and I do not underestimate the bright, energetic and powerful people, who are working around the clock to prevent this contagion from spreading.
However, highly leveraged investment houses that in the past few years have bid up all asset classes into bubble territory will have to unwind many their positions as the fraudulently valued CDO’s are reappraised. Say the CDO’s are actually only worth 75 percent of what they had been valued, this wont simply mean a 250 billion dollar write down, because the investment banks leveraged their bets times ten, so actually this is going to take two and a half trillion dollars out of play. This is going to sop up more then just excess liquidity.
The Federal Reserve will soon be forced to lower its rates in the face of falling asset values, combined with a slowing economy. The rest of the worlds central bankers have indicated that their rate tightening cycle is not yet complete, so the US will be swimming against the current. This will most likely precipitate another down ward leg for the dollar.
Best of luck to all!