Shaky Markets Prompt Rumors of Who’s in Trouble (NYTimes, 8/10/07)

August 10, 2007
Shaky Markets Prompt Rumors of Who’s in Trouble
By JULIE CRESWELL
The global stock and bond markets these days seem to be playing a giant game of hide and seek.
In this version, played on a global field, investors are scrambling to discover which banks, hedge funds or public companies are holding potentially hundreds of billions of dollars in bad loans and subprime-related mortgage securities that are imploding.
On any given day, traders are exchanging rumors of a hedge fund that has blown up or a Wall Street brokerage firm that has incurred losses in subprime or other mortgage-related securities, creating a frenzy and a whipsaw of trading activity in the stock and bond markets.
So far, most rumors have turned out to be unsubstantiated and untrue. Still, exposure to and losses from subprime and other mortgage-related securities are being revealed, slowly, in all corners of the world.
Yesterday France’s largest bank, BNP Paribas, stopped withdrawals from three of its asset-backed securities funds, saying it could no longer value them accurately because of problems in the subprime market in the United States.
Also yesterday, the insurance giant American International Group revealed that it held $28.7 billion in subprime securities, but that given its size, it was not under any pressure to sell the securities at a loss.
Already the turmoil in the mortgage market has led Germany’s central bank, the Bundesbank, to bail out a bank, IKB Deutsche Industriebank, that held subprime investments. Several hedge funds in the United States, four in Australia and at least four additional funds in Europe have either closed or halted investor withdrawals as they sort out the value of their subprime and other mortgage-related investments.
In reaction to the growing losses on subprime mortgages and related securities, the European Central Bank stepped in yesterday morning and provided $130.2 billion in emergency loans to European banks while the Federal Reserve injected $24 billion in liquidity into the United States banking system.
Capital markets have undergone periods of extreme turmoil and lack of liquidity in the past. In 1998, the credit markets virtually froze up after the hedge fund Long-Term Capital Management buckled and Russia defaulted on its debts. Many investors dumped mortgage securities into the market and prices tumbled.
Yet, the nervousness seems more intense given the amount of leverage, or borrowed money, that had been made available to hedge fund investors in the subprime and mortgage arena. The use of borrowed money, along with the sheer size of the mortgage market, should only worsen investor losses.
“This is a market that has grown tremendously in the last five years,” said Professor Stijn Van Nieuwerburgh of the Stern School of Business at New York University, “and whereas a lot of the mortgages were previously held by banks, now, particularly with subprime mortgages, they are held by a lot of new players who are essentially just getting used to them.”
Last year, Wall Street firms issued $773 billion in mortgage-related securities, up from $217 billion in 2001, according to the Securities Industry and Financial Markets Association.
Yet trying to ferret out which one of these relatively new players will be the next to report big losses on subprime or mortgage-related securities, whether they be an Asian bank or American hedge fund, is difficult.
Unlike investors who hold large stakes in publicly traded American stocks, and must report those holdings to the Securities and Exchange Commission, no central government agency or private organization tracks who may be holding subprime or other mortgage-related securities in any detail. (The United States Treasury does track broad foreign country holdings of American mortgage securities.)
“I don’t think any of the regulators have a handle on where the net exposure of subprime is,” said Christopher Whalen, managing director of Institutional Risk Analytics, which builds risk systems for regulators and auditors.
Mr. Whalen said the situation was worse in Europe, where even less public data was available.
Furthermore, because of accounting rules, some holders of these mortgage-backed securities do not have to own up to or recognize any losses until they actually sell them.
But these days, trying to value certain subprime securities or the more complicated collateralized debt obligations, or C.D.O.’s, which are pools of mortgage securities, is difficult as well.
Unlike stocks that trade openly on exchanges and whose value can easily be determined at any point of the day, mortgage-related securities and C.D.O.’s change hands behind the scenes via individual bids and offers made on trading desks across Wall Street.
And while, typically, billions of dollars of securities can move in and out of these markets with great ease, in recent weeks trading in mortgage-related has seized up because Wall Street firms are reluctant to buy or sell them, many traders and portfolio managers said.
Trading in C.D.O.’s has become a “standoff” said James L. Melcher, president of Balestra Capital, a New York-based hedge fund.
Jokingly, Mr. Melcher said the attitude of some investors in C.D.O.’s seems to be: “I am dancing here. Don’t bother me about this iceberg we have hit.”
If there is an upside to the mortgage meltdown, some analysts said, it may be that because these securities are held by so many investors the pain will be spread among many market participants instead of taking down a large single financial institution.
Indeed, two rating agencies, Moody’s and Standard & Poor’s, said this week that the large American investment banks face modest risks and manageable losses because of subprime-mortgage losses.
“The good news is that the losses will be widely distributed across the different owners of these pools of securities,” said Stuart A. Gabriel, a finance professor at the Anderson School of Management at the University of California, Los Angeles.
“The bad news,” he said, “is because of the difficulties in valuing these mortgage pools and the high levels of uncertainty and panic that have set into these markets, we have a situation where there is a severe lack of liquidity in the mortgage market and that has created an extremely dangerous situation for our economy and the global economy.”
Eric Dash and Vikas Bajaj contributed reporting.