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Fund Woes Drag Down Home-Loan Bonds
Asset Backed Alert, Harrison Scott Publications Inc. (July 20, 2007)

The values of subprime-mortgage securities are plummeting again, as hedge funds that invest in such products stampede to liquidate their positions.

The erosion of values is occurring across the credit spectrum, even affecting senior products that are generally perceived as safe bets to remain insulated from performance problems within their underlying loan portfolios. Over the past week, for example, secondary-market spreads on five-year, triple-A-rated bonds backed by subprime mortgages and home equity loans have swelled by 10-15 bp.

Those instruments are now trading around 55-60 bp over Libor. Industry players expect spreads to keep climbing for the next few months as more hedge funds face pressure to bow out of the sector.

The market's wobbly state is connected in part to the well-publicized struggles of two Bear Stearns hedge funds: Bear Stearns High-Grade Structured Credit Strategies Fund and a sister vehicle called Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund. Both were hit with massive margin calls last month after bets they had placed on subprime-mortgage instruments lost value, eventually resulting in the liquidation of much of their holdings.

By this week, Bear was reporting that the value of the remnants of High Grade Structured Credit Strategies Fund had sunk to less than one-tenth of the $925 million that investors had put into the fund, while the $638 million Enhanced Leverage entity was essentially worthless.

As the blowups reverberate throughout the financial markets, inventories are coming on the market from a growing number of similar vehicles. Some of the sales are being conducted by managers who were instructed by margin lenders to either put up more securities against the money they borrowed or repay their debts. Others are coming from the margin lenders themselves, after seizing assets held by the vehicles.

Selloffs are also springing up from fund managers who need to liquidate their positions after shareholders - fearing further troubles among vehicles that invest in subprime-mortgage bonds, CDOs backed by such securities and related derivative instruments - asked for their money back.

Among those caught in the onslaught were Basis Capital's Basis Yield Alpha Fund and Basis Pac-Rim Fund. The Wall Street Journal reported this week that Citigroup and J.P. Morgan Chase were offering subprime-mortgage bonds held by the vehicles, after both lost money last month due to markdowns of their holdings.

United Capital's Horizon ABS vehicles also halted investor redemptions this month after losing money in the market for subprime-mortgage securities.

The result of so many of those funds' holdings hitting the secondary market all at once is that the volume of securities up for bid has exceeded the ability of other investors to absorb them, causing spreads to widen. That marks a continuation of issues that have been haunting the subprime-mortgage industry all year, as more borrowers default or fall behind on their loans.

The current supply-and-demand discrepancy is magnified by the fact that the hedge funds who are now sellers previously made up a sizable portion of the market's investor base. There has been somewhat of a domino effect too, as the resulting bad press further suppresses demand by scaring other investors away from subprime-mortgage bonds and CDOs backed by them.

For the hedge fund managers that need to unload positions, meanwhile, it often makes the most sense to shop holdings of more-liquid triple-A-rated securities - which explains why spreads on those products are widening even though their senior status means they stand little chance of defaulting.

The new-issue market is also feeling the pinch. A $24.2 million batch of 7.2-year senior bonds that Bayview Financial incorporated into a $370 million subprime-mortgage securitization this week sold for 55 bp over Libor. A week ago, C-Bass placed a similar piece of a $433 million issue at 34 bp over Libor.

New-deal supply was said to have dried up this week for that reason and others.

It wasn't long ago that the values of subprime-mortgage bonds were on the comeback trail, following a big dip when the market's widespread troubles first surfaced. In fact, many triple-B-rated products were trading near their pre-bust levels heading into June - before word of Bear's struggles began to emerge.

In recent weeks, Moody's and S&P have downgraded billions of dollars of bonds backed by subprime mortgages. S&P also cut grades on $3.8 billion of home-equity loan securities this week, lowering some from triple-A to triple-B.



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