US subprime woes start to spread

Stock markets across the world had an attack of the jitters last week, led by Wall Street. A key worry is that two hedge funds run by US investment bank Bear Stearns - which made some bad bets on the US housing market - could collapse. So what exactly is the problem - and could it be the start of something big?

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Stock markets across the world had an attack of the jitters last week, led by the US. On Friday, the Dow Jones lost more than 100 points, to close down at 13,360.

One of the key worries is the condition of two hedge funds ran by investment bank Bear Stearns. The funds both invested in securities related to the US subprime mortgage market - the elephant in the global economy's living room that all the participants are desperately trying to ignore in the hope that it will just go away.

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So what exactly is the problem - and could this be the start of something bigger?

Two of Bear Stearns' hedge funds - the High-Grade Structured Credit Fund and the High-Grade Structured Credit Enhanced Leverage Fund - are experiencing problems. In essence, the funds made some bad bets on the US housing market, and now they've run into trouble. Other banks that had loaned the funds money to make those bets now want it back, but they don't have it.

The troubles emerged when Bear Stearns stopped investors in the second fund (the enhanced leverage' one) from pulling money out - which is, as Bloomberg put it, "the first sign of an impending collapse." So naturally, "the investment banks who had lent money to the Bear Stearns hedge funds said We want our money back. And if we can't get our money back right away, we may seize collateral and sell it,'" Janet Tavakoli of Tavakoli Structured Finance told CBS.

Some of the banks reached deals with Bear Stearns, but others - including Merrill Lynch - began selling assets, or are at least considering doing so. Bear Stearns seems to have saved the first fund for the moment, by putting up $3.2bn of its own money to bail it out, but it looks like the second will be wound down.

The idea the funds might collapse certainly has some analysts worried.

"The demise of two Bear Stearns managed Leveraged Mortgage Funds could be the tipping point of a broader fallout from subprime mortgage credit deterioration that would lead to cascading de-leveraging and ultimately [end] with higher rates to new mortgage borrowers," reported Bank of America analysts last week.

So how would this happen? Well, derivatives are complicated beasts, but like most things in finance, the basic concepts aren't that difficult to get your head around.

The big problem with the Bear Stearns funds is that a lot of the assets they have are of dubious quality and are illiquid - in other words, they don't change hands very often. That means that no one is entirely sure of how much those assets are actually worth. And that situation is made worse by the fact that in the wake of the subprime mortgage collapse, they are probably worth much less than they were when everyone in America still believed that house prices could only go up.

"The problem is not what we see happening but what we don't see," Joseph Mason, of Drexel University in Philadelphia, told Bloomberg. "We don't know the price of these assets. We don't know which banks are exposed to this sector. These conditions are classic conditions for financial crises across history."

If Bear Stearns has to sell off its assets, it will probably reveal that they are worth much less than anyone had thought. And that means that anyone else who has invested in similar assets could see huge writedowns on their value it could also lead to a sharp rise in the number of people trying to rush out of the market.

In any case, even if the two funds go down without much of a wider impact, it shows that the problems caused by the troubled US housing market are a long way from being over. Many analysts and authority figures are keen to point to a bottom in the market, or suggest that the impact will be restricted to a very small portion of the population - the poor, basically, who should never have been able to get hold of these home loans in the first place.

But house prices in the US are already falling, while lending standards are tightening. That has an impact on everybody. With the savings rate well into negative territory, where it has been for a long time, US consumers (and not just the 'poor' ones) have been relying on being able to borrow money against the ever-increasing value of their homes for a long time, particularly as wage growth hasnt been enough to provide much of a boost to the average person's standard of living.

Now they can't do that anymore. So if you can't borrow more money, then you either have to cut back on your spending, or you have to earn more. And one of the easiest ways to earn more is to demand more from your employer. And why shouldn't employees ask for more? After all, we're always hearing about how the global economy is in a sweet spot' and that times have never been so good and that corporate profits are at record levels compared to employees' wages - why shouldn't the workers demand a bigger slice of that?

Of course, the problem with that is that higher wage demands tend to drive up inflation. That puts pressure on interest rates to rise too, and that makes debt servicing even harder. As the US (and the UK) economic 'miracles' have been built on cheap debt, its absence is likely to kick the legs from under them. Already in the UK we're hearing concerned noises from more and more retailers - music chain Fopp was forced to deny rumours of impending financial problems at the weekend, for example.

Yesterday the Bank for International Settlements (the BIS, or the central banker's central bank' as it's also known) warned of the consequences as borrowing becomes more expensive. "Given the key role that a benign credit environment has been playing in boosting the performance of the financial sector over the past years, a turn in the credit cycle represents a significant risk to its outlook."

So Bear Stearns may live to fight another day - but the more testing times for the global economy are just beginning.

Turning to the stock markets

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In London, the FTSE 100 ended Friday in the red as financial stocks weighed, losing 28 points to close at 6,567. Insurers Friends Provident and Resolution were among the day's biggest fallers whilst Barclays and Royal Bank of Scotland were also weaker. It was a better day for retailers, however, with Tesco, Home Retail Group and Morrison's all making good gains. For a full market report, see: London market close.

Elsewhere in Europe, the Paris CAC-40 closed 17 points lower, at 6,023, whilst the Frankfurt DAX-30 was 15 points lower, at 7,949.

On Wall Street, stocks closed sharply lower after a day of volatile trading. The Dow Jones was 185 points lower, at 13,360. The S&P 500 was down 19 points to end the day at 1,502. And the tech-heavy Nasdaq fell 28 points to close at 2,589.

In Asia, markets were hit by Friday's weakness on Wall Street. The Japanese Nikkei was 101 points lower, at 18,087, and the Hong Kong Hang Seng was down 185 points at 21,841.

Crude oil futures had given up Friday's gains today, last trading 46c lower at $68.68. In London, Brent spot had fallen 41c to $72.30.

Having risen over $2 on Friday, spot gold was holding steady at $653.05 this morning. Silver, meanwhile, was last trading at $13.02.

Turning to the foreign exchange market, the pound was at 1.9989 against the dollar and 1.4866 against the euro, whilst the dollar was at 0.7437 against the euro and 123.64 against the Japanese yen.

And in London this morning, Europe's third largest hedge fund manager GLG Partners agreed to a $3.4bn takeover by US-based Freedom Acquisition Holdings Inc. The deal will give GLG a Wall Street listing and access to the American market.

And our two recommended articles for today...

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.