Here comes the credit crunch

The markets were sent reeling yesterday by news that there is practically no value left in two Bear Stearns' hedge funds that were invested in subprime mortgage debt. But this could just be the beginning. John Stepek reports on how the subprime disease looks to be spreading to other credit markets.

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"How many Wall Street types does it take to value a collateralised debt obligation?" asks Lex in the FT this morning.

It's not the snappiest joke in the world, and the punch line isn't particularly funny either. It's taken weeks for its analysts to figure out, but investment bank Bear Stearns has finally unveiled the extent of the losses suffered by investors in its beleaguered hedge funds.

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The revelation that there was practically no value left in the funds sent markets reeling. But this could just be the beginning

Bear Stearns yesterday revealed to the world just how much value was left in its two hedge funds that were invested in subprime mortgage debt. Investors in the most highly leveraged fund will get none of their money back. Investors in the less risky one, will get nine cents for every dollar they put in - in other words, they've lost 91% of their money.

This was worse than many had hoped. That's partly down to the current mood of blind optimism on Wall Street, but also because the funds had only actually invested in the higher-rated tranches of CDOs. In other words, this is the investment grade stuff we're talking about.

The trouble is, the only difference between the bits of CDOs that ratings agencies gave high grades to, and those granted sub-investment grade rating, is distance. They're all the same trashy sub-prime mortgage debt, it's just that the lower grades take the pain from anyone defaulting first.

As Lex sums up nicely, the AAA-rated tranches "don't have better collateral, just more protection from losses because more junior tranches stand as a buffer."

The trouble is, subprime defaults have soared far beyond expectations (or at least, the expectations of anyone who thinks lending money to people with no proof of income is a good idea). And it seems that means that the shielding of the lower tranches has been ripped to shreds, leaving the higher tranches vulnerable too.

Obviously, the big worry now is that everyone else holding this kind of debt will hit the buffers too. As Lex puts it, "the next time a subprime-focused hedge fund takes its time providing a firm net asset value to its investors, expect the worst."

But it's not just about subprime, which the optimists keep blithely saying is only a small part of the market. The fear caused by not knowing when the next hedge fund is going to revalue all the way down to zero has the potential to hurt other credit markets too.

Here's just one example. Yesterday, another investment bank, JP Morgan Chase announced some decent second quarter figures. But the results were overshadowed by chief executive Jamie Dimon's clear concerns over the amount of money banks have agreed to lend to private equity firms.

Banks have agreed to lend private equity firms an estimated $100bn in total, says the FT but they haven't actually financed this yet. They plan to fund this with "the issue of high-yield bonds in the next few months. Mr Dimon acknowledged that this was a lot' for the market to absorb but there had been no deterioration in the creditworthiness of the borrowers."

But you know, the last batch of investment grade high-yielding debt that the markets lapped up turned out to be pure poison. So maybe investors won't be quite so keen to help the banks offload all this debt they've taken on.

The private equity firms meanwhile are taking a mixed view of this change in credit conditions. Mr Dimon said that some "were being flexible' and allowing banks to alter the terms on which they committed to provide funding. But he admitted that some were being tough and demanding that banks stand by the original terms."

Mr Dimon says that if JP Morgan had to take all the funding it had committed to onto its balance sheet it would be OK'. But as Lex again points out, "others might be feeling less comfortable."

It's small wonder that Ben Bernanke was finally forced to admit yesterday that subprime is leading to "increased concerns among investors about credit risk on other types of financial instrument."

So what does all this mean? Well, we're sometimes accused of being too bearish, so we'll let an expert do the talking for us just this once.

Here's TJ Marta, a strategist at RBC Capital Markets: "Leveraged hedge funds are subject to leveraged losses and the same fate as the Bear Stearns funds, while real money investors can be forced by their investment mandate to sell non-investment grade paper."

In other words, other hedge funds will go the same way as Bear Stearns. And not only that, some of the investors who've put money into what they thought were investment grade CDOs will be forced to sell them when credit ratings agencies downgrade them. What happens then, TJ?

"A vicious downward spiral could result, leading to the liquidation of other assets and positions, including the FX carry trade."

It's also known as a credit crunch and it won't be pretty. We'll be looking at the potential impact on various asset classes in an upcoming edition of MoneyWeek. In the meantime, subscribers can read James Ferguson's most recent take on the bond markets here: The tide is going out - is your portfolio covered?

If you're not already a subscriber, you can sign up for a three-week free trial of the magazine, just by clicking here: Sign up for a three-week free trial of MoneyWeek.

Turning to the wider markets

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In London, the FTSE 100 slid 92 points lower to a close of 6,567 as concerns over credit markets weighed. Utilities Severn Trent and Kelda topped the risers on defensive buying, but there were heavy losses for miners including Anglo American and Lonmin. For a full market report, see: London market close.

Across the Channel, the Paris CAC-40 was 45 points lower, at 5,995. And in Frankfurt, the DAX-30 was 94 points lower, at 7,893.

On Wall Street, reports that two of Bear Stearns' hedge funds are almost worthless plus warnings from Fed chief Ben Bernanke that the situation in the subprime market looks set to get worse weighed heavily on US stocks. The Dow Jones broke its five-day winning streak to end the day at 13,918, a 53-point fall. The tech-rich Nasdaq was 12 points lower, at 2,699. And the S&P 500 was down 3 points at 1,546.

In Asia, there were gains for Japanese stocks as reports of strong demand from China boosted shipping companies. The leading Nikkei index was up 100 points to 18,116. In Hong Kong, the Hang Seng had risen 140 points to 22,982 today.

Crude oil futures had risen to $75.13 this morning and Brent spot was up to $79.29 in London.

Spot gold was last trading at $672.50, having hit a high of $673.80 in Asia trading. For more on the gold market, see our daily gold report here: investing in gold. Silver, meanwhile, had risen to $13.18.

In the currency markets, the pound remained near 26-year highs against the dollar - last trading at 2.0534 - and was at 1.4874 against the euro. And the dollar was at 0.7242 against the euro and 121.79 against the Japanese yen.

And in London this morning, mobile phone giant Vodafone beat analysts' estimates by increasing subscribers numbers by 4.1% in the first quarter. The company has been expanding into emerging markets such as India and Turkey as growth has slowed in Europe. Vodafone also reiterated its full-year forecast of £9.3bn to £9.8bn in profits for the year ending June 2008. Shares were up by as much as 1.7% in early trading.

And our two recommended articles for today...

Why politicians must act before the energy crunch

- In the words of Lord Rees-Mogg, 'oil ruled the 20th century; the shortage of oil will rule the 21st'. So why aren't the powers-that-be doing anything to develop alternatives? asks Garry White. For more on why safeguarding our energy supply is of paramount importance, click here: Why politicians must act before the energy crunch

Where to find healthy profits

- It's not hard to see why the healthcare sector is a good defensive bet. The population may be getting older (therefore more in need of drugs and procedures) but it is also richer (therefore more able to spend money on treatments). But are the obvious stocks - the big pharmas - really the best ones to go for? To find out more about the key developments in the healthcare sector and the drugs minnows with big futures ahead of them, read: Where to find healthy profits

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.