Subprime Isn't Done Yet Folks

Yesterday a hedge fund managed by Bear Stearns announced their intention to sell $4 billion of mortgage backed bonds. The fund -- the High-Grade Structured Credit Strategies Enhanced Leverage Fund -- has been hurt by their exposure to the subprime sector and is allegedly down almost 25% this year. One way to track the damage in the subprime sector is to monitor the ABX Home Equity BBB Index. Here is some quick background on the ABX index courtesy of Nouriel Roubini's Blog:

“One way to measure the effects of problems in the sub-prime mortgage sector is to look at Credit Default Swaps (CDS). Remember that these CDS contracts effectively work as a kind of insurance policy for banks or other holders of bad mortgages. If the mortgage goes bad, then the seller of the CDS must pay the bank for the lost mortgage payments (alternatively ... if the mortgage stays good then the seller makes a lot of money).

The index that measures the CDS market for home equity is called the ABX.HE index. The sub-variation of this index that refers to risky sub-prime loans is called the ABX.HE BBB index.

I just checked the ABX.HE BBB index. It has dropped by about 5-7% since July of 2006. This is a substantial drop! Notably, there was a major plummet of the index starting in Dec 2006 when some of the dealers in risky mortgages started going belly up.

So what does this mean? It means that someone out there is now having to cough up the losses in the bad loans. It could be hedge funds, or maybe overseas lenders. But someone is starting to see some losses happening on their balance sheets, and the problem is going to grow significantly in 2007.”

Keep in mind Roubini had this on his blog back on January 11th, 2007. Back then the ABX Home Equity Index had fallen from 101 to 93 in 6 months, which at the time surely seemed like a "substantial drop." Since then the index has fallen precipitously. It now trades in the low 60's and looks ready to re-test its February lows. See graph below courtesy of Markit:


So who is paying for these bad loans? Well in this case its the investors in Bear's fund and perhaps the banks who helped Bear lever up 10 to 1 . . . it makes you wonder who is next.