The Orderly Deleveraging at Bear Stearns

If you've taken even a sideways glance at Yahoo! Finance or The Wall Street Journal over the past few weeks, you've likely seen mention of the ongoing troubles at Bear Stearns (NYSE: BSC  ) . The firm has been figuring out what to do about a couple of its hedge funds that have made some not-so-successful bets on the subprime mortgage market.

Though you may very well be sick of hearing about the subprime market, there's good reason for Fools to know what's going on at Bear, since it's not unlikely that similar situations could pop up elsewhere.

The Bear bones
By this time, I can't imagine that there are investors who aren't familiar with the trouble in subprime. The digest version, though, is that lenders lent money to risky borrowers and didn't price the loans correctly, and rising defaults are now causing some extra-strength headaches.

While the problems at many of the lenders, such as Accredited Home Lenders (Nasdaq: LEND  ) and Novastar Financial (NYSE: NFI  ) , stemmed from getting too aggressive in selling subprime loans, the hubris at Bear Stearns was in making after-the-fact bets on the loans. Two of the hedge funds in Bear's asset management arm -- the High Grade Structured Credit Fund and the High Grade Structured Credit Enhanced Leverage Fund -- are now doing some hand-wringing as the funds' performance has gone down the tubes.

Bear's funds apparently decided that the time to buy is when there is blood in the streets, so they doubled down on subprime when the market started showing serious weakness earlier in the year. Unfortunately, there was more blood left to spill. As the funds' investments faltered, performance took a hit, and investors started pulling money out. Making matters worse, both funds were heavily leveraged, and when times started getting tough, creditors came knocking.

Bearing with it
In coping with the escalating situation, the funds had to figure out a way to deal with the demands of their creditors and investors. As liquidity was pinched, dumping some of the remaining paper held at the funds seemed to be the only solution. Unfortunately, dumping the holdings would flood the market and likely cause massive repricings, further damaging the funds' positions and only increasing the pressure from creditors and investors.

So to ease the situation, the parent company offered up to $3.2 billion to one of the funds to provide intermediate-term liquidity and prevent the need for a fire sale of its assets. In the end, it looks like Bear will only end up having to cough up $1.6 billion, but the $3.2 billion offer -- nearly 25% of the firm's book value as of May 31 -- shows how critical it is to the firm to get the fund stabilized.

While many are saying that the overall financial impact to Bear could be fairly small, the harm to the firm's reputation could be significant. On Wall Street, where brand and reputation can count for a lot, the episode could take some time to fade away. It has even been suggested that the turmoil could leave the $20 billion firm open as a takeover candidate for a larger bank looking to bolster its investment banking or capital markets operations.

Bearing the brunt
Bear could prove to be just the tip of the iceberg. The securities built around the subprime loans -- particularly the CDOs that have become hugely popular -- may still not have fully repriced to reflect current realities. Bear avoiding a fire sale of its funds' assets may have prevented a rapid, panicked devaluation, but a significant devaluation may yet be in order. This would likely affect other Wall Street firms, such as Lehman Brothers (NYSE: LEH  ) , Morgan Stanley (NYSE: MS  ) , and Goldman Sachs (NYSE: GS  ) , which are exposed to the subprime market from various angles.

A frequent party line is that the failures in the subprime market are contained and pose little threat to the broader credit or financial markets. Thus far, this has held true, but in recent weeks it has appeared that lenders, who have been particularly loose in the past few years, have started to tighten their purse strings.

If further problems in the subprime market end up really spooking lenders, they may start pushing up rates and drawing hard lines on debt terms -- which have been notably light recently. This in turn could pass the ripple out to corporate borrowers, as well as the buyout firms like Blackstone (NYSE: BX  ) , which have been taking advantage of highly accessible debt to make massively leveraged take-private deals. Such a turn of events could certainly take some pep out of both the equity and debt markets.

Predicting what might happen is more difficult than ever because of the complexity of structured debt products and the elaborate models that holders use to determine value. What seems logical to me, though, is that if some of the smartest guys in the game are slipping up, there are probably some cracks developing elsewhere.

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Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned, nor has he ever seen, touched, tasted, or smelled a CDO. The Fool's disclosure policy abides, dude.


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