Confidence Game - Christine Richard [96]
On June 13, 2007, word began to circulate about problems at Bear Stearns. The firm had been trying to sell $3 billion of highly rated mortgage-backed securities. Apparently, Merrill Lynch had called in a loan to the Bear Stearns High-Grade Structured Credit Enhanced Leverage Fund, a hedge fund run by the firm’s star mortgage trader, which invested in double- and triple-A-rated mortgage-backed securities and CDOs. These sales were testing market demand for the securities, and the results were not encouraging. No one wanted to touch securities tainted by subprime, no matter how high the rating.
On June 20, 2007, J. G. Kosinski of Kore Capital e-mailed Ackman to tell him MBIA credit-default swaps had jumped. “The Street is using it as a proxy hedge for the Bear Stearns CDO-squared fire sale.” CDO-SQUAREDS are securities largely backed by other CDOs, which are high risk and extraordinarily complex to analyze.
On June 25, Deutsche Bank held a conference call to address investor concerns about the Bear Stearns funds, CDOs, and the subprime market. Investors bought triple-A-rated securities because they didn’t want to worry about credit issues; now these securities had become the focus of the market’s fears. “You must understand that we’re very much in uncharted territory in many ways,” Karen Weaver, head of global securitization at Deutsche Bank, said as the conference call in New York got under way.
Weaver explained that the market had been flooded with new types of mortgages that had never been tested in a downturn such as no-income-verification mortgages and loans that let borrowers pay only part of their monthly payments and roll the rest into a larger principal balance. Home-price appreciation had been unprecedented, which might invalidate models that tried to predict the performance of the housing market. “And when you take that and lever it within a structure and then take that structure again and lever it into a CDO obligation,” Weaver said, “you’ve taken that uncertainty and really magnified the impact.”
“Is it possible that everyone is thinking ‘Oh, Jesus, this is the tip of the iceberg’?” an investor asked the Deutsche Bank analysts. Might the market be realizing that next year after the inevitable downgrades hit “that some of these, let’s say double-A, triple-A instruments could go for 50 cents on the dollar? Is that possible?”
“We don’t have a crystal ball,” replied Anthony Thompson, Deutsche Bank’s head of asset-backed and CDO research.
But the crisis was drawing nearer. “We were expecting not to see the first downgrades probably until fall,” he said. “It looks like they’re going to be coming sooner than that.”
Not only was it impossible to predict how deep the loss of value would be on some securities, but also the breadth of those losses was an unknown. The so-called synthetic CDO market added to the uncertainty, Thompson said. These CDOs didn’t actually hold mortgage-backed securities. They referenced the securities through a credit-default swap. So although Countrywide Financial might have sold only one $2 billion bond issue backed by subprime mortgages in October 2006, that bond issue might have been referenced 20 times in synthetic CDOs. “This is what has allowed the CDO market to essentially grow much faster than what we’ll call the collateral market—this ability to reference the security