What happened next requires a little background explanation. Mortgage-backed securities (MBS) were invented years ago and were a very good idea. A pool of mortgages is placed in a trust and bonds, secured by the principal and interest payments on the mortgages in the trust, are sold to investors. This frees up capital to make more mortgage loans, facilitating the American dream of home ownership. Creating MBS generates fees for Wall Street firms which are quite creative when fees are involved. Soon mortgage loans were made available to less credit-worthy borrowers (subprime mortgages). Again, initially this was an idea with great social merit. These mortgages bore higher interest rates and could be "securitized" into even more profitable MBS. Then, these mortgage-backed bonds were pooled into new trusts and securitized again, creating collateralized debt obligations (CDOs) and more fees. Credit risk was thus moved further and further from the originator of the loans.
During the second quarter it was investors’ turn to make news. Two hedge funds sponsored by investment bank Bear Stearns had invested in subprime MBS and had borrowed lots of money to enhance (leverage) their returns. One fund borrowed roughly $9 for every $1 of investor equity. It is very hard to value many of these securities, since each issue is unique and transactions are infrequent, so as the creditworthiness of subprime mortgages began to be questioned, investors sensed trouble and asked for their money back. Bear Stearns tried to sell some of the portfolios’ securities with very limited success and decided that it had to suspend redemptions pending a re-calculation of the funds’ values. In the past few days, Bear Stearns has come to the conclusion that investors in the more conservative of the funds would lose 91% of their money while investors in the other would lose 100%. These hedge fund clients’ losses are regrettable, but the much larger issue is whether the hundreds of billions of dollars worth of MBS and CDO paper held by others, often in leveraged vehicles, are being similarly mis-priced. This remains an open question.
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