Subprime Tsunami

The mortgage securities market in US is at 50% of its GDP at $6.5 trillion. The financial stability of Bear Sterns was invariably linked to repayment of loans that it had underwritten. Just a few days prior to the collapse of the investment bank , Carlyle Capital (PE), one of the oldest private equity funds the world had known, went bust after its mortage losses wiped out its entire equity. Carlyle capital was leveraged to the extent of 32 times its book value. Though Carlyle had not taken any exposure to subprime assets and was holding only AAA rated mortgage bonds of Freddie Mac and Fannie Mae, many hedge funds had sold these bonds on the fear of a credit crisis prevailing in these two government guaranteed institutions resulting in excess supply of these bonds in the market. As a consequence, excess supply resulted in bonds prices falling and margins calls getting triggered for more collateral from Carlyle. The fact that most of the lenders of Carlyle were investment banks like Bear Sterns who dint want to extend any lenity was an indication of the problems they themselves faced internally.
Subprime mortgages were sold to homeless borrowers with lax credit standards on the pretext that they could refinance their homes to pay up later. But what was not explained to them was the interest rate clause would be reset every two years. As long as the interest rates were low, there was huge demand for housing and there was a construction boom that was witnessed all across the US which eventually resulted in excess supply of real estate. The situation was almost surreal with houses getting refinanced for a second mortgage just to fund consumption in the US. A consumption boom was also necessary to finance the US war in Afghanistan and Iraq. Government agencies operated in full swing bringing out ads to fuel consumption in US. As inflation spiralled out of control and interest rates began to spike up, these loan reste clauses came into effect. The subprime borrowers began to default unable to meet their liabilities. Most of these subprime borrowers had no source of income whatsover or had falsified the records while submitting the loan applications. Once they started to default, there were only two options, either to sell the house and meet the committment or subject the property to foreclosure. But with property rates having fallen under high interest rates and excess supply of real estate, they could neither refinance their house nor dispose them at falling prices. Most subprime borrowers have foreclosed their accounts by surrendering the plot resulting in the mortgage companies being left with houses whose value/collateral was way below the Loan value. The subprime contagion had begun and had a chain reaction throughout the economy. Today, the monster has resulted in losses close to $ 1 trillion in the US economy, almost the size of the Indian economy.The losses faced by mortgage companies resulted in many of them filing for bankruptcy and all the bonds securitised by them in the form of pass through certificates after a due diligence rating from the S&P's and Moody's of the World were reduced to nullity in terms of value. This resulted in huge write off's in the balance sheet of hedge funds and investment banks who had to mark to market assets held by them.
Similar was the case with Bear Sterns, the second largest underwriter of mortgage bonds in the US. The exposure to exotic derivatives at Bear sterns was almost the size of the US economy at $13 trillion. As has been proved over the last one year, these derivatives have indeed become weapons of mass destruction. The collateralised debt obligations and its liabilities on Credit defualt swaps underwritten had led to the collpase of two hedge funds owned by it. Post Carlyle's collapse and the FED's surprise interest rate cut by 75 basis points, credit spreads began to widen, there was panic among the market participants that there are more skeletons waiting in the closet. Rumours started doing the rounds that Bear Sterns was in trouble. Bear Sterns also handled the largest volume of trading transactions on the bourses and hence had huge deposits of collaterals and margin money from clients. These clients started withdrawing cash from the company and the latter was put into a liquidity crisis. Margin calls coudnt be met on mortgage bonds and CDO's. The firm sold its holdings in equities all across global markets held through its investing arm BSMA triggering off a fire sale of equities in most EM's. Bear Sterns was set for bankruptcy before the FED stepped in and aided JP morgan Chase to buyout Bear Sterns at $2 per share. The share price had collapsed from a high of 170$ before the subprime crisis broke out to $30 when the crisis was as its peak, almost wiping out the lifetime savings of its employee base who had put their hard earned money into Bear Sterns equity.