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[Tor]

Bear's in the woods - what next in mortgages? The subprime pain taken by Bear Stearns and others is an opportune moment to revisit our longstanding concerns about US mortgages where we see subprime losses as the symptom of the broader ARM resetting cause. Key issues are the impact of securitisation on liquidity and valuations. For bondholders, caution towards investment banking seems sensible. In the US bad housing market news seems set to continue, and there is evidence of pain emerging in some European property markets, such as in Spain, Ireland and the UK. Just as 100% LTV ratios mean the borrower has little 'skin' in the deal, so also that 80-90% of subprime mortgages have been securitised means originators and investment banks may have focused on quantity rather than quality. Bear's decision to take over the lending to one of its troubled funds highlights the risk of leverage and the importance of liquidity. When stress builds and confidence falls short-term liabilities may not be rolled. The absence of liquidity can kill financial institutions rapidly as confidence disolves, while bad debts tend to inflict slow (but not normally terminal) pain over an extended period. Things are different for securitisations though. The layering of tranches in structured credit, whether ABS or CDO, means that as credit costs are incurred at the equity level, the probability of layers immediately above the equity having to absorb losses rises very rapidly. This is unlike a 'regular' bank, which has a wide range of revenue sources and the vast majority of liabilities rank pari pasu and hence would absorb equitably should all of shareholders' funds be used up. In practice, this means that as losses rise above de minimis levels, then the expected loss accruing to BBB-rated tranches changes. And, when the losses occur early in the life of the loan, as they have in subprime, then the change may be particularly dramatic. The most recently extended loans tend to be those with the greatest loss potential in the residential mortgage market. This is since over time house price and wage inflation normally reduce the effective burden on borrowers; in the rental market yields have declined, but valuation increases mitigate this. It is this dynamic, it seems to us, that has driven the change in values that has hurt investors as losses in subprime have occurred before effective LTVs have reduced. Bear's decision to extend huge liquidity lines, albeit on a secured basis, to an associated company has significant implications, we think. By stopping the forced sale of assets, Bear may have stabilised the fund for now. It may also have calmed the broader market for now. A sale at distress value could have forced Bear and others to recognise a much lower value on subprime-linked assets than is currently the case and this could have led to further problems and concerns in the investment industry and more