Collateralized damage in subprime mortgages

by Patrice Sarath, August 14th, 2007, 6:40 am

Like some kind of Lovecraftian demon god, the tentacles of the subprime mortgage bust have twined into some farflung places, spelling doom for unlikely victims.

Okay, seriously, when it looks like Bear Stearns is in trouble because of the mortgage debacle, you know things are bad — maybe not Cthulhu bad, but bad nonetheless. Bear Stearns co-president Warren J. Spector (and check this out — separated at birth?) resigned from the venerable investment firm because of the firm’s bad bets on subprime mortgages. Bear Stearns cancelled the proposed IPO of Everquest Financial, which was to invest in collateralized debt obligations, or CDOs, or basically, high-risk subprime loans.

What had originally seemed to be a more or less localized situation, with the obvious victims and villains (often the same companies, as witness the demise of New Century Financial and American Home Mortgage Investment, to name two), is now seen to have growing ramifications. When D.R. Horton CEO Donald Tomnitz said that “2007 is going to suck, all 12 months of the calendar year,” little did he know that he was talking for everyone in the construction, real estate, and financial services sectors, not just his company. The fallout from the bust has spread all around the world, reminding all of us just how connected the financial markets really are.

But back to Bear Stearns — are they in trouble? Does Spector’s resignation foreshadow more ominous events to come? It’s hard to believe that one of the oldest names on Wall Street could find itself in a perilous state entirely due to the shortsightedness of some very smart people. Hindsight is 20/20 and all that, sure, but seriously, the housing bubble was fueled by very low interest rates that started rising again in 2006. That was a year ago. So what was Bear Stearns thinking when it created Everquest Financial?

Then again, human nature being what it is, I can see how smart people wouldn’t want to look dumb and instead try to brazen things out. John Maynard Keynes wrote: “The market can stay irrational longer than you can stay solvent.”
 
To which Bear Stearns’ Spector must so painfully reply, “The market can also become rational just when you least expect it.”