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Worries rise as fund crashes

Times Staff Writers

Anxiety intensified Friday about the toll the sub-prime mortgage meltdown is taking on the financial industry at large, as Bear Stearns Cos. pledged to lend $3.2 billion to rescue a hedge fund battered by rising defaults on home loans. The jitters sent stocks tumbling across the board.

“We know that these holdings are not unique to Bear Stearns,” said Drexel University professor Joseph R. Mason, co-author of a recent study warning of dangers in securities backed by home loans to high-risk borrowers. “It would be hard to find a Wall Street firm that hasn’t created similar funds.”

The hedge fund, which is managed by a Bear Stearns division, had taken in nearly $7 billion -- $600 million raised from investors plus 10 times that sum borrowed from Wall Street firms. Such a great amount of leverage would sharply boost any profit generated -- as well as any loss incurred. The fund invested mostly in bonds that paid generous yields and were backed by sub-prime mortgages.

But as the nation’s housing market soured, setting off a wave of defaults on sub-prime loans, the securities held by the fund lost substantial value, although exactly how much hasn’t been disclosed. The borrowing by the fund magnified the losses.

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One of the fund’s lenders, Merrill Lynch & Co., this week seized a reported $850 million in assets that had served as collateral on its loans to the fund. Other lenders were threatening to do the same when Bear Stearns stepped in with a credit line to shore up the fund.

Bear Stearns moved to prevent the fund’s dissolution “because there continues to be significant value in it,” Sam Molinaro, chief financial officer of the New York-based investment bank, said in a conference call Friday.

Molinaro said the credit line would allow an orderly sale of assets, preventing “massive liquidations” at fire-sale prices.

The hedge fund’s troubles, Molinaro said, “appear to be relatively contained.”

But stock investors weren’t comforted. The Dow Jones industrial average dropped 185.58 points, or 1.4%, to 13,360.26, while the broader Standard & Poor’s 500 index sank 19.63 points, or 1.3%, to 1,502.56.

“We are selling on fear and lack of information,” said David Brady, president of Brady Investment Counsel in Chicago. “We’ve got a heavily leveraged hedge fund in trouble, and that’s got the market spooked.”

All industry groups were hit, said Gary Schlossberg, economist with Wells Fargo Capital Markets in San Francisco. That’s partly because the market simply doesn’t know what other problems might be out there, he added.

The big fear, Schlossberg said, is that hedge funds have borrowed too heavily in an effort to pump up their returns. But borrowing amplifies losses too and can fuel selling as asset values decline. “There is a concern about a ripple effect,” he said.

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Still, Brady and Schlossberg said they believed that market fundamentals remained strong. Unless another shoe drops, they said, the market is likely to recover in a few weeks, when second-quarter corporate earnings start to come out.

“It’s similar to what happened in February, when the first round of sub-prime fears started to rock the market,” Brady said. “People sell first and ask questions later. And the selling can really snowball.”

Mason, the Drexel University professor, expressed greater concern about the potential damage from sub-prime mortgages.

Bear Stearns, he noted, is tying up its own capital on a bet that it can hold onto the risky investments until the market for them improves. Merrill Lynch made the same bet by auctioning off only a fraction of the assets it seized from the Bear Stearns hedge fund, he said.

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The problem, he said, is that sub-prime woes will grow as home prices fall in many areas and monthly payments jump over the next year on almost $1 trillion in adjustable-rate mortgages.

Bear Stearns is relying “on the implicit assumption that recovery is right around the corner, when in fact it looks like we’re in for a summer of increased defaults,” Mason said.

What’s worse, he said, is that the biggest investors in mortgage-backed debt are not hedge funds, whose investors are supposed to be wealthy enough to withstand losses. Instead, they are banks, asset managers, pension funds and insurance companies that serve mainstream Americans and have put their money at risk by buying exotic mortgage securities, he said.

Kurt Eggert, a Chapman University professor who testified to Congress in April about the complexities of such securities, said it was unsettling that Bear Stearns, which has a reputation on Wall Street as “the smartest guys in the room,” was unable to manage the bonds’ risks. He, too, said the threat from the sub-prime market was wider than many realized.

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Securities backed by mortgages have “allowed the risk of sub-prime loans to pervade our financial institutions,” Eggert said. “The sub-prime market can affect people and institutions that would have seemed to be walled off from it.”

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scott.reckard@latimes.com

kathy.kristof@latimes.com

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