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From Reuters:

American Home Mortgage Investment Corp said on Tuesday it can no longer fund home loans and may liquidate assets, putting its survival in doubt and sending its shares plummeting 90 percent.

Let me see if I understand this correctly: on Thursday of last week, everything was fine with AHM. Then on Friday, things suddenly changed and the company has to suspend its dividend, and on Monday, the value of the company’s mortgage investments just suddenly declines and AHM is hit with margin calls, liquidity problems and asks the NYSE to suspend trading in the shares. On Tuesday the company resumes trading, but questions its own survival and the shares plummet 90%.

So what was the hobgoblin that destroyed the lender so quickly?

The AHM situation is similar to the one that hit the Sowood Capital Management Hedge Fund. Over the weekend, it was reported that the fund was down 10% for the year, then on Monday, the news comes out that the funds are down by over 50% and have been sold to another fund manager.

IKB in Germany faces similar issues, as the lender to small and medium-sized corporations was hit with requests for more collateral, margin calls, et al, as the value of their portfolio of subprime-backed securities has declined substantially. This, despite the fact that there haven’t been many defaults in the pool of loans backing said securities. The only difference with IKB as opposed to AHM & Sowood is that IKB has more than enough liquidity to survive and is only having its credit worthiness questioned in addition to getting a credit rating downgrade and rising credit costs, as opposed to being forced out of business.

So back to the question, who (or what) is this financial hobgoblin that is flying around wrecking declining investment value, margin call, and liquidity destruction on hedge funds and lenders, causing them to go from a “functioning entity” to “liquidation/fire sale” over night? The answer is simple: the veritable hobgoblins are the managers of the failing funds and lenders.

What’s happening here is that a lot of hedge funds, lenders, and other institutional investors are hanging on to mortgage-related (notice I said mortgage, not just subprime - AHM was a prime lender) securities that have lost significant value. Instead of selling these “lost cause” securities and recognizing the losses, the securities are held on to for as long as possible in hopes that the market will turn around. As a result, the lenders, institutional investors, and hedge funds have their hands forced in the form of margin calls, requests for more collateral, and liquidity issues.

Understandably, in today’s environment there are some good reasons for hanging on as any whiff of “mortgage security losses” can make it harder for you to operate. You may be faced with a rash of withdrawals from your hedge fund and it could hurt your stock price. However, a depressed stock price and operational difficulties are far superior to being forced into a fire sale or worse.

The trend of institutional investors hanging on to money-losing, mortgage-related securities instead of just selling them and eating the losses is reminiscent of the Japanese Banking Crisis, according to a recent report published by Reuters:

Investors and banks holding on to U.S. subprime mortgage bonds in hopes of a recovery in value may make losses worse, mirroring the Japanese banking crisis in the 1990s, according to authors of a new report.”…” The Japanese experience of holding large losses as opposed to taking a hit and moving on was a direct cause of the Japanese malaise," said Josh Rosner, co-author of the report and a managing director at Graham Fisher, an investment research firm in New York.

Now, I don’t think the US banking system will go into a crisis due to a series of collapsing hedge funds and pure play (or perhaps single play) lenders like AHM. However, when its reported that the German banking and European banking sectors are facing problems due to US mortgage investments and hedge funds, and lenders are going from “everything is fine” to “fire sale” overnight, it does warn of a pending credit crisis of some sort.

When it comes to a credit crunch, the real question at hand is what it will look like and what will be the impact of the actions taken to resolve it? Remember, that whilst a rate cut may sooth some of the pain caused by these problems and/or send certain credit-related stocks soaring, there is no free lunch. After all, rate cuts created a lot of our current problems in the first place.

Disclosure: The Author doesn’t hold positions in any of the companies mentioned in this article.

Source: The AHM Meltdown: Symptom of a Much Larger Problem