U.S. Financial Crisis Is Increasingly Self-Feeding

The U.S. financial crisis took on more of a self-feeding dynamic last week with the demise of hedge-fund Carlyle Capital and the emergency rescue of venerable Wall Street investment-banker Bear Stearns (BSC). Both were undone by downward pressures on the prices of mortgage-backed securities [MBS].

The “poisonous circle” began earlier this year with rising delinquencies on subprime mortgages. This gave rise to growing skepticism about the quality of MBS paper (mainly bundled packages of subprime mortgages) and led to a falling off of demand and ratcheting up of selling from hedge funds, pension funds and other buyers.

As prices of MBS slid, lenders withdrew credit from investors with large holdings of the paper. Many of the latter, to meet their financing requirements, were compelled to sell off parts of their MBS holdings, putting more downward pressures on prices.

The seizing up of the MBS market cut off a flow of funds propping up the U.S. housing market. With the ranks of house buyers substantially reduced, house prices stopped rising and began falling. Foreclosures climbed higher as homeowners walked away from mortgages worth more than the value of their houses, and as adjustable rate mortgages reset.

These worsening conditions in the housing market fed back into the MBS market and dragged down prices of the securities more. Lenders in turn additionally pulled back on funding to MBS holders, which, in turn, sparked additional forced selling. Downward pressures on MBS prices intensified.

The tumble in prices triggered margin calls on Carlyle Capital’s MBS portfolio and led to the fund’s default last week. As Bear Stearns was a creditor to Carlyle and had a lot of MBS paper on its balance sheet too, lenders of short-term financing to Bears Stearns grew fearful and shut off their financing when confidence evaporated on Thursday. Then the Federal Reserve and JP Morgan (JPM) stepped in to fund the short fall.

Comments

[Research123:]

A self fulfilling prophecy. What will stop the waterfall started by ABX short sellers??

2008 Mar 17 01:59 PM

[phdinsuntan...:]

short DBB now...

2008 Mar 17 04:31 PM

[AEB:]

The article is an excellent, simple explanation. It leaves out the important element of leverage, without which there would have been no margin calls. I don't think that this is well understood by most people.

2008 Mar 17 09:14 PM