Bear Stearns & Cos. yesterday said it would close two troubled subprime mortgage hedge funds that are worthless as a result of surging defaults as Federal Reserve Chairman Ben S. Bernanke admitted that the subprime mess will further sink the housing market and depress economic growth this year.
The news sent stocks tumbling, with the Dow Jones Industrial Average falling as much as 140 points before recovering some in trading yesterday. Bear Stearns” move raises questions about the value of as much as $1.5 trillion of mortgage-backed securities issued at the height of the housing boom when lax lending standards and ebullient market conditions enabled shaky borrowers to easily obtain loans on overpriced homes.
Mr. Bernanke admitted for the first time that the fallout from the collapsed housing market and mounting credit crunch could spread to consumers and the overall economy as defaulting loans lead to foreclosures and plummeting home values in many neighborhoods, although he was optimistic that the economy would avoid the worst reverberations.
“Rising delinquencies and foreclosures are creating personal, economic and social distress for many homeowners and communities — problems that likely will get worse before they get better,” he said in testimony before the House Financial Services Committee.
Speaking after the Commerce Department announced that requests for new housing construction permits dropped to their lowest level in a decade, Mr. Bernanke said, “Declines in residential construction will likely continue to weigh on economic growth over coming quarters, although the magnitude of the drag on growth should diminish over time.”
While acknowledging the depth of the housing debacle, Mr. Bernanke gave no indication that the Fed would consider lowering interest rates to prop up the residential market, saying that rising inflation remains a threat and that the Fed will be vigilant against it.
The Fed is preparing rules for subprime and exotic loans to curb the abuses that led to today’s problems, and Mr. Bernanke urged Congress to take action as well by, among other possibilities, requiring mortgage brokers to be licensed by the federal or state governments. But he also cautioned against overreacting in a way that causes lending in the subprime market to dry up altogether.
Even as he spoke, Bear Stearns informed investors in two hedge funds once valued at $20 billion that their investments have “very little” or “no value left” as a result of rising defaults on the securitized subprime loans in their portfolios.
“In light of these returns, we will seek an orderly wind-down of the funds,” it said in a “Dear Client” letter to holders of two enhanced leverage funds, acknowledging that “this is a difficult development for investors.”
It was the latest in a series of disclosures of deep losses on subprime loans that have shaken markets this year. Rumors abounded yesterday that other big investment houses on Wall Street will have to close or mark down the value of mortgage funds they have packaged and sold to investors such as pension funds, insurance companies and hedge funds.
The losses at hedge funds, whose activities and holdings seldom come to public light, are often magnified many times over because they take on massive amounts of debt to purchase investments — with the goal of enhancing returns but with the possibility of multiplying losses.
The threat of a major hedge-fund collapse amid spreading defaults and losses has troubled Wall Street all year and raised worries in Washington that the markets could be destabilized as they were in 1998 when the Long Term Capital Management hedge fund imploded and had to be rescued by the Fed to avert a market meltdown.
Mr. Bernanke expressed no worry about such a possibility yesterday. But the Fed has been repeatedly surprised all year by the depths of the subprime and housing woes, which have forced the central bank several times to make major revisions in its economic outlook and regulatory policies.
Mr. Bernanke once again asserted that hedge funds are “good for the economy” because they enable banks and mortgage brokers to sell their riskiest loans to rich investors who can afford to take big risks and lose a lot of money. That way the losses are diluted and spread in a way that lessens the threat to the banking system and overall economy, he said.
Although he did not provide details of the Fed’s regulatory plans, Mr. Bernanke said they will go well beyond the guidelines that the Fed previously has provided on subprime and exotic loans that were mostly focused on ensuring lenders provide consumers with complete information about the loans they take out.
He suggested that the Fed may go so far as banning some abusive practices that led to soaring defaults, such as not requiring proof of income on subprime loans.
“Disclosure alone may not be sufficient to protect consumers,” he said, reversing the Fed’s previous “borrower-beware” approach to the problem.
Apparently mollified by the Fed’s more aggressive regulatory stance, House Financial Services Committee Chairman Barney Frank called the Fed’s actions “a very important first step.” The Massachusetts Democrat had threatened to strip the central bank of its authority to write consumer-protection rules if it didn’t act.
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