Answers About Bear Stearns' Mortgage Exposures

Yesterday, I wondered what the connection was between the weak subprime-mortgage market, on the one hand, and some weakness in the second-quarter results from Bear Stearns and Goldman Sachs, on the other.

Today, Kate Kelly and Serena Ng of the WSJ try to answer some of those questions, although their article is a bit confusing. It starts off by talking about a Bear Stearns hedge fund, which has indeed taken a serious bath in subprime mortgages, but which hasn't had a significant effect on Bear's bottom line. Later on, they seem to continue to elide the difference between the performance of managed funds and the banks' operating results:

Both Goldman and Bear yesterday sounded one common chord: that continued troubles in the mortgage market remain a big worry.
With the sort of weakness investors are seeing in the subprime market, "there's no hedging strategy you're going to be able to employ that's going to completely immunize you," said Sam Molinaro, Bear's chief financial officer, in an interview. Investors have made big profits on subprime loans in recent years, and losses on risky mortgage loans "are to be expected," he added. "While you don't like to have them, it's a fact of life in the business."
In a call with reporters, Goldman finance chief David Viniar was even blunter. "I don't think we've seen the bottom" of the subprime problems, he said.
Bear, which is known for its tough risk controls, has so far been unable to navigate its way out of the turmoil. This raises the specter that other Wall Street funds are sitting on big losses that could crop up in the days and weeks ahead.

I do understand that banks generally make more money in bull markets than in bear markets. But what exactly are the losses being talked about by Bear's Molinaro, here? Are they losses for the bank, or losses for investors? And the same question can be asked of those hypothetical "Wall Street funds" which might be sitting on large losses.

To the rescue comes my favorite informant on matters subprime, who sent me an email yesterday explaining a lot of this. (He hasn't given me permission to use his name yet, so for the time being he'll remain anonymous.) Firstly, he explains why the subprime losses are showing up in the banks' second-quarter results, rather than their first-quarter results.

The reason is that the subprime meltdown didn't really happen until the end of the banks' first quarter, which ended in February. So in a large part of their first quarter they continued to make money by securitizing and trading subprime mortgages, as well as by lending money to subprime originators. Then, when the bottom fell out of the market in February, volatility spiked upwards, and banks generally make money in times of high volatility. So what they lost in terms of securitization and lending revenues they made up for on the trading floor.

In the second quarter, however, volatility fell back down, but there was much less activity on the lending and securitization fronts. Which means the banks were hit on both fronts, and there was no way for them to make money in the subprime sector. Unless and until subprime wakes up again, it's unlikely to be a source of much profit for banks. And of course if a sector was providing large profits and now provides very little in the way of profits, then that means the bank's profits are falling. In journalists' shorthand, this often equates to "losses" in the sector: the important thing is not whether profits are greater than zero or not, but rather whether they're going up or going down.

The sector is still alive: the same WSJ story reports that Merrill Lynch yesterday launched a $1.6 billion bond issue backed by subprime mortgages, which "generated significant investor interest". But such deals were certainly much more common a year ago than they are now. And with long-term interest rates rising, consumers' appetite for new housing debt is sure to be constrained.

Banks such as Bear Stearns and Lehman Brothers have made a lot of money in recent years from the mortgage sector in general and the subprime part of it in particular. For the foreseeable future, they're going to have to look elsewhere for those profits.