“What would collapse of hedge funds mean?”

From the NY Post:

BEAR MART SALE

Merrill Lynch yesterday followed through with its plan to auction off assets belonging to a collapsing Bear Stearns hedge fund, providing more drama to a bond market that’s already licking its wounds from a fresh batch of subprime woes.

The move came after Merrill, which appears to have lent about $80 million to Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage fund, shocked Wall Street late Tuesday by bailing out of discussions to rescue the fund, refusing to participate in a highly conditional plan crafted by Bear Stearns and Blackstone Group to pump $2 billion into the fund.

The initial reports on Merrill’s $857 million auction were mixed.

One partner at a $4 billion mortgage hedge fund said, “We bid [but] the question is on what,” referring to the dubious value of the super-complex, subprime bond laden securities called collateralized debt obligations.

But late afternoon reports from Wall Street’s mortgage bond-trading desks cast doubt on whether Merrill was able to get bids that met its so-called reserve levels.

Deutsche Bank also conducted a $300 million auction of the Bear fund’s assets, but pulled it slightly before the appointed 1 p.m. close. Sources familiar with Deutsche said the firm is trying to broker a series of private trades to unload the CDOs.

J.P. Morgan’s $400 million auction was pulled near its 2 p.m. close. A J.P. Morgan executive told The Post that the firm is “trying to negotiate directly with [Bear Stearns]” to get its capital back.

Q&A from the AP:

What would collapse of hedge funds mean?

Q: So do the funds own individual mortgages? Could it own my mortgage?

A: No. The fund invests in things like bonds that are backed by individual mortgages. Banks and other mortgage originators make the loans to consumers, package groups of similar mortgages together, and sell them to investors in a process called securitization.

Q: What went wrong with the Enhanced Leverage fund?

: The fund reportedly lost 23 percent of its value in the first four months of the year. The reasons are not clear, but starting earlier this year, there was a sharp increase in the number of delinquencies and defaults on loans made to borrowers with spotty credit histories. Bonds backed by these subprime mortgages lost much of their value, before stabilizing somewhat in April and May.

The decline led one big investor, Wall Street bank Merrill Lynch, to ask for its money back. When Bear Stearns balked, Merrill Lynch requested its collateral for the loan — in this case at least $800 million in bonds backed by subprime loans.

Q: What would the fund’s collapse mean for the broader market?

A: It could a shift in how the market values risk.

During the recent bull run, lenders have charged a historically low premium to borrow money to make risky investments. As more of these securities falter, lenders will start asking for more in return.

That would lead to higher volatility, or more ups and downs in the prices of securities. As securities get more volatile, investors typically reduce their exposure to risk.

Q: What does all this mean to potential homebuyers?

A: The bottom line is that big losses in subprime investments are likely to make investors more reluctant to risk their money on these instruments in the future.

That will make it harder for mortgage originators like banks to sell these types of loans in bundles to the bond markets, which will, in turn, reduce the availability of funds for subprime loans and make it much harder for subprime borrowers to obtain financing.