Deadly ripples threaten subprime funds

LONDON (CNNMoney.com) -- The fallout from problems at two Bear Stearns hedge funds that may be on the verge of collapse could roil the bond market and lead to a tightening of credit, analysts said Thursday.

The problems at the two funds, which bet heavily on securities backed by subprime mortgages, are also affecting stocks, which took a beating Wednesday as jitters about the possible effect on credit markets coursed through Wall Street. The Dow industrials, S&P 500 and Nasdaq all sank at least 1 percent Wednesday and opened lower Thursday, though stocks later recovered and ended with modest gains.

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The declines at the two Bear Stearns Cos. funds - its High-Grade Structured Credit Strategies Enhanced Leverage Fund and High Grade Structured Credit Strategies Fund - have revived fears about the subprime mortgage sector and triggered worries that worse is yet to come.

"The unraveling of the Leverage Fund is at best an embarrassment for BSC, and at worst, it threatens to have a ripple effect on valuations across the subprime sector," Kathleen Shanley, an analyst at independent corporate bond research firm Gimme Credit, wrote in a recent report.

Wall Street has weathered hedge fund implosions fairly well in the past. Amaranth, a $9 billion hedge fund that collapsed last year after bets on natural gas futures went sour, didn't send many tremors through the markets.

"But this has the potential to be more widespread," said Jeff Schwartz, a fixed income analyst at investment firm Payden & Rygel who focuses primarily in asset-backed securities. Mortgage-backed debt is being held in a lot of different places and "that's leading to a lot of nervousness," he said.

Bear's two funds are close to being shut down after suffering deep losses in bonds backed by subprime mortgages. Creditor Merrill Lynch (Charts, Fortune 500) seized about $850 million of assets from the fund Wednesday and has already begun selling some of those assets, according to Reuters.

Market watchers say now they're watching to see if problems like those at Bear Stearns (Charts, Fortune 500) start cropping up elsewhere. That could trigger more sales and lead to an across-the-board repricing of these securities.

"Some guys made bad bets so we may see some more sellers out there," said Dan Castro, managing director at GSC Group in New York. "There isn't going to be a flood of hedge funds liquidating, but other guys are having problems."

Problems in the subprime mortgage market, which gives home loans to borrowers with poor credit, surfaced in the spring as a spike in defaults led to the collapse of subprime mortgage lenders like New Century Financial.

A jump in risky subprime loans in recent years helped fuel the U.S. real estate boom and also provided a windfall to Wall Street firms, which have made big money packaging the loans and selling them as securities to investors like hedge funds.

These complex securities aren't heavily traded, and a flood of supply into the open market could drive prices down, forcing other holders of these securities to mark down the value of their holdings, analysts say.

"These instruments are held by a very large number of accounts - not just hedge funds, but all sorts of investment vehicles - that thereby highlights the hit everyone is taking from this process," said Charles Diebel, an analyst at Nomura International in London.

Besides the prospect of losses piling up, there are also concerns that investors could reduce their appetite for risky bonds and loans. "In an environment where there are already concerns about credit and liquidity, more risky debt could be undermined," Diebel said.

That could reduce the availability of financing for everything from leveraged buyouts, which have been a key support for stocks, to future home borrowers.

While delinquencies on subprime mortgages are on the rise, the losses haven't really hit full force yet on the bonds backed by those mortgages, according to Schwartz at Payden & Rygel.

"But rating agencies are downgrading bonds in anticipation of the losses and hedge funds are having to look at these securities and put a value on where the market would price them right now," he said.

Last week, credit-rating agency Moody's cut its ratings on 131 bonds backed by subprime mortgage loans because defaults on those loans were rising faster than expected.