Impact of Mortgage Crisis Spreads Beyond Housing

Impact of Mortgage Crisis Spreads
Dow Tumbles 2.8%
As Fallout Intensifies; Moves by Central Banks

By GREGORY ZUCKERMAN, JAMES R. HAGERTY and DAVID GAUTHIER-VILLARS
August 10, 2007; Page A1

Fallout from the intensifying credit crisis stretched from a French bank to the largest home-mortgage lender in the U.S., triggering unusual central-bank interventions and driving the Dow Jones Industrial Average to its second-worst drop this year.

The troubles demonstrated both the global reach of the crisis and its impact on a widening circle of markets and companies. The first jolt came from French bank BNP Paribas, which said early in the day that it was freezing three investment funds once worth a combined $2.17 billion because of losses related to U.S. housing loans. That prompted the U.S. and European central banks to inject cash into money markets to keep interest rates down.

The unease accelerated in the U.S. with news that several hedge funds were in the red and selling off assets. Apartment and condominium builder Tarragon Corp. raised doubts about its ability to remain in business amid weak demand and an inability to raise new financing. After markets closed, mortgage-lender Countrywide Financial Corp. said "unprecedented disruptions" in credit markets could affect its financial condition.

The stock market, which on Wednesday had risen sharply on hopes credit problems were being contained, swooned as hedge funds, many of which borrowed increasing amounts of money in recent years to boost returns amid placid markets, scrambled to sell holdings and cut their borrowings. The Dow Jones Industrial Average ended down 387.18 points, or 2.8%, at 13270.68.

Meanwhile, Countrywide, of Calabasas, Calif., said in a Securities and Exchange Commission filing that it was shoring up its finances and had "adequate funding liquidity." But the company, the nation's largest home-mortgage lender in terms of volume, warned that "the situation is rapidly evolving and the impact on the company is unknown." Reduced demand from investors is prompting Countrywide to retain more of its loans rather than selling them.

The statement could send shivers through financial markets today. It came just a week after Bear Stearns Cos., the Wall Street trading giant, had to reassure investors that it had ample cash on hand amid concern that it faced funding problems because of deteriorating credit-market conditions and the implosion of two of its hedge funds.

On Friday, markets in Asia tumbled in early trading. After the Nikkei 225 index fell more than 2%, Japan's central bank injected $8.39 billion into money markets. That followed actions Thursday by the European Central Bank, which provided more than $130 billion to money markets, and the U.S. Federal Reserve, which added $24 billion in reserves to the U.S. banking system.

What started late last year as worry over a sharp rise in defaults on subprime mortgages has mushroomed into a crisis for the entire home-loan industry and investors world-wide. By March, late payments were reaching worrisome levels on Alt-A mortgages, a category between prime and subprime that includes many loans for which borrowers "state" rather than verify their incomes. Most prime loans continue to perform well, but Countrywide has reported a rapid rise in delinquent payments on certain prime home-equity loans that were used by people stretching themselves to buy homes with little or no money down.

Payments were at least 30 days late on about 20% of "nonprime" mortgages serviced by Countrywide as of June 30, up from 14% a year earlier, the company said. Nonprime includes loans to people with weak credit records and high debt in relation to their income, as well as to people who don't document their income or assets. On prime home-equity loans, the delinquency rate was 3.7%, up from 1.5% a year before. For all loans, the rate was 5%, up from 3.9%.

In a sign of the growing difficulty in selling loans, Countrywide said that it transferred $1 billion of nonprime mortgages from its "held for sale" category to "held for investment" in the first half -- meaning they will stay on the books instead of being sold. Countrywide marked the value of those loans down to $800 million. Despite its current woes, the company argues that it is well-placed to gain market share from weaker rivals.

Rattled by a constant stream of bad news, investors in recent days have been shunning nearly all mortgages except for those that can be sold to Fannie Mae and Freddie Mac, the government-sponsored investors that guarantee payments on loans that "conform" to their standards. That has prompted lenders to boost rates on prime "jumbo" loans -- those totaling $417,000 or more, too big to be guaranteed by Fannie or Freddie -- to as much as 7.25% or 8%. Usually, such loans cost only about a quarter percentage point more than "conforming" mortgages, but the gap has ballooned to as much as 0.8 point during the past week.

In financial markets, several entities thought to be insulated from the subprime meltdown now turn out to be affected, leading investors to wonder who might be next. For instance, BNP just last week had said the three funds were conducting business as usual. But Europe's sixth-largest bank by stock-market value said yesterday that it had been forced to suspend the funds on Tuesday because of a sudden and unexpected dearth of buyers and sellers.

"The market for the assets has just disappeared," said Alain Papiasse, head of BNP Paribas's asset-management-services division. "Since the start of this week, there are no prices for instruments that carry, directly or indirectly, some types of U.S. assets."

In the U.S. the latest crop of hedge funds to be hit hard by the market's turmoil includes those that focus on "market-neutral" strategies, or strategies that seek to do as well in both falling and rising markets. The strategy has been embraced by some of the biggest names in hedge funds, in part because it's popular with institutional investors who hunger for gains in any kind of market.

Many market-neutral funds have been wagering on high-quality stocks, or stocks that trade at low valuations based on various metrics, and betting against stocks that look expensive. Because this stance is seen as relatively conservative, the funds felt comfortable borrowing money to boost returns.

But as banks began getting worried about their hedge-fund clients in recent weeks, some hedge funds were asked to put up more collateral to back the loans, or anticipated these requests. The funds sold some of their holdings of high-quality stocks to raise the cash, and closed out "short" trades, or bets against companies, by buying back shares of companies seen as expensive. Others sold positions simply to become more conservative, in a rocky market.

Since market-neutral funds often are guided by similar computer models and share similar holdings, the actions magnified moves in asset prices. The last week has been the worst on record for many large hedge funds focusing on this strategy, worrying traders across Wall Street, many of whom look to these firms for signs of stability in difficult markets.

During the past several days, a number of other quantitative funds have also been hard-hit. These funds generally operate by building computer models of market behavior and then allowing computer programs to dictate trading. With the recent trouble in financial markets, many lenders, funds and brokerages were following statistical models that grossly underestimated how risky the environment had become.
--Kate Kelly, Alex Frangos, Henny Sender, Anita Raghavan and Ian McDonald contributed to this article.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com, James R. Hagerty at bob.hagerty@wsj.com and David Gauthier-Villars at David.Gauthier-Villars@dowjones.com