Wall Street, Bear Stearns Hit Again By Investors Fleeing Mortgage Sector By KATE KELLY, LIAM PLEVEN and JAMES R. HAGERTY August 1, 2007 Weakness in the nation's housing market is further infecting financial companies, with Wall Street, lenders and insurers taking hits as investors flee the mortgage sector. Bear Stearns Cos., its reputation already dented after two of its hedge of its funds that had bet heavily on securities connected to risky home loans blew up in June, has prevented investors from taking their money from another fund that put roughly $900 million into mortgage investments. In recent weeks, as the U.S. housing market continued to weaken and trading firms began pricing many mortgage investments at discounted levels, Bear executives realized their Asset-Backed Securities Fund was facing a rough July, said a person close to the matter. The Bear news capped a chaotic day on Wall Street. The Dow Jones Industrial Average, which was up more than 140 points earlier in the day, ended down 146.32 points, or 1.1%, at 13211.99 -- a swing of nearly 300 points. The S&P 500, with financial stocks as the biggest sector, was down 3.2% for the month of July after falling 1.2% yesterday. It is now up just 2.6% year to date. U.S. Treasurys rallied in a flight to quality. Unlike the other two Bear funds that hit the rocks in June, said the person close to the situation, the asset-backed fund borrowed no capital and had only limited exposure to subprime mortgages, as home loans extended to people with weak credit histories are known. But a combination of markdowns on the value of a broad range of mortgages and a series of investor requests for their money back could force the fund out of business eventually, according to one person familiar with the situation. The firm disputed that, however. "There are no plans to shut down the fund," said Russell Sherman, a Bear spokesman. "We believe the fund portfolio is well positioned to wait out the market uncertainty. And we believe by suspending redemptions, we can ensure the best long-term results for our investors. We don't believe it's prudent or in the interest of our investors to sell assets in this current market environment." Traders said yesterday's selloff was set off by a warning from American Home Mortgage, whose stock had been halted on Monday and part of Tuesday, that pressure to repay its creditors may cause it to liquidate its assets. Its shares subsequently plunged 89% to $1.13. Several Wall Street firms have loaned money to American Home, the 10th-largest U.S. home-mortgage lender in this year's first half, according to Inside Mortgage Finance, a trade publication. The Melville, N.Y., company said the turbulent conditions in the mortgage market forced it to mark down the value of its portfolio of home loans and loan-backed bonds. Some of the lender's financial backers want their money back, and the company said it needs to hold on to cash in case the credit environment worsens. The insurance sector was also singed as two large mortgage insurers saw their share prices drop sharply after saying their stakes in a firm that invests in subprime mortgages had been "materially impaired." The primary line of business for mortgage insurers MGIC Investment Corp. and Radian Group Inc. is to insure the repayment of mortgages taken out by people who borrow more than 80% of the estimated value of the home. What spooked investors, though, was that the insurers, which have announced plans to merge later this year, also invested in Credit-Based Asset Servicing and Securitization LLC. This firm, known as C-BASS, invests in mortgages and related securities. Each insurer had more than $465 million of equity in the firm as of June 30. It is quickly becoming clear that many investors' belief that the troubles with subprime mortgages would remain contained is being tested. Although corporate balance sheets are largely in good shape, and relatively few U.S. companies have run into trouble recently, corporate bonds have been hit hard over the past month, pushing yields sharply higher, notes ITG economist Robert Barbera. "What we've seen in the U.S., it seems to me, is a break in the subprime mortgage market which served as a reminder that things don't always work out perfectly," Mr. Barbera said. "That led to a violent change in the willingness to finance risky companies." Many derivative instruments backed by corporate debt are constructed in a similar fashion to the collateralized debt obligations backed by subprime-mortgages that have fallen into turmoil. Many investors believe the structure of these so-called CDOs themselves, and not just the mortgage-backed assets they held, were to blame for the scope of the losses, and that has led to a broad-based reexamination of similar instruments. That has hurt stocks, too, because higher interest rates make it more expensive for companies to easily finance share buybacks and for private-equity players to finance buyouts. The latest developments in the credit markets are taking on a potentially dangerous, self-reinforcing quality. In the case of American Home, Wall Street banks including UBS AG, Bear Stearns and J.P. Morgan Chase & Co. said they wouldn't extend the company any more money. Some lenders have demanded back money they have already lent. In the case of the latest Bear hedge fund to run into trouble, investors began demanding their money back, even though it wasn't heavily exposed to subprime mortgages. In both cases, there was a crisis of confidence among backers. The process can feed on itself. The funds being hit by redemptions from investors or so-called margin calls from bankers -- requests for additional cash or collateral -- can be forced to sell their holdings at reduced prices, further lowering the market value of these assets. That in turn hurts other investors who hold similar assets. So far, the market turmoil created by the growing subprime crisis has been relatively contained. Even as two giant Bear hedge funds blew up in June, for instance, the stock market reached new heights. A bout of forced selling that feeds on itself could be a new problem for investors. It is too early to say that such a self-fulfilling cycle is setting in. Some investors are already circling in search of bargain investments in bond and loan markets, a sign of underlying demand that could help stabilize these markets. Still, there were more signs of institutions anxiously dumping even relatively high-quality mortgage assets. One investor received an email from Credit Suisse Securities seeking bids of 70 cents to 80 cents on the dollar for mortgage loans pledged as collateral on a short-term "warehouse" credit facility to American Home Mortgage. For Bear, the decline in the asset-backed fund is yet another black eye for its embattled Bear Stearns Asset Management unit. The weakening and eventual failure of two structured-credit funds in June and July, known as the High-Grade Structured Credit Strategies Fund and the High-Grade Structured Credit Strategies Enhanced Leverage Fund, cost investors as much as $1.6 billion in equity and forced the ouster of the unit's chairman. Perhaps more importantly, the events have delivered a blow to Bear's longstanding reputation on Wall Street as a savvy risk manager. Since the first week of June, when word of the High-Grade funds' struggles began circulating in the market, Bear's shares have taken a beating, dropping 25.5% so far this year. Late in New York Stock Exchange trading yesterday, Bear shares closed down nearly 5%, at $121.22. And in the past week, Bear's asset-management unit faced the departure of portfolio manager James O'Shaughnessy, a respected strategist and investor. Late last month, Mr. O'Shaughnessy, who joined Bear in 2001, announced plans to leave the firm in September to open his own institutional-investing business, to be called O'Shaughnessy Asset Management. Executives at Bear, which will have a stake in the new company, characterize the departure as long-planned and amicable. Nonetheless, with between $12 billion and $16 billion of assets under management, Mr. O'Shaughnessy's group of funds controlled a significant portion of the Bear unit's roughly $60 billion. Mr. O'Shaughnessy referred a call for comment to Bear's press office. Investors' concerns about Bear creditworthiness are showing up in other ways. The annual cost of protecting a notional amount of $10 million of the firm's bonds against a possible default for five years was at $93,000 Tuesday afternoon, according to GFI Group, a New York-based interdealer broker, citing credit-default swaps levels. That is significantly higher than the $21,000 it cost to buy the same protection at the beginning of the year, signaling that derivatives traders have been increasingly viewing Bear as a junk-rated credit. IndyMac Bancorp, another large home-mortgage lender, said the market for mortgage securities below investment grade has virtually dried up. That will force lenders such as IndyMac to make more-conservative loans that it can either retain as investments or sell to Fannie Mae or Freddie Mac, the two government-sponsored providers of mortgage funding. "The market [for mortgage securities] is pretty much terrified at this point," said David Castillo, senior managing director at Further Lane Securities, a dealer based in New York. "It's starting to sink in that this is a broad-based issue that's not going to go away any time soon." Citing turmoil in the subprime market, MGIC and Radian said Monday that their investments were impaired. The insurers each said they didn't know what charge they would ultimately need to take, but said it could equal their whole stake in C-BASS.