One might pick March of 2007, when one rating agency admitted on a conference call that it didn’t use the ability of borrowers to repay mortgage loans as criteria for rating residential mortgage-backed securities–and that their risk-models didn’t include a scenario in which house prices could fall–more than a percent or two, anyway–and we all know now what foolishness that was.
Maybe it was June 2007 when two highly-leveraged Bear Stearns hedge funds failed–they were loaded with mortgage-backed holdings that had dramatically decreased in market value. Bear Stearns guaranteed more than $1 billion to pay back the Wall Street firms that had provided the leverage–the creditors–which were, of course, higher up in the capital structure than shareholders. But the funds’ losses were so dramatic that there was virtually no money left in the funds, and Bear Stearns left shareholders to swing in the wind–see ya–no Bear guarantees for shareholders. Investors lost more than $1 billion in those two funds.
Now, of course, there is very little sympathy for investors who are qualified to invest in hedge funds. They are not widows and orphans, generally. However by their very nature, hedge funds are supposed to be, wait for it…hedged! Apparently, or allegedly, these were not so much hedged in a way that was meaningful or positive for investors as used as a levered betting machine. And, although they were hedge funds–these were not money market funds– the fact that Bear did not so much as apologize to investors for the egregious losses in funds that were supposed to be hedged–said volumes. (See related stories “Coming Home to Roost,” and “Litigation A-Go-Go,” from Investment Advisor.)
Back in that summer of 2007, there was a turning point in which some people started to recognize the huge amounts of leverage in mortgage, car and consumer loan, and other collateralized securities, and regulators and others started to realize how complex many new structured or derivative securities were. Some started to realize that unwinding some of these securities in which mortgage or other loans had been shredded and basically scattered among so many owners that nobody could tell who “owned” which mortgage–because it was in so many pieces in hands of so many different investors. That made it impossible to tell servicers of those mortgages–since they were effectively orphaned in terms of ownership–what to do if homeowners defaulted, so there was a gap in ownership responsibility and response to the crisis in its nascent stage.