On Musical Chairs and Subprime Lending

Subprime lending is often a bit like a high-stakes game of musical chairs: everyone knows the loan has a higher (high?) risk of non-payment and/or default, but so long as the cash is flowing, yields are meaty. So the loans are packaged, sold, repackaged and resold, over and over again. It’s not a new game — money flows freely while the music plays; the only question is who is left standing when the music finally stops. Lest you be foolish enough to think that Wall Street can’t move quickly enough to find a seat of its own in the most recent subprime downturn, witness the recently-announced IPO of a previously unknown company known as Everquest Financial:

Never underestimate the ability of a Wall Street investment firm to find a new way to pawn off risky assets onto retail investors. The latest example? The initial public offering for Everquest Financial. Everquest is a fledgling financial-services company that has been buying up equity interests in risky bonds backed by subprime mortgages from hedge funds managed by Bear Stearns (BSC)—one of Wall Street’s biggest underwriters of mortgage-backed securities and other exotic mortgage-related bonds. The deal appears to be an unprecedented attempt by a Wall Street house to dump its mortgage bets.

Essentially, the play here is simple: pool a bunch of CDOs — which are themselves a pooled hodge-podge of assets — package the “pooled pools” in a publicly-tradeable security offering and see what kind of capital the IPO can generate. (Or, at the very least, have fun watching investors try to figure out how to value the whole thing.) Those who read this site regularly know that CDO managers, up until recently, had a nearly insatiable appetite for the meaty yields offered by residual tranches of subprime securitizations. And therein, HW readers, lies the rub:

…Everquest’s portfolio could be a time bomb. A “substantial majority” of the CDOs are backed by mortgages to home buyers with risky credit histories, according to its filing with the Securities & Exchange Commission.” The Everquest filing notes this possibility, saying: “Subprime mortgages have experienced increased default rates in recent periods. A deterioration in the assets collateralizing the asset-backed securities held by our CDOs could negatively affect the cash flows.”

Oh, but if that were all there was to this story of aggregation of risk gone wild. Ever heard of an “arms-length” transaction? Everquest hasn’t.

But the risk factors section of the Everquest IPO—spread out over 21 pages—would give even the most high-stakes gambler reason to pause. That’s especially so in light of the close relationship between Everquest and Bear Stearns. The filing notes that most of the CDOs were bought from hedge funds managed by Bear Stearns and based on valuations established, in part, by Bear Stearns. The filing concedes that the transaction, in which Bear Stearns hedge funds received 16 million shares in the soon-to-be public company and $149 million in cash, was “not negotiated at arm’s length.”

This could actually be a brilliant move on the part of BSC, if it works. And the fascinating thing to me is that this just might work, for a number of reasons I won’t cover here — in spite of the fact that this IPO would seem to take the well-worn concept of “the market’s collective intelligence” out to the woodshed for a sound beating.

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