NEW YORK - Wall Street shuddered when two hedge funds managed by Bear Stearns Cos. buckled from exposure to subprime loans, but economists say investors' reaction might be overblown.
At first, the news this past week seemed alarming. Shareholders of Bear Stearns found out Tuesday that two of its hedge funds were rendered practically worthless by wrong-way bets in complicated mortgage securities. Then, a few days later, several top U.S. banks said they've added to reserves to withstand loan defaults expected in the second half of the year.
But there were calming words from Federal Reserve Chairman Ben Bernanke, who said during congressional testimony that while there will be significant losses from the subprime market, he still views them as bumps along the road. And economists agree that losses from subprime mortgages won't likely trigger a systemwide credit crunch.
"There's a chance investors have been overreacting," said John Lonsky, chief economist at credit-rating agency Moody's Investors Service. "You don't want to be too cavalier about the difficulties with subprime, but you also need to realize it is going to take more than a subprime meltdown to trigger a recession and send your broad equity markets 10 percent or
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20 percent lower."
Recurring concerns about the fallout from bad subprime mortgages at times unnerved Wall Street this past week even as the Dow Jones industrials crossed the 14,000 mark for the first time. They also prompted buying in the Treasury market as bond investors sought quality.
Those tracking the subprime market believe the turmoil shouldn't have been completely unexpected. After all, in 2006 some $600 billion of subprime loans were extended by banks trying to cash in on the housing boom. The decline in home prices caused tens of thousands of home loans to go bad.
But, that doesn't mean all subprime loans are in jeopardy. In fact, Bernanke said Tuesday he expects losses in the range of
$50 billion to $100 billion as a worst case scenario.
And, that's not a massive amount for banks to grapple with considering they've set aside billions of dollars to cover the possibility of losses to their mortgage portfolios. Meanwhile, these same banks stand to benefit - buying up troubled loans and repackaging them as investments, such as collateralized debt obligations.
"All the Wall Street shops are really licking their chops to get at these loans," said Guy Cecala, publisher of Inside Mortgage Finance, a trade publication. "They'll set up entire divisions that will do nothing but buy non-performing loans and resecuritize them."
He also points out that the big Wall Street banks - Goldman Sachs Group Inc., Morgan Stanley, Merrill Lynch & Co., Lehman Brothers Holdings Inc., and Bear Stearns - "can afford to write off loans." Further, they've already made millions of dollars from underwriting securities that back the loans - and will continue to do so.
For instance, Bear Stearns does not expect its earnings to take a hit because of the collapse of the hedge funds. The nation's biggest banks - including Citigroup Inc., JPMorgan Chase & Co., and Bank of America Corp. - also raised their loan loss provisions.
And, even if there are losses, analysts believe these financial institutions will end up in much better shape. They are better positioned to handle troubled loans and investments. And, they've also shed some of the riskiest parts of their portfolios and raised borrowing standards.
"The spillover into other areas, like auto loans, has been much less than we thought it would be," said David Weiss, global chief economist for Standard & Poor's. "And the subprime problems were really a good wake-up call to those creditors that had become too complacent about default risk."
S&P said last week it was reviewing $12 billion worth of residential mortgage securities for possible downgrades. Moody's Investors Service also is re-
examining how it rates debt linked to subprime loans.
What economists are more troubled about isn't the loan side of the equation, but the fact there doesn't seem to be a let-up in the housing market decline. Construction activity has curbed as builders try to get rid of unsold properties while default rates among subprime borrowers has surged.
On Tuesday, Pulte Homes Inc. became the latest builder to warn of a hefty loss in the second quarter because of weak sales and write downs. Rivals like Meritage, D.R. Horton and Ryland have also warned.
"Declining home prices implies that consumer spending will grow less rapidly," Weiss said. "But, we're not seeing that. Chances are consumer spending will be great enough to extend the economic recovery, and keep the equity markets higher."