Ten years ago yesterday, Bear Stearns sent a letter to shareholders of two specific hedge funds that it sponsored. Whenever anyone brings up the name now, you immediately know where this is going. That wasn’t the case in 2007, however. Whatever the world may think of Bear in hindsight, a decade ago it was a highly reputable firm.

These two particular hedge funds had earlier that year caused a rumble throughout the shadow system. On July 17, 2007, the bank finally declared them all but worthless, total wipeouts. In the mainstream, nobody could quite figure out why apart from invoking the generic idea of subprime mortgages. Everyone knew, or claimed afterward to know, that they were risky, but pinpointing the exact point of failure proved incredibly difficult. Something, something, CDS.

I wrote on August 1, 2007:

The strategy for the hedge funds, in simple terms, was to invest in senior tranches backed by subprime mortgages, hedged by puts against an ABX index. Information on the exact nature of the investments is still hard to come by under the veil of hedge fund secrecy but it looks to be that 90% of the investments were senior or better, meaning that 90% of the assets were AAA rated…

Then the wheels fell off, exactly where the models cannot predict. Despite the falling valuation of subprime CDO’s the ABX index stabilized. It seemed that the subprime loans made before the middle of 2006 were performing within constraints – it was the loans made in the third and fourth quarters that were the trouble. This distinction was the reason for the “all clear” signal that Wall Street and the Fed sent shortly after the New Century and Countrywide troubles were made public.

Credit default swaps through the Gaussian copula had been used since 2000 to obtain (meaning infer from market prices) correlation, which had meant up to that point mass production of even subprime MBS. The idea of senior tranches, including super senior, was overcollateralization; a thickness of protection where waterfall losses should never be able to wipe out all the mezzanines and equity pieces above. Yet, it was the senior tranches that were throughout of the greatest concern.

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