Fed keeps focus firmly on inflation

The financial markets were rocked last week by news of the near-collapse of two Bear Stearns hedge funds — both of which were big holders of shaky subprime mortgage bonds. Losses by those funds, and the murky nature of the mortgage bond market, left investors speculating on whether wider losses could spill over into the broader credit markets.

So far, the damage appears to be contained. Wall Street is relying on a system of credit firewalls that have been built into mortgage-backed securities — the pools of bonds that are created to slice up the risk of default — paying the highest returns to those who take on the most risk.

Instead of owning mortgages directly, investors buy separate bonds backed by mortgage payments. These new bonds come in different classes; holders of the highest-rated bonds get paid first. That way, even if most of the underlying loans go bad, the top-rated bondholders won’t lose money. Investors who buy the riskiest bonds — like those that are now showing the biggest losses — get the highest returns but are the first to get hit when defaults start rising.

To provide further protection for investors, some mortgage-backed bonds pay out lower interest rates to bond holders than the interest rate they take in from the underlying loans.

“That spread — that interest rate differential between what people are paying (on their mortgages) — and what the bonds are expected to pay — that can be used to cover losses,” said Susan Barnes, head of residential mortgage-backed securities ratings at Standard & Poors.

If mortgage payments come through faster than expected, the extra money can be used to pay off bonds faster than planned. That also helps offset the risk of any future defaults on the underlying mortgages.

So far, despite the high profile collapse of the subprime mortgage market, the fire walls seem to be holding. Though the total losses from mortgage defaults may eventually run into the billions, both Moody's and Standard and Poors say the riskiest paper represents less than 2 percent of all mortgage-backed securities.

Investors and central bankers are keeping a close lookout for signs that the subprime mortgage mess is spreading to the wider credit markets, which continue to amass huge pools of capital for a record pace of deal making. By historical measures, that capital is about as cheap and plentiful as it gets. The worry is that the nervousness in the mortgage market prompts lenders and investors to pull back on providing that capital — sharply reducing the amount of “liquidity” in the financial system.

“You don’t see that,” said Hoffman. “You hear tales about maybe on the edges some deals are going to be more costly in term of rates. But you don’t see any real signs of a liquidity squeeze.”

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