The hedge funds saw the panic building in the general marketplace and they wanted to lighten up. But who wanted to buy this mortgage-backed paper? Bids evaporated quickly and overnight, panic ensued.

Now normally, if you owned a stock or a bond for cash -- with no leverage propping up the purchase -- you could just hold on to the asset and wait for better times. But with leverage, the game is quite different.

If the $1,000 mortgage-backed paper was all of a sudden worth $600, because that's all someone was willing to pay for it, the math turns real ugly, real fast. Go back to our example of the $100 million fund supported by $10 million cash equity and $90 million borrowed. If the fund is now valued at $60 million rather than the $100 million, the $10 million of cash equity is gone and the $90 million loan still exists. The fund has fallen into negative equity immediately and is forced to sell whatever paper it owns to salvage something. But traders can be nasty people. When they know you have to sell, the bids go even lower. Why offer you $600 for your original $1,000 paper? Why not offer you $400, take it or leave it? The growing snowball keeps rolling down the hill.

Remember, if the fund owned the paper outright, paid for with cash, this would not be a problem. It could hold on and wait it out, or at least wait until the paper goes back up to $800 or $900. But no, these funds had to sell. Firms like Goldman Sachs (NYSE: GS) and Lehman Brothers (NYSE: LEH), who ran some of their own hedge funds, had to immediately inject their own firm's capital into the funds or face some serious Federal actions. This cost Lehman and Goldman a few billion to begin with. But wait there is more...

Who would buy the distressed paper? The system went haywire as bids disappeared and the confidence in the system was shaken to the core. Mortgages in the pipeline had no homes (pardon the pun) to underwrite and sponsor them. Terms changed quickly, and buyers of new homes were also traumatized. The flow of the mortgage market was trying to work through some huge clots. Money that flowed normally and naturally to keep that market going was hiding and running into short-term U.S. Treasuries. Even the Commercial Paper market, AAA rated, was in jeopardy of collapse. Corporations rely on short-term 30-day Commercial Paper to fund their daily operations. Many investors are not aware, but most money market funds are nearly 100% comprised of Commercial Paper.

As a note of comparison, even in the worst of situations, the stock market still maintains fluidity and liquidity. Investors may not like the bids, but the bids are present, and selling can normally be accomplished with ease and quickness. The credit markets have proved otherwise. There are no exchanges to speak of for the credit markets, just firms bidding on paper or selling paper. The dealers are normally in sync with each other, and the credit markets have had a good history of managing through tough times.

The problem with subprime mortgage paper and Alt-A mortgage paper is of course the underlying security of the homeowners -- the real estate. Sure, 97%-98% of Americans are still current with their mortgage obligations, but the 2%-3% in foreclosure are scary. With home values down anywhere from 10%-35% depending on location, the quick re-sell of a foreclosed property is not evident. This further erodes confidence. Throw on top of all this the billions of dollars of mortgages that will re-set to higher rates here in the fourth quarter and throughout 2008, and confidence erodes even more...

Continue reading The Good, the Bad and the Ugly: The Financial Stocks, Part 4

Georges Yared is the CIO of Yared Investment Research and the author of Stop Losing Money Today.