Bear Stearns Hedge Fund Blow Up - So What?
..
I started the Continued Fun at Bear Stearns... thread because I believed that we could be witnessing proliferating cracks in the underlying financial foundation supporting the credit / real estate bubble and that it might be instructive to watch the story play out. Hopefully, there are others similarly interested.
As I understand it, a couple of highly leveraged hedge funds, heavily invested in subprime mortgage backed CDO's, blew up because of lack of liquidity and so far that event hardly registered a ripple in the $24 trillion bond market or overall financial markets. So other than the original investors losing around $1.5 billion, (and maybe Bear losing a few hundred million) is this a "so what" situation or will there be repercussions? Hey, hedge funds are generally known to be somewhat high risk, can offer excellent returns, and are unregulated so caveat emptor, right?
I see the failures of the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund and High-Grade Structured Credit Strategies Fund as a result of bad management decisions and really not that significant of an event from the big picture perspective. After all, if Bear Stearns wouldn't have leveraged so drastically, it probably would have been able to pay out the redemption requests and avoided this whole situation.
When slogging thru all of the details, what really caught my attention was how investment banks and ratings agencies turned high risk, subprime mortgages into AAA rated investment grade bonds / securities thru the use of Residential Mortgage Backed Securities (RMBS) and Collateralized Debt Obligations (CDO). Mr. Bill Gross, manager of the $104 billion Pimco bond fund is actually quoted as saying:
Holders of investment-grade portions of collateralized debt obligations may lose all of their money...
...``AAA? You were wooed Mr. Moody's and Mr. Poor's by the makeup, those six-inch hooker heels and a `tramp stamp,''' Gross said in his monthly commentary posted on Pimco's Web site today. ``Many of these good looking girls (AAA rated CDO tranches) are not high-class assets worth 100 cents on the dollar.''...
I see part of the problem boiled down to this: The rating process used for CDO tranches is not the same as what is used in the corporate world. However, they use the same designations. The risk associated with an AAA rated tranche in a CDO based on subprime mortgages is definitely different from that of an AAA rated corporate bond. How many investors really understand that difference? I see a hoard of lawyers on the horizon with regards to this issue and some of them are shouting FRAUD! But no worries, the ratings agencies covered themselves with a disclaimer statement.
One major change I believe we are going to see is how CDO's and MBS's are rated. I believe the system where these securities are rated by some mathematical model made up by investment bankers and ratings agencies will be forced to change to a more standardized, regulated, and transparent system. Investors will then see CDO's for what they really are and this will have a drastic negative effect on the marketing of high risk mortgages.
I have no background in finance and I know there are a lot of intellegent, experienced people who visit this blog. It would be interesting to hear from those who have been following the Bear debacle as to what you think the eventual fallout, if anything, will be.
Is the Bear Stearns hedge fund blow up a "so-what" thing?
..
I started the Continued Fun at Bear Stearns... thread because I believed that we could be witnessing proliferating cracks in the underlying financial foundation supporting the credit / real estate bubble and that it might be instructive to watch the story play out. Hopefully, there are others similarly interested.
As I understand it, a couple of highly leveraged hedge funds, heavily invested in subprime mortgage backed CDO's, blew up because of lack of liquidity and so far that event hardly registered a ripple in the $24 trillion bond market or overall financial markets. So other than the original investors losing around $1.5 billion, (and maybe Bear losing a few hundred million) is this a "so what" situation or will there be repercussions? Hey, hedge funds are generally known to be somewhat high risk, can offer excellent returns, and are unregulated so caveat emptor, right?
I see the failures of the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund and High-Grade Structured Credit Strategies Fund as a result of bad management decisions and really not that significant of an event from the big picture perspective. After all, if Bear Stearns wouldn't have leveraged so drastically, it probably would have been able to pay out the redemption requests and avoided this whole situation.
When slogging thru all of the details, what really caught my attention was how investment banks and ratings agencies turned high risk, subprime mortgages into AAA rated investment grade bonds / securities thru the use of Residential Mortgage Backed Securities (RMBS) and Collateralized Debt Obligations (CDO). Mr. Bill Gross, manager of the $104 billion Pimco bond fund is actually quoted as saying:
Holders of investment-grade portions of collateralized debt obligations may lose all of their money...
...``AAA? You were wooed Mr. Moody's and Mr. Poor's by the makeup, those six-inch hooker heels and a `tramp stamp,''' Gross said in his monthly commentary posted on Pimco's Web site today. ``Many of these good looking girls (AAA rated CDO tranches) are not high-class assets worth 100 cents on the dollar.''...
I see part of the problem boiled down to this: The rating process used for CDO tranches is not the same as what is used in the corporate world. However, they use the same designations. The risk associated with an AAA rated tranche in a CDO based on subprime mortgages is definitely different from that of an AAA rated corporate bond. How many investors really understand that difference? I see a hoard of lawyers on the horizon with regards to this issue and some of them are shouting FRAUD! But no worries, the ratings agencies covered themselves with a disclaimer statement.
One major change I believe we are going to see is how CDO's and MBS's are rated. I believe the system where these securities are rated by some mathematical model made up by investment bankers and ratings agencies will be forced to change to a more standardized, regulated, and transparent system. Investors will then see CDO's for what they really are and this will have a drastic negative effect on the marketing of high risk mortgages.
I have no background in finance and I know there are a lot of intellegent, experienced people who visit this blog. It would be interesting to hear from those who have been following the Bear debacle as to what you think the eventual fallout, if anything, will be.
Is the Bear Stearns hedge fund blow up a "so-what" thing?
..
Comments
Bear Sterns is one of the first shoes to drop in the financial sector. I don't believe that it will directly cause the next shoe to drop, but what it does instead is it shines some light on what's really going on. The biggest question is what shining that light will uncover.
Some things to keep in mind:
Bear Sterns' funds were highly leveraged. That's why they had a problem, and if you look closely, there is far too much leverage going on right now. Whether it's leveraged buy outs, leveraged hedge funds, or even leverage on housing. Everyone has taken the class where you learn how leverage can make your 5% return become a 35% return. When things go up, this is great, but when they go down it is catastrophic.
Additionally, it has shown that mark to model evaluations are probably flawed. We're going to see the effects of re-evaluation for a long time. Some institutions investing in subprime tranches are required to hold only investment grade securities. If these get marked down, those investors(pensions mostly) must sell. The problem is that selling is exacerbated by leverage. A sell on 10-to-1 leveraged positions moves a lot more money than a sell on unleveraged positions.
Those are the two things I think need to be learned about Bear Sterns.
The reason the BSC funds are important to me are:
End of mark to model.
High profile CDO implosion. Gets attention of other CDO bagholders.
Feds perk up.
It starts to constipate the entire secondary market for MBS. This pinches off the liquidity to the retail real estate market. This has the very real potential to become dynamically unstable and feed on itself.
Credit problems start small and grow exponentially. Once they reach critical mass, the entire system siezes up. The next fund blowup will be easier then the BSC, as bagholders and lenders have a hair trigger on their interests.
If the system starts to cross contaminate, equities will start to falter.
Prior to the BSC problems, there were problems but nobody could point to anything concrete. Everyone thought problems were theoretical.
No longer.
This agrees with my leverage argument, but it adds a confidence argument as well. IE if Bear Sterns causes lower marketplace confidence, and if other funds are leveraged as much as Bear Sterns was, then you may see similar action moving forward.
Good feedback. I especially agree that CDO's will become much more scrutinized.
I can't help but wonder if these hedge fund failures are related to the recent tightening of lending standards - like the straw that broke the camels back?
(23 July 2007) To answer to my own question - the Bear debacle definitely was a stimulus for the ratings downgrades on bonds related to subprime mortgages (read RMBS's and CDO's), which apparently then motivated lenders to give up on 2/28 ARM's.
Cornered banks drop bread-and-butter subprime loans
...Lenders abandoned their 2/28 programs one after another in a matter of days after rating agencies announced hundreds of bond issue downgrades tied to these subprime loans and tightened credit requirements last week....
Other related
Bear Stearns to be sued over subprime funds: CNBC
Investors in Bear Stearns Cos. (BSC.N: Quote, Profile, Research) hedge funds that were virtually wiped out from large bets on risky mortgages are planning to sue the company as early as Monday, television channel CNBC reported on Friday.
The lawsuit will be brought by the firm of Bernstein Litowitz Berger and Grossman LLP, which represented investors against WorldCom Inc. over a massive accounting fraud, CNBC said.
According to CNBC, the lawsuit will allege Bear Stearns made material misrepresentations in offering documents, misrepresented risks of the hedge funds in those documents, and misrepresented its ability to control those risks.
An official at Bernstein Litowitz told Reuters the firm was contacted by some investors who were seeking their advice.
Officials at Bear Stearns did not immediately return requests for comment.
Legal experts have said the losses in the Bear funds are so large that litigation is almost inevitable.
But they say plaintiffs could have a tough time proving their case. Because the funds were aimed at sophisticated investors such as institutions and wealthy clients, it could be hard to argue that the risks were not properly understood.
..
Just came to point out that I think we're being too impatient here. Analogy of a ripple was a good one, but extend it out. The ripple starts where the stone goes into the water, and an hour later it reaches the shore, having covered the entire body of water before it gets done.
Bear matters a lot, but it could have been anyone: somoene had to be first. They are by no means the only over-leveraged entity who forgot about risk since 2002. It's standard procedure now, haven't you heard?
So, Bear's fate will become the fate of many, many others, but IN SLOW MOTION. The action on the dollar has actually been pretty fast lately. Oil has gone from $10 to $80 in only 9 years. These things seem slow when you compare June to July, but global markets are like geologic time.
So, I see a lot of people looking at this as a 'so what' moment so far, but when your quarterback gets knocked out of the game, do you shrug it off as no big deal when you are still winning three plays later? Hell no, because you know it is a long game and your team is too paralyzed to keep winning.
Give this time to play out; keep the big picture in mind and you'll see that Bear is as far from 'so what' as you can get.
Leverage, Ratings and Forced Unwind
....Given that, if you're still puzzled about how, exactly, all this leverage and marking to market and downgrading of securities can come together to wipe out entire large hedge funds, here's an attempt to explain the basic mechanisms. Those of you who are well beyond basic mechanisms should go play outside today....
...
With regards to possible repercussions, I think we are seeing some now. Could it be so simple that the reason high-grade corperate bonds are taking a hit is because they share the same ratings designations as high risk, subprime mortgage junk? I keep reading that "sophisticated" investors know the difference. If that's true, why are lawyers involved now claiming "misrepresentation"?
Subprime takes toll on high-grade corperate bonds
The perceived risk of owning investment-grade corporate bonds rose on Friday by the most since February as worries about the subprime mortgage market took a toll on investors' appetite for risk.....
......Risk aversion has spread from the junk bond market to higher-rated corporate bonds as rating agencies downgraded hundreds of bonds tied to subprime loans. Losses at two Bear Stearns (BSC.N: Quote, Profile, Research) hedge funds exposed to subprime mortgages have also touched off worries about broader fallout.....
..
On Wall Street: The time has come to clarify ratings criteria
The virtual collapse of two US hedge funds sent shockwaves through financial markets this week, as investors faced up, yet again, to the continuing fallout from the US subprime mortgage crisis.
Investors in the two Bear Stearns-managed hedge funds discovered that their holdings were worth almost nothing. Bear said the losses reflected, in part, "unprecedented declines in the valuations of highly rated (AA and AAA) securities". Complex instruments backed by low-quality US subprime mortgages were the culprits.
The subprime debacle initially caught rating agencies, and investors, by surprise. Fitch, Moody's and Standard & Poor's may deserve criticism but other factors are also at work.
A top credit trader half-jokingly told me that 90 per cent of Wall Street is in the business of arbitraging ratings. This often involves betting on clever debt structures that achieve certain ratings but pay investors more interest than similarly rated, old-fashioned bonds.
Debt, including risky subprime mortgages and junk-rated loans, can be repackaged into new securities, most of which carry far higher ratings than the underlying loans. Such mortgage-backed securities (MBSs) and collateralised debt obligations (CDOs) can be mind-bogglingly complex.
Could Bear's fund managers have focused too much on the "excess" return they thought they were getting on securities with a given rating and not enough on the actual credit and market risks? Possibly. But if so, the mindset owes something to a system, blessed by the politicians now pointing fingers, that encourages investors to rely blindly on credit ratings.
Some US regulated financial institutions can only buy debt with certain minimum credit ratings. And the Basel II rules for bank capital could actually increase the importance of ratings, according to Louise Purtle of CreditSights. Investors should, of course, do their own analysis but the temptation must be to buy whichever security with a given rating pays the highest return.
Yet even if ratings accurately reflect the risk of default, they explicitly do not address "illiquidity" – one aspect of which is that market prices for some rarely traded instruments can fall far below expected levels. Ideally, regulators would force investors to assess debt investments for themselves, using only the outside opinions they find persuasive. But abandoning decades of practice is unrealistic. US lawmakers have instead tried to clarify criteria for official recognition of rating agencies and set standards for their procedures.
Sadly, that does not guarantee accurate ratings. For a start, the "garbage in, garbage out" rule applies. MBS and CDO ratings require assumptions based on actual experience. If history is not representative for the relatively young business of subprime lending and inputs turn out to be flawed, so will ratings.
Other issues arise with aggregated data. After two agencies' recent conference calls, Ms Purtle said, investors were left feeling that key questions about subprime MBSs were "too specific to be addressed by using broad averages but that the relevant detailed data is not necessarily available".
It hardly instils confidence when agencies mess up on the basics. S&P, for example, last week corrected a high-profile release on rating moves on subprime MBSs. The 612 actions affected $7bn of securities, not $12bn as the agency originally said – an astounding error. Some critics also fault the complex mathematics used in such ratings: the agencies say they make their methods public, allowing investors to draw their own judgments.
The influence of the big three creates another problem. It means they are reluctant to take negative actions too early because it could undermine investor confidence but more often, they get brickbats for moving too late.
The agencies are careful to call their ratings mere "opinions", successfully insulating them from legal liability to date. But the more faith placed in them by officialdom, the more investors rely on them. And the bigger their apparent shortcomings, the more likely a devastating loss in the courts surely becomes.
That risk might fade if the agencies did more to dispel their mystique, perhaps indulging in the occasional frank mea culpa. Of course, over time that would erode their credibility and influence – and profits.
..
Cause most of the people with "safe" retirement portfolios are invested in bonds, but these are the other non-sophisticated group. What kind of bonds are in those retirement funds? Well, only sophisticated investors ask such questions.
<tangent warning>
Oh, were the boomers planning to retire early again? They just recovered from their 2002-can't-retire-yet depression? Oops.
See, Wall Street didn't spend the last 30 years getting us all to invest in the markets 'long-term' so we could just up and take it all out one day! Why, that'd make US rich, and stop making THEM rich! Who would pay the fees and commissions???
Expect some resistance to that cash-out plan, boomers. The idea has never been to make YOU wealthy so you don't have to do real work.
I like to think of all the 401(k)'s in the country as a big fat juicy target. If you want to make a lot of money, you have to find someone who can lose a lot of it. Hmm, where is there a big pot of money just lying around? It would be great if people couldn't even move it away from your control while you fleece them, wouldn't it? Hmmm, where to find such a score????
</warning>
Very good point, perplexed. You have to understand your investments to at least a minimally competent degree to ask questions. So it has to be the "unsophisticated" investors who are represented by these lawyers, right?
It might be interesting to learn how the "sophisticated" investors are differentiated from the "unsophisticated" investors during the upcoming legal confrontations.
..
"Sophisticated" or "Accreditited" investor is actually a legal description used by the SEC under Reg D (AKA "rich person"). A sophisticated investor could buy into a hedge fund or other unregulated/lowly regulated security. J6P is limited to buying straight bonds or mutual funds with his 401k.
Okay, so the individuals suing Bear must be the unsophisticated, (simple, not knowledgeable) sophisticated (rich, accredited) investors. --
..
KKR, Homeowners Face Funding Drain as CDO Sales Slow (Update1)
The Wall Street money-machine known as collateralized debt obligations is grinding to a halt, imperiling $8.6 billion in annual underwriting fees and reducing credit for everyone from buyout king Henry Kravis to homeowners.
Sales of the securities -- used to pool bonds, loans and their derivatives into new debt -- dwindled to $9.1 billion in the U.S. this month from $42 billion in June, analysts at New York-based JPMorgan Chase & Co. said in a report yesterday. The market, which was ``virtually shut'' earlier this month, is showing ``signs of life,'' the bank said.
Investors are shunning CDOs after the near-collapse of two hedge funds run by Bear Stearns Cos. that owned the securities. Standard & Poor's downgraded bonds from 75 CDOs as mortgages to people with poor credit defaulted at record rates. Concern about losses on home loans are rattling investors across the credit spectrum.......
...
Did you see the article on bloomberg about their CEO?
Yeah, I've seen that article. Mr. Cayne took some heat from some bloggers / MSM columnists for playing golf during a "crisis" - a bit petty in my opinion.
I also noted the "....doesn't expect to lose even a dime...." statement. It's curious how wildly variant estimates of Bear's expected losses are. This article indicates zero loss and I read somewhere else that Bear is expected to lose $Billions. Considering the fact that hedge funds are "opaque", provable numbers may never be made available. Is that the way you see it?
..
You'll get numbers just as soon as Bear Sterns writes them off some quarter. But it might not be a quarter that correlates chronologically with mid June-July.
From what I can tell, the following basically happened.
- Banks sell bad loans, and end up holding the bag. - Banks create Hedge Funds to pass the bag off. - Hedge Funds promise spectacular gains to wealthy, thus passing the bag off. - Wealthy investors catch on, and start getting out. - Hedge Funds open up investing to 'Every Joes', telling them what a great deal it is. - Cue the suckers. - June 2007
Moody's Says Subprime Rout Is a `Serious' Worry (Update2)
The credit market rout caused by the slump in U.S. subprime loans gives ``serious reasons to worry'' and is a ``reality check,'' without posing a systemic threat, according to Moody's Investors Service.....
......Moody's, Standard & Poor's and Fitch Ratings have been criticized by investors because their ratings on bonds backed by mortgages to people with poor or limited credit didn't reflect the highest default rate in 10 years. Some bonds backed by subprime mortgages fell by more than 50 cents on the dollar this year without their credit ratings changing.
Moody's and Standard & Poor's this month cut ratings on billions of dollars of bonds backed by subprime mortgages, on expectations home-loan defaults will rise.
Moody's in its report today said the criticism of its subprime debt rankings stem from ``a lingering confusion'' about its role. Credit ratings provide an assessment of default risk for the ``hold-to-maturity credit world'' rather than addressing the ``volatility-liquidity issues'' that interest investors such as hedge funds
``Ratings are not and cannot be predictors of market prices,'' the report said.
....The collapse of two Bear Stearns Cos. hedge funds caused investors to shun collateralized debt obligations, securities that repackage bonds, loans and their derivatives into new debt. Demand from CDOs for new debt was one of the engines behind a credit boom in which financial companies gave mortgages to people with poor credit histories and little or no documentation...
...Some of the losses caused by subprime mortgages have yet to emerge and Bear Stearns' bailout of its hedge funds indicates ``some degree of contingent liability'' for banks and securities firms that sponsor hedge funds, Moody's said....
..
RCC,
You were saying on previous posts that investor confidence will be an influencing factor:
Goldman Sachs, Bear Stearns Bond Risk Soars, Credit Swaps Show
The risk of owning bonds of Wall Street firms soared as concerns escalated that investment banks will be hurt by losses from subprime mortgages and corporate debt.
Credit-default swaps on $10 million of Goldman Sachs Group Inc. bonds jumped as much as $18,000 to a record $85,000, according to broker Phoenix Partners Group in New York. Bear Stearns Cos. credit swaps surged as much as $29,000 to $110,000, also a new high. Lehman Brothers Holdings Inc. climbed as much as $24,000 to $104,000.....
....An increase in credit-default swaps, used to bet on the companies' creditworthiness, signals deterioration in investor confidence......
....That confidence has been sapped after hedge funds run by at least seven firms reported or forecast losses after the rout in securities backed by subprime mortgages, some of which have lost at least half their value as defaults among the riskiest borrowers rise. Slumping demand for high-yield, high-risk debt forced almost 40 companies to rework or abandon bond offerings in the past three weeks.
The rising risk perceptions of brokers extended to indexes tracking the risk of owning everything from bank loans to subprime mortgages.....
What are credit default swaps?
..
this is the logical extension of the troubles in the mortgage market, and what I think will be the straw that breaks the camel's back.
the market could probably absorb a few more BS hedge implosions. Chrysler to Cerebus going kapoowee? not so much. that would mean LBOs as a driver of upside are DEAD. debt-levered returns are gone.
I read they couldn't place the second-place debt at LIBOR +900BP. That's something like 13% interest rate. that's what is tubing the market.