In case you missed it, the US stock market was rattled by the continuing aftershocks of the Bear Stearns subprime-related hedge fund fallout, with the Dow down 185, and Bear itself was down in line with the Dow (both fell 1.4%, although Bear was up slightly in the aftermarket at this hour).
Now the odd thing about the continuing coverage of the Bear drama is the disconnect between the Wall Street Journal and the Financial Times (one of our favorite themes). The Journal story is shocking in terms of journalistic negligence (please find the full article at the end of this post).
The Journal piece tells us at the beginning (as we recounted yesterday) that Bear has decided to lend up to $3.2 billion to bail out one of the two troubled hedge funds. Early on, the article notes:
Bear may have prevented a wider meltdown — and kept many of the subprime bonds from plunging in value in a fire sale. Its injection of money also will help bring order to the market and pay back loans made by other big Wall Street banks to the Bear-managed hedge fund called the High-Grade Structured Credit Strategies Fund — though prospects for a sister fund that relied even more on debt, the High Grade Structured Credit Strategies Enhanced Leverage Fund, remain in doubt.
It also gave some reassurance:
Others anticipate more limited fallout, though. “We continue to see this issue as more a reputation issue for Bear versus one that could lead to significant loss of equity capital,” Banc of America Securities analyst Michael Hecht said in a report.
The article then goes into a very detailed discussion of the events: a bit of background on Bear, the establishment of the funds, and their deteriorating performance; a riveting recount of the last few days, of Bear at first letting the funds and their manager Ralph Cioffi twist in the wind, then entering into a tense and contentious series of presentations to and negotiations with creditors to the funds.
Aside: one of the benefits of things getting ugly is that all the participants take good notes.
So why am I taking the Journal to task when it did a great job of getting the dirt? Read to the very end of the piece:
[Bear Stearns Co-President ] Mr. Spector worked the phones Thursday afternoon, reaching out to various CEOs and senior Wall Street executives, according to a person familiar with the matter. The upshot: save the less leveraged fund that had better-quality assets and let the other fund collapse.
Huh? Let the other fund collapse? If this is where things stand, this is a vastly more important news item than anything preceding in the story. Stopping here is the sort of trick you see in serialized fiction, not serious journalism. The backstory and the prurient details of the wrangling, while impressive, are largely entertainment. The crucial bit, of most importance to readers, is what the prospect for these funds is and what the windup or failure of these funds might mean.
Let’s assume the bombshell at the end of the article was true. Why would other heads of Wall Street firms advise Bear to save the fund with better collateral but less debt outstanding? Normally, one would think the bigger fund, which had much greater borrowings (roughly $6 billion) and junkier assets, would do more damage if it failed.
1. The bagholders, um, creditors to that fund were less concentrated (i.e., even though the damage in aggregate would be greater, individual firms were less exposed).
2. (Merely a variant of 1) The bagholders were not major Wall Street firms
3. Bear was somehow more heavily exposed to the bigger fund (meaning the other firms are telling Bear to stuff it)
But a related question is why would the other Wall Street firms advocate a liquidation in the junkiest end of the subprime market? This puts them at risk. The investment banks themselves will likely be required to write down similar paper (regulators are now keenly interested and keeping illiquid paper at stale valued may no longer fly). That will lead to margin calls to any hedge funds or other investors that have borrowed against similar paper. That could lead another hedge fund to tip over, raising the possibility of a domino effect.
1. As the Journal story made clear, a lot of players are mad at Bear. Once they take the weekend to cool off, they will relent
2. This is mere posturing. Bear is making a grossly inadequate offer and everyone has learned the only way to get Bear to improve its terms is to tell it to go to hell
3. Perhaps these firms individually believe that they do not have much exposure to the weakest credit quality mortgage paper. As the biggest lender to hedge funds, Bear would be the most damaged in any large scale hedge fund meltdown. Perhaps Bear is also disproportionately more active in lending to hedge funds that were active in the crappiest subprime paper. Or perhaps most of the buyers of this paper didn’t leverage it at all (Bear was selling “toxic waste,” the worst CDO tranches, to public pension funds)
4. Perhaps the powers that be deem an unravelling at the very bottom to be the least bad outcome (hopefully only other terrible paper will be revalued, while a revaluation of higher-grade paper would force everything below it to be repriced)
There are likely other explanations. Honing in on them would seem a worthwhile exercise. Most people believe this toxic waste was sold to real chumps. It could fetch as little as 25 cents on the dollar (and that might even be a generous estimate, given that the fund will presumably be dumping a lot of paper at once). $4.5 billion of losses (75% of $6 billion) is not a trivial number even if it is spread around, since some firms are likely to be more exposed than others (by comparison, Bear’s equity is roughly $13.3 billion).
By itself, even this level of damage will not create systemic distress, but it will at least trim a lot of sails. And if another subprime hedge fund goes into a meltdown, all bets are off.
I don’t begin to have the answers to these issues. But for the Journal to have deployed its considerable reporting horsepower on reconstructing the past rather than getting the best reading possible on the current state of play, is a misallocation of resources and a disservice to its readers. But maybe its staff is warming up for the Murdoch era.
By contrast, the Financial Times, while it got no where near the level of access and cooperation that the Journal appears to have obtained, kept its eye on the ball and gave a simple but clear recap of current state of negotiations (and made clear the bigger fund’s state was unresolved):
Bear Stearns raised its exposure to subprime mortgages on Friday, confirming it would extend $3.2bn (£1.6bn) in secured loans to one of its two in-house hedge funds suffering from bad subprime bets.
The announcement drove down shares in Bear and other investment banks, helping push the Standard & Poor’s 500-stock index down about 1.3 per cent.
The news came at the end of a week in which Bear struggled to satisfy creditors who have seized some of the funds’ assets.
Banks including Merrill Lynch, JPMorgan and Cantor Fitzgerald have sold some of the collateral. Under the terms of the loan, first reported by the Financial Times, Bear agreed to provide a $3.2bn credit line to its High-Grade Structured Credit Strategies Fund.
The loan did not address problems faced by the closely related but larger High-Grade Structured Credit Strategies Enhanced Leverage Fund, which borrowed at least $6bn from banks to make bets on the subprime market.
The enhanced leverage fund is down about 23 per cent this year to the end of April, according to people familiar with the matter. Bear is continuing to work with creditors to that fund.
The rescue package does not cover Barclays Bank, which is understood to have financed $200m-$300m of extra leverage for investors who wanted more gearing than Bear’s funds provided.
Barclays remains in negotiations with Bear, but market sources said it was likely to consider legal action.
Barclays said its loss was “not material” and declined to say more.
Sam Molinaro, Bear Stearns chief financial officer, said the bank was comfortable that the $3.2bn loan was over-collateralised by assets held by the fund.
However, he acknowledged that the value of those assets had declined significantly in recent weeks, making it unclear whether Bear could recoup the entire $3.2bn.
Bear Stearns shares fell 1.6 per cent to $143.45.
Joseph Mason, a professor at Drexel University in Philadelphia, said the outlook for subprime mortgages and securities based on them was bleak with defaults expected to increase with higher interest rates and lower house prices.
From the Journal article, “Bear Stearns Bails Out Fund With Big Loan“:
Bear Stearns Cos.’s dramatic decision to lend as much as $3.2 billion to one of its two troubled hedge funds staves off the risk of a fund collapse that could have damaged its position as a major Wall Street bond player — and had the potential to ripple through a jittery subprime-mortgage market.
The loan on Friday came only after days of high-stakes brinksmanship with some of Wall Street’s biggest players. All wanted to protect their stakes in the hedge funds, but they worried as well that a liquidation of the funds — which invested heavily in subprime-mortgage assets — risked igniting a broader panic in the mortgage-bond market.
The events have kept Wall Street riveted for two weeks because a lot of firms are deeply invested in the subprime sector — which caters to borrowers with weak credit, and which has suffered in the housing downturn as delinquent loans have spiked.
Bear may have prevented a wider meltdown — and kept many of the subprime bonds from plunging in value in a fire sale. Its injection of money also will help bring order to the market and pay back loans made by other big Wall Street banks to the Bear-managed hedge fund called the High-Grade Structured Credit Strategies Fund — though prospects for a sister fund that relied even more on debt, the High Grade Structured Credit Strategies Enhanced Leverage Fund, remain in doubt. The firm, whose move helps preserve its reputation, eventually might even make some money from the struggling investments. And late Friday, as rivals continued to sell or wind down their positions with the one fund, it became clear that Bear may only need to lend $2 billion or less.
Together, the two Bear funds once commanded investments of more than $20 billion in complex debt instruments, mostly backed by subprime mortgages, in addition to billions more in wagers that certain markets would fall.
Stock and bond markets remained wobbly Friday. The Dow Jones Industrial Average on Friday fell 1.4%, closing at 13360.26.
Even if Bear is able to salvage one of its funds, the crisis is a black eye for the brokerage house, a rough-around-the-edges firm run by 73-year-old James Cayne. One of Wall Street’s most colorful characters, he is known for smoking cigars in his office and being unbending, often saying he doesn’t want to travel to see other chief executives and politicians. It may also end up being a financially costly gambit for the firm, whose performance is already feeling the pinch of the subprime woes. Prior to yesterday, Bear’s financial exposure to the funds was largely limited to $40 million invested by the firm and its executives.
Yesterday, Bear described the move as a responsible one for the market. “We’re trying to deal with this problem in as forthright a way as we possibly can,” Bear’s chief financial officer, Sam Molinaro, said in a midday conference call with analysts. Its share price fell more than 4% for the week, after dropping $2.06 on Friday to $143.75.
The clash provides a case study on the challenges that some big hedge funds face in navigating a world full of complicated financial instruments. Over the past decade or so, financial markets have grown substantially and have spread globally, leading to sophisticated and complex ways to place bets, often with large amounts of leverage.
The past several years have been noteworthy because there hasn’t been a major system-shaking financial problem, but with that has come a worry — among regulators, scholars, central bankers and others — that has led an ever-increasing appetite for risk that is bound to end badly for someone. So far, none of the hiccups has had a system-rattling effect: No major institution has collapsed, stock and bond markets have been buoyant. But each new episode renews worries that it will be the one to have ripple effects.
“Regulators are likely to force banks to review their lending standards more carefully” in light of the funds’ meltdown, said Richard Bove of Punk, Ziegel & Co., a boutique investment bank. “The economics of the business have changed in a very negative fashion as Bear makes its $3.2 billion loan. The American banking system is safe and sound because the regulators demand that failing loans be allowed to fail.”
Others anticipate more limited fallout, though. “We continue to see this issue as more a reputation issue for Bear versus one that could lead to significant loss of equity capital,” Banc of America Securities analyst Michael Hecht said in a report.
The steady inflow of cash from yield-hungry players such as hedge funds into subprime mortgages in recent years is one reason it became so easy for borrowers with spotty credit to get loans. Market conditions had already turned against such lending earlier this year, and the threat of fire-sale prices of subprime-backed securities by the hedge fund or its creditors could have further tightened the taps on such credit, making it even more difficult for borrowers to get loans.
Firms that loaned money to the hedge funds to make additional investments — some of Wall Street’s other big players such as J.P. Morgan Chase & Co., Merrill Lynch & Co., Goldman Sachs Group Inc. and Barclays PLC — spent much of the week testing the market’s appetite for the mortgaged-backed assets in the fund, which they held as collateral. The results were mixed.
Some assets were scooped up at or near asking prices, but others received offers of 50 cents on the dollar or less, which left some of Bear’s lenders holding hard-to-sell assets. Bear’s rescue attempt might not end the turmoil in the market. The future of both funds remains in some doubt. It isn’t clear yet how other banks will respond to this latest financing offer. Banks are still seeking to sell off collateral from the more indebted fund. Meanwhile, the credit line proposed by Bear could enable the less-leveraged fund to survive.
It isn’t the first time Bear, known as one of the savviest bond players, has had tense dealings with Wall Street firms in a crisis. Some industry veterans still resent the way Bear and Mr. Cayne acted during the Wall Street-led bailout of Long-Term Capital Management, a large hedge fund that nearly collapsed in 1998. There were striking similarities to the current predicament in that situation, too: A large hedge fund was failing and it fell to Wall Street to consider propping it up or walking away.
In that case, 16 major financial institutions met at the New York Federal Reserve in September 1998 to determine their contributions to the LTCM bailout. Speaking first, Mr. Cayne jolted the gathering by announcing Bear wouldn’t participate, according to witnesses, arguing his firm already had taken on plenty of risk clearing trades for LTCM. Some rival executives were incensed.
Even now, Bear relishes its contrarian role. At private dinner Wednesday night in Washington to meet presidential candidate Barack Obama, several of Wall Street’s top executives were in attendance. Bear Stearns Co-President Warren Spector drew some of the biggest laughs when he introduced himself as working for Bear Stearns, “the current scourge of Wall Street.” Mr. Spector didn’t return a call seeking comment.
The funds behind the current blowup are run by Ralph Cioffi, 51, a 22-year Bear veteran, whose low-key manner has made him popular with fellow investors and salespeople in the mortgage-bond securities industry.
Mr. Cioffi joined Bear as a bond salesman, and became its New York head of fixed-income sales in 1989. A specialist in securities backed by other kinds of bonds and debt, he helped build Bear’s business of creating and trading these products. He took on other top roles in the investment bank over the years. In March 2003, he started the High-Grade Structured Credit Strategies Fund.
The two funds he managed, as their names implied, invested more than 90% of their assets in securities that were supposed to be as safe as, or almost as safe as, a U.S. Treasury bond, according to documents reviewed by The Wall Street Journal.
But these investments were much different from Treasurys. While Treasurys are widely traded and have values that can be easily tracked, the Bear funds were concentrated in little-traded derivative instruments known as collateralized debt obligations, or CDOs. These investments package together pools of assets and pay investors interest based on the payments they receive from the assets. The assets backing many of these CDOs were subprime mortgages.
Though subprime mortgages are highly risky, Wall Street carves CDOs into pieces so that some investors can take on more risk than others. The Bear hedge funds took on many less-risky pieces. They also borrowed heavily, which helped to enhance their returns on those less-risky pieces.
The strategy paid off for a long time — so well that in August 2006 Mr. Cioffi’s team created a similar fund that would rely significantly more on borrowing to fund its investments to boost returns. At the time, the High-Grade fund had returned more than 36% in less than three years, according to documents reviewed by the Journal. By January 2007, it had gone through 40 months without a decline, and boasted a cumulative return of 50%.
Many investors in the first fund shifted some of their money to the second fund last summer. One of them was Ted Moss, a 67-year-old real-estate developer from Cleveland, Tenn., who invested about $1 million in the High-Grade fund during 2004.
“I often bragged about the fund because it didn’t have a single down month in three years, and that was just amazing to me,” says Mr. Moss. When the second fund was launched, Mr. Moss withdrew his money from the first fund, kept half of it, and invested the other half in the Enhanced Leverage fund.
At the same time, the fund was making other bets on the mortgage market, including a trade structured to pay off if an increasingly popular trading index tied to subprime loans was to fall. Until March, it had been a winning trade. This index, called the ABX index and managed by a London firm called Markit Group Ltd., had been falling. It had the added benefit of being a hedge: If the subprime market continued to weaken, it could hit CDO bonds, but investors who were betting against the ABX index could make up their money on declines in the index.
In February, the trades started to go haywire. As the market for subprime-mortgage backed bonds was in disarray, many securities and CDO assets dived in market price, even though their high credit ratings didn’t change. The market value of assets in the Enhanced Leverage Fund fell 14.4%, which offset a 13.5% gain the fund reaped from its bets against the ABX and other derivatives, which dived that month.
The other fund saw its assets marked down 4.4%, but remained profitable that month because its bets on a fall in the ABX and other derivatives earned 5.3%.
But then the ABX index started to stabilize, and Mr. Cioffi’s funds got squeezed on two sides: Its CDO bonds were falling in value, and its ABX bets were no longer making money.
The Enhanced Leverage fund’s losses were magnified by the significant amount of borrowing it used to finance its trades. As of Jan. 31, it had $699 million in investor capital, but had over $12 billion in investments. A month later, its investor capital had dropped to $667 million, but its bets on the market had increased to $15 billion, according to documents reviewed by the Journal. The fund added to its bullish bets and doubled down on its bearish bets, a move that resulted in significantly worse performances in March and April. By the end of April, the fund was down 23% year-to-date.
In March, Mr. Moss, the Tennessee developer, sold out of the Enhanced Leverage fund entirely at the behest of his investment adviser Brad Alford, who runs Alpha Capital Management in Atlanta. Mr. Alford says he was uncomfortable with the fund’s complex strategy, its subprime exposure and its heavy use of leverage. “I thought it was very late in the cycle for such strategies, especially in an illiquid market,” he says.
Early in the second week of June, word was trickling out on Wall Street that Mr. Cioffi’s funds were starved for cash and might not be able to make margin calls, which are when lenders request additional cash or collateral on a loan. Creditors such as Merrill and J.P. Morgan grew concerned.
On June 14, the funds’ dozen or so creditors gathered for a status update at Mr. Cioffi’s 237 Park Ave. offices, where attendees were given an 11-page handout summarizing where the two funds stood. It wasn’t pretty.
As of June 8, the more-indebted fund was facing $145 million of outstanding margin calls, according to the handout, which was reviewed by the Journal, and the older, less-indebted fund faced $63 million of margin calls. The booklet laid out a plan for meeting the margin calls over a two-week period, using proceeds of additional planned asset sales and from sales of shares of Everquest Financial Ltd., a private asset manager.
Flipping to the last page, some people were shocked to see a list of bullet points under the heading “What We Need From Our Counterparties,” say people who were in the room. The points included a 60-day moratorium on margin calls and the release of derivatives collateral back to the funds.
An hour and a half into the meeting, John Hogan, head of risk management for J.P. Morgan’s investment bank, raised his hand. “With all due respect, I think you’re underestimating the severity of the situation,” he said to Mr. Cioffi and his boss, Bear Stearns Asset Management Chief Executive Richard Marin, according to people who were there. The funds “needed to figure out” how to meet their margin calls, he said, and if that meant bringing in funding from the parent company, “we recommend you do that.”
Many attendees were puzzled by Bear’s apparent unwillingness to bail out the struggling fund, according to people who were there. After the meeting, these people say, there was sympathetic talk about Mr. Cioffi, a loyalist to the firm who seemed to be getting no help in return, and grumbling over memories of the Long-Term Capital Management crisis.
That afternoon Steve Black, J.P. Morgan’s co-chief of investment banking, put in calls to Bear co-presidents and chief operating officers, Mr. Spector and Alan Schwartz. “Is Bear going to stand behind your asset-management company?” he asked Mr. Schwartz, according to people who were briefed on the conversation. Mr. Schwartz said he’d get back to Mr. Black.
An hour later, he called and said that on the advice of Bear’s lawyers, the firm wasn’t going to get involved, these people said. A spokeswoman said Mr. Schwartz couldn’t be reached for comment.
Pacing his Tenafly, N.J., bathroom a few minutes before midnight last Saturday, Mr. Cioffi searched for a way to save his two giant funds.
He had spent the prior day and a half behind closed doors with his team, trying desperately to map out a plan for recapitalizing the fund as angry creditors circled. On Friday, Merrill had prepared to seize $400 million of the two funds’ assets, an aggressive move that Mr. Cioffi knew could force a shutdown of both entities.
He hoped new capital could stave off Merrill’s auction and a swoon in the market for mortgage-backed securities. Barclays, the British bank that had been one of the fund’s top lenders and knew the fund intimately, seemed an obvious choice. “We’ve got to go to them,” he typed in a late-night e-mail to his group at Bear. “There’s no time to wait.”
Barclays came back to Bear with a promise of additional capital, paving the way for a roughly $250 million cash infusion that Bear’s asset-management group believed would help the troubled funds.
Dressed in slacks and athletic shoes, Mr. Cioffi and his assistant spent Sunday working multiple phone lines, which rang simultaneously throughout the day. He had called in his 35-person team, plus another five or so executives from other parts of Bear, and had retained restructuring expert Timothy Coleman from the Blackstone Group to help advise him. At 8:00 p.m. that night, Mr. Cioffi held a conference call with creditors to let them know he had hired a consultant.
The next morning, the creditors reconvened at Bear’s offices at 11 a.m. This time Mr. Cioffi didn’t hand out his presentation in advance. Instead, he announced the group that Bear Stearns was going to “step up,” say people that attended the meeting, with a $1.5 billion secured loan that would be attached to at least $500 million in additional equity capital, subject to due diligence by the lender. Again Mr. Cioffi asked the group to cancel their collateral auctions and their default notices, and accept a 12-month freeze on new margin calls. No detailed information about the underlying risk was provided.
Representatives from Merrill and J.P. Morgan, each of which had at least one outstanding default notice and were owed roughly $850 million and more than $500 million, respectively, were taken aback, according to people who were there. Both had collateral assets securing the loans and, in J.P. Morgan’s case, trading positions that offset the debt. But asking for a year-long moratorium on margin calls at a time when the borrower was clearly in default was practically unheard of. One attendee asked Mr. Marin if he was serious about the waiting period. He was told yes.
The attendees — Citigroup Inc., Barclays and Dresdner Kleinwort, each of which was owed far greater sums of money — seemed more amenable, according to the people who were at the meeting. “People had different perceptions of what was important,” one of these people said.
Realizing after the meeting that the margin-call standstill and other requests for patience weren’t going to fly, Messrs. Cioffi and Coleman began negotiating to unwind whatever loans they could. The first three to come to terms were Goldman Sachs Group Inc. and Bank of America Corp., which together were owed $2.25 billion in credit. On Tuesday, frustrated with a lack of progress, Merrill and J.P. Morgan pressed forward with plans for auctions of their collateral assets the next day.
Merrill put up its $850 million in collateral for sale, seeking bids from a wide range of investors. When the bids came in late Wednesday, many of them were significantly below prices that Merrill was willing to sell the securities at. The bank ended up offloading only a fraction of the assets and is expected to try to sell the rest privately. J.P. Morgan, meanwhile, pulled its auction just minutes before the scheduled 2:00 p.m. EDT start time, having reached its own private unwind agreement with the Bear funds.
Others have followed suit. Starting Thursday, Lehman Brothers Holdings Inc. and Citigroup attempted asset auctions, and the bond brokerage Cantor Fitzgerald L.P. said it had successfully sold off about $400 million of assets, extricating it fully from the fund.
As the problems mounted, there was increasing talk among hedge funds and brokerage firms about Bear’s failure to stand behind its own hedge funds, according to Wall Street executives. It wasn’t clear that Bear’s promised $1.5 billion loan would materialize, or would be enough to meet the funds’ needs even if it did. That intensified pressure on Bear to act, lest its brand-name suffer.
With the funds’ standing deteriorating, Bear also saw an opportunity: come in with a larger loan to prevent a fire sale of their assets. Such a move could help stabilize the assets’ perceived value and prevent widespread markdowns of similar securities that would hurt Bear and others.
Mr. Spector worked the phones Thursday afternoon, reaching out to various CEOs and senior Wall Street executives, according to a person familiar with the matter. The upshot: save the less leveraged fund that had better-quality assets and let the other fund collapse.