This story, which describes the in extremis sale of $4 billion of bonds by a Bear Stearns hedge fund, “Bear’s Fund Is Facing Mortgage Losses,” is currently the lead story on the Wall Street Journal’s website, so it is likely to get page one coverage in the print edition.
The fund, the High-Grade Structured Credit Strategies Enhanced Leverage Fund, has scheduled an auction for 10:00 a.m. this morning to raise cash, which means its securities values have likely fallen far enough to trigger margin calls. While the article says the sale is defensive, rather than forced, the sale is sufficiently high profile and unusual as to make one wonder. Even though the bond rout of last week was the immediate trigger, investors who tried to redeem last month were “blocked,” so the fund has probably been performing poorly for some time.
Even though the press last week focused on the sharp downdraft in the Treasury market, observers went to some lengths to point out that spreads didn’t widen in the corporate bond markets. However, the uptick, particularly in the key 10 year bond, will have a strong impact on mortgage rates, which would worsen the outlook for housing prices, which would in turn make it harder to refinance mortgages, which is one of the ways that defaulting mortgages are kept out of foreclosure. And the article points out that the ABX, an index linked to low credit quality mortgages, has fallen to 62.5 (its low last month was 67), which is near its nadir last February.
It may be true that the Bear fund is liquidating more aggressively than it needs to. The housing market is in worse shape than it was in February: foreclosures have risen, inventories are higher, and now mortgage rates are rising. Even though the ABX has spiked upwards, it’s not hard to imagine its retreat will continue. Bear is smart to be getting out before the MBS market works through the implications of the change in sentiment (although Wednesday showed quite the optimistic reversal in the Treasury market).
It isn’t yet clear as to whether this is a harbinger for other leveraged mortgage securities players. The Bear move could have a psychological impact out of proportion to the size of its sales. Bear is considered to be a canny player, and to see one of its ventures in what may be the early stages of folding is worrisome. The Financial Times has been making worried noises for some time about the CDO market, and many mortgages and mortgage securities wind up in CDOs (and hedge funds like Bear’s unit are also buyers of CDOs). CDOs are levered, hedge funds leverage on top of that, and some of these hedge funds have fund of funds as investors, which sometimes add even more leverage. Add to that the fact that structured credits feature dubious practices, like mark to model. If there is going to be serious trouble in the marketplace, this is how it could start.
From the Wall Street Journal:
A hedge fund managed by Bear Stearns Cos. is scrambling to sell large amounts of mortgage securities, a setback for a Wall Street firm known for its savvy debt-market trading.
The fund makes bets on bonds backed by mortgages, many of which are subprime, meaning they go to especially risky borrowers.
Faced with losses on its investments, the fund, called High-Grade Structured Credit Strategies Enhanced Leverage Fund, together with a sister fund, is trying to sell about $4 billion in mortgage-backed bonds to raise cash, according to people close to the fund and traders who have been solicited to buy the bonds.
The sales represent a sliver of the $7 trillion residential-mortgage-backed bond market, but it is still a large amount to be sold at one time and a potentially troubling sign for the broader mortgage-backed bond market.
In a separate matter, Bear, a feisty company run with a hands-on approach by Chairman and Chief Executive James Cayne, has also been arguing with other hedge funds over its trading desk’s dealings in the mortgage-backed securities market. In part because it is exposed to the mortgage-bond business, Bear is expected by analysts to report a 6% drop in fiscal second-quarter earnings today, compared with a year earlier.
Bids for the sale of bonds are due at 10 a.m. EDT today — shortly after Bear announces its results.
Late Tuesday, Wall Street traders began circulating a list of mortgage assets that Bear had put on the block, according to email exchanges reviewed by The Wall Street Journal. On the list were roughly 150 of the funds’ most easily traded, investment-grade bonds, which are backed by subprime mortgages. The estimated value of the bonds ranges from $1 million to nearly $110 million apiece.
Yesterday, Bear directors convened for a regularly scheduled board meeting, during which they were briefed on the fund’s performance and outlook. Two people familiar with the situation said if the sale isn’t a success, the Enhanced Leverage Fund could ultimately be shut down.
Bear’s Limited Exposure
The Bear fund, which was down 23% in value in the year through April, has more than $6 billion in assets. Bear’s own exposure to it is limited. The firm and some of its executives have invested just $40 million in the fund, meaning Bear isn’t likely to be hit deeply by losses if the fund’s problems mount.
Other investors include wealthy individuals and other hedge funds. It is run by Ralph Cioffi, a Bear mortgage-bond veteran.
The mortgage-bond market has been a key source of profit for Wall Street, which has gone beyond simply packaging and trading these bonds to owning subprime lenders themselves and starting up hedge funds that focus on the sector.
After several years of playing heavily in the market for subprime mortgages, players like Bear now contend with falling home prices and a rise in late or missed payments on some of the shakiest mortgages. Investor concerns about these developments have led them to sell some mortgage-backed bonds, putting downward pressure on portfolios like the one run by Bear.
Bear isn’t alone. Early last month, the Swiss bank UBS AG shut down Dillon Read Capital Management, an internal hedge fund, after bad trades in mortgages led to a $124 million loss.
Lots of Leverage
The Bear fund, only 10 months old, is highly levered, meaning that in addition to raising money from investors, it borrows heavily to fund its investments.
Launched last year, the fund quickly raised more than $600 million in investments, much of which was put toward the purchase of mortgage-backed securities.
Combined with around $6 billion in borrowing from a dozen major Wall Street players, including Goldman Sachs Group Inc. and Bank of America Corp., it has assets in excess of $6 billion. Goldman and Bank of America declined to comment. The sister fund, which uses less leverage, was launched four years ago and goes by a similar name, High-Grade Structured Credit Strategies Fund.
A person familiar with the situation said the fund is liquidating positions to free up cash for redemptions and to prepare for likely margin calls. A margin call is when a bank asks for repayment of its loans or more collateral as its borrowers’ investments fall in value.
Last month, Bear blocked some investors from taking money out of the fund.
The fund is part of Bear’s internal asset-management unit.
A Rocky Quarter
Analysts are bracing for a rocky quarter and have been edging down their forecasts for the big brokerage over the past month or so, according to data provider Thomson Financial. So far this year, Bear’s stock has fallen 8% compared with a rise of about 2% for the broader Dow Jones Wilshire U.S. Financial Services Index.
As for some of its peers, Goldman is up 16% so far this year and Lehman, which also has a big exposure to the mortgage market, is down 1.1%.
Bear is a bit of an anomaly on Wall Street. As financial firms like Citigroup Inc. have built their firms through acquisitions or by significantly pushing into new business lines, from insurance to retail banking, Bear remains a singular Wall Street bond house. It is known for tight cost and risk controls and has managed to avoid a major trading blowup over the years.
The latest mortgage woes seem to be hitting the broader market.
An index tied to risky subprime bonds has in recent days plunged to lows last seen in late February. Traders say the dive in the index, called the ABX, was triggered by reports of rising delinquencies and foreclosures and a steep rise in long-term bond yields.
Rising interest rates could make it more difficult for homeowners to refinance their mortgages and could send more borrowers into default. The ABX index yesterday traded at around 62.5, down from 73 a month ago and a high of 97 early in the year, according to Markit, a data firm.
“There are concerns about investment vehicles that are seeing negative returns because of their subprime exposure,” said Alex Pritchartt, a mortgage-derivatives trader at UBS Securities. “If some funds try to liquidate their portfolios and sell large blocks of securities, it could cause a backup in prices and spreads.”