Bear Stearns Hedge Fund Meltdown Rattles Subprime Sector

The Financial Times and the Wall Street Journal give complementary updates on the unraveling of the Bear Stearns subprime hedge funds, the larger of which was the High Grade Structured Credit Strategies Enhanced Leverage Fund.

Merrill Lynch and Deutsche Bank put up over $1 billion in assets seized from the funds for sale today. Some of the higher quality instruments sold by Merrill fared well, but the illiquid securities, particularly the collateralized debt obligations, which one investor called ““junk in investment-grade clothing,” went for distressed prices. The similarly poor results achieved from some conversations with prospective buyers apparently persuaded JP Morgan, which was also set to sell its collateral from these funds, to instead negotiate a settlement with Bear Stearns. The Nattering Naybob tells us that Goldman and Bank of America similarly got taken out by Bear.

The big question is what if anything these events portend. A $1 billion sale in the bond world is peanuts. However, the sales of the illiquid, presumably weaker credit quality bonds were at atrocious prices. This outcome will almost certainly force prime brokers to mark down similar collateral, which in turn could lead to margin calls. The last thing funds in this sector want to do is sell more securities into a market that is already choking (that’s why JP Morgan pulled back on its sale: it was clear that any settlement with Bear would be better than the alternative, particularly since forcing the market lower could damage other hedge funds and along with them, investment banks).

The Wall Street Journal speculates that if this drama is not resolved quickly, it could bode ill for the scheduled sale of $250 billion of junk bonds over the next four to eight weeks, most of it in conjunction with LBOs. But so far, this appears to be merely an embarrassing one-off. However, were another sizeable fund in this sector be forced to liquidate, the perception of risk could change dramatically. This failure will not set off a systemic collapse, but if more hedge funds falter, investors will become more discriminating about risky investments, and interest rate pressure will take a toll on the economy.

From the Financial Times:

The giant market for securities backed by US subprime mortgages was thrown into turmoil on Wednesday as lenders struggled to sell more than $1bn of assets seized from two Bear Stearns hedge funds that suffered heavy losses on subprime bets.

The complex securities being auctioned are rarely traded and early attempts to sell the collateral met with mixed results. The prospect of the “fire sale” knocked down prices for similar mortgage-backed assets and sent a key derivative index for the market to record lows.

The rout highlights the risks investors take when they buy illiquid and hard-to-value securities. Fire sales in times of stress can trigger dramatic changes in pricing in such markets, perhaps leading other holders of assets to mark their values down and triggering demands for additional collateral from lenders.

Kathleen Shanley, analyst at research firm Gimme Credit, said the unravelling of the Bear Stearns funds was “at best an embarrassment for Bear Stearns, and at worst it threatens to have a ripple effect on valuations across the subprime sector”.

The sales began on Tuesday and were set to continue on Wednesday. Among the assets for sale by lenders Merrill Lynch and Deutsche Bank were investments in so-called collateralised debt obligations, or CDOs, which pool securities that can include mortgage-backed bonds, corporate bonds, leveraged loans and sometimes other CDOs. Many of the CDOs the Bear Stearns funds invested in were backed by risky mortgage securities, which have suffered heavy losses and ratings downgrades in recent weeks.

One mortgage investor said that while the CDO assets for sale carried high credit ratings, they were backed by such risky mortgages as to be “junk in investment-grade clothing”.

Merrill Lynch was set to auction $850m of such assets on Wednesday after rejecting a Bear Stearns offer to buy them directly, while Deutsche Bank was also planning to sell $350m of CDO assets seized from the funds. JPMorgan began selling seized collateral on Tuesday, but yesterday halted its sale and then made a private deal with Bear Stearns to eliminate its exposure to the fund.

The ABX derivative index, which tracks home loans made to risky subprime borrowers in the second half of last year, dropped to a record low of 59.25 on Wednesday.

From the Wall Street Journal:

The near-collapse of two big Bear Stearns Cos. hedge funds marks an important test of the financial markets’ resiliency.

Stocks and bonds fell broadly yesterday as word spread that several investment banks were having trouble finding buyers for subprime mortgage securities they pulled out of the teetering hedge funds at the Wall Street firm. Meantime, market indexes that track the mortgage and corporate debt market fell as investors saw their risk rising. Securities and Exchange Commission Chairman Christopher Cox said the agency was tracking Bear developments, but didn’t see systemic problems.

Still, if recent history is any guide, the stock and bond markets might be expected to bounce back quickly.

In just the past few years, the markets have been tested by turmoil in the automobile sector, rising global interest rates, a weakening dollar and the housing slowdown. They quickly bounced back after brief spasms of risk-aversion in every case. The last bout of jitters was just this past February, when problems in the subprime mortgage sector sparked brief selling.

Ample amounts of cash in the hands of investors — something investment pros call liquidity — and a growing confidence in the market’s resilience, have helped them to overcome worries. But some investors wonder if this case could be different.

“The fear is that this Bear situation is the tip of the iceberg and it could lead to other funds being liquidated,” said Todd Clark, director of stock trading at Nollenberger Capital Partners Inc. in San Francisco.

The state of the Bear funds — called High Grade Structured Credit Strategies Enhanced Leverage Fund and High Grade Structured Credit Strategies Fund — was fraught with uncertainty yesterday.

J.P. Morgan Chase & Co., a lender to Bear’s hedge funds, was scheduled to begin an afternoon auction of collateral it held from the bear fund, mainly mortgage-backed debt. Minutes before the sales were to begin, the firm pulled back. Later, J.P. Morgan came to terms with Bear to eliminate its exposure to Bear’s troubled hedge funds, said a person briefed on the matter. Some traders said the bank might have been forced to settle with Bear because the loans it had put up for sale would have fetched so little in the market.

Deutsche Bank AG and Merrill Lynch & Co., among others, remained in limbo, said people briefed on those talks. Earlier in the day Deutsche quietly approached some market participants to gauge their interest in some of its collateral assets, said one of these people. Deutsche’s loan officers were also talking with Bear about privately unwinding their financing.

Merrill also planned to sell collateral and stopped negotiating with Bear, according to a person familiar with the matter. Due to the mortgage market’s restless state, some of the early prices bandied about for Merrill’s assets were relatively low. But when Merrill’s auction took place late in the afternoon, it managed to sell some higher-quality assets at reasonably high prices, according to an investor familiar with the auction.

This drama is being watched very closely on Wall Street for several reasons. One is the tangle that so many big Wall Street players now find themselves in over the hedge funds trades. Another is the scale of the hedge funds; as recently as March 31, they held more than $20 billion in investments in securities and derivatives, not to mention billions more in bets that certain markets would fall.

The problems are also a lesson in the perils of using borrowed money to make trades; one of Bear’s funds was highly leveraged. Moreover, investors and traders are uncertain about what Bear’s complex holdings are worth. If it can’t fetch much for them in the market, others might have to mark down the value of their own holdings.

“There’s fear of further liquidations,” said Jeffrey Gundlach, chief investment officer at the TCW Group.

It all comes just as about $250 billion in junk bonds and corporate loans are slated to be sold to investors, much of it tied to the corporate buyout boom. The debt is expected to be issued in the next four to eight weeks. If worries about subprime woes spread, and investors suddenly become risk averse, it could lead to troubles for these debt sales.

Yesterday, a closely watched derivative index tied to junk-rated corporate loans fell for an eighth straight day, to a new low of 99.05, down 0.65 from a day ago, according to data from Goldman Sachs Group Inc. The index, called the LCDX, was launched just a month ago and dropped below 100 earlier this week for the first time.

Still, investors didn’t appear to be anywhere near panic. The 10-year Treasury note, which investors typically flock to buy in times of trouble, fell instead, pushing its yield, which moves opposite its price, higher.

Gold, another favorite destination when markets are distressed, fell $4.60 to $656.10 an ounce. Volatility expectations in the stock and bond markets, derived from options prices, rose but didn’t shoot higher like they usually do in panic situations.

“The world is nothing if not resilient,” said Brown Brothers Harriman portfolio manager Richard Koss. “It’s amazing how the market keeps on taking shots and keeps absorbing them.”

In many ways, investors have been conditioned to believe that financial markets are better able to absorb jolts than in the past. While the collapse of the hedge fund Long-Term Capital Management in 1998 prompted a market swoon, Amaranth Advisors’ $6.4 billion loss last year had little effect.

Similarly, the market quickly bounced back from worries last year that rising Japanese interest rates would stanch the flow of capital globally. A General Motors Corp. debt downgrade that caught many investors off sides briefly roiled markets in 2004, but ultimately had little effect.

“Amaranth slipped under the waves without a ripple,” said Byron Wien, chief investment strategist at hedge fund Pequot Capital Management. As long as a large number of hedge funds don’t all fail at the same time, he said, “the system can survive.”

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  1. Dave L

    “…But so far, this appears to be merely an embarrassing one-off. However, were another sizeable fund in this sector be forced to liquidate, the perception of risk could change dramatically.”

    Seems to me you’re conflating two issues here. 1) it is (just) possible that no other funds will be forced to the wall as Bear Stearns has; but 2) every fund with a portfolio of CDOs – and obviously mortgage products in particular – will be affected by a re-evaluation of the riskiness of those assets.

    There is just no way to put a good face on the sale results, and all the public worrying about how to avoid any additional distressed sales only makes matters worse. What, are we supposed to believe that these assets would have been okay in somebody else’s portfolio? -That they were fundamentally sound, but not really intended for use as collateral?

  2. Yves Smith

    Dave L.,

    Thanks for your comment, and apologies for not being clearer.

    While quite a few subprime-related CDOs have clearly been carried at considerrably higher values than they were worth (and therefore also overvalued as collateral), there is now actually an open question as to whether the recent sales represent fair value or not.

    While mark to market is the only sensible way to run a trading business (it’s much more arguable for banks), when the bottom drops out of a market, as it has thanks to the Bear liquidation, paper can trade at very distressed prices, lower than its intrisic value, yet no one will buy it because the supply/demand imbalance may appear likely to worsen in the near term. No one wants to catch a falling safe.

    Look at it another way: the only natural buyers of the riskier Bear assets are likely to be actively managed CDOs and hedge funds. But given the severity of the move down, no one is likely to step forward to buy in meaningful amounts until they have some confidence that another shoe isn’t about to drop.

    Mind you, I am not saying that some of the Bear paper was sold at less than its economic value. I am not in that market and have no way of knowing. But given that a lot of supply hit in an illiquid, hard to value corner of the market, it is within the realm of possibility. In the wake of the LTCM failure, swap spreads took a full year to return to historically normal prices, even though the crisis was well in hand within a month and no other players were in distress.

    Now I happen to be pretty negative on the prospects for housing, so I’d bet on paper in this sector deteriorating in value regardless…..

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