Latest on the Bear Stearns Subprime Hedge Fund Fallout

It continues to be lively on the Bear Sterns front. As readers doubtless know, two Bear Stearns sponsored hedge funds run by Ralph Cioffi that focused on subprimes had trouble meeting margin calls and went into liquidation. On the one hand, the Wall Street Journal appears not to be putting it on the first page of its Friday paper (the much more upbeat Blackstone IPO has displaced it). However, developments continue apace.

Tellingly, Bear Stearns has apparently assumed responsibility for more of the hedge fund’s liabilities. Merrill was able to sell only $100 million of the $850 million it seized from the funds, which is not a good sign for the prospects for a forced sale of more assets. Bear has proposed a restructuring with other creditors to give more time for an orderly liquidation or workout. The Financial Times gives more detail:

Merrill Lynch auctioned off some of the collateral while others negotiated private deals on the assets. Merrill Lynch sold only $100m of the $850m of assets it put up for auction, and the bank has no plans to sell the remaining assets, according to a person familiar with the situation. CDOs are hard to value and investors speculated that prices may have fallen far below the banks’ expectations.

Bank officials said Bear Stearns itself has taken on little new risk and that the deals JP Morgan, Goldman, Bank of America and others were making to eliminate their exposure were with the hedge funds and not with Bear. Investors seemed unconcerned about Bear taking on any additional risk, sending shares in the bank up nearly 2 per cent $145.81.

It remained unclear on Thursday who, beyond the limited number of equity investors in the funds, had taken on any significant losses based on the funds’ problems.

Separately on Thursday, people close to the matter said Bear offered deals to another group of creditors including Deutsche Bank, Wachovia, Barclays and others.

Under that proposed deal, Bear said it would serve as the counterparty to $3.2bn in repurchase agreements between the banks to the less leveraged of the two troubled Bear hedge funds.

In return, the banks would have to agree not to seize and sell collateral held in the highly-leveraged fund for 90 days. It remained unclear last night whether any banks would accept any version of that deal.

Jack McCleary, head of asset-backed securities syndication at UBS said: “The market does good job of sniffing out leverage. Dealers will look at funds with similar positions to ensure valuations are appropriate.”

A Bloomberg story confirmed the effort to work out a deal with creditors:

Bear Stearns Cos. may take over about $3.2 billion of loans that banks and securities firms made to one of its money-losing hedge funds to prevent creditors from seizing more assets, according to people with knowledge of the plan…

An agreement between the creditors and New York-based Bear Stearns, the second-biggest underwriter of mortgage bonds, may avert a fire sale of the fund’s assets. Bear Stearns has spent the past few days attempting to rescue the two hedge funds after they made bad bets on so-called collateralized-debt obligations, securities backed by bonds, loans and derivatives.

“For the sake of its reputation, Bear needs to put this behind it as soon as possible,” said Peter Goldman, who helps manage $600 million at Chicago Asset Management, including shares of Bear Stearns. “The firm might take on some of the risk of the fund they didn’t have before, but they’re a bond shop and they wouldn’t take on risk they shouldn’t.”

Bear Stearns spokesman Russell Sherman declined to comment.

Backing Away

Merrill today backed away from a threat to dump about $850 million of securities it seized from the hedge funds, according to people with knowledge of the firm’s decision. New York-based Merrill sold a portion of the CDOs through an auction, said the people, who declined to be identified because details weren’t announced.

Merrill spokeswoman Jessica Oppenheim declined to comment.

Bear Stearns’s is making the offer on the High-Grade Structured Credit Strategies Fund, which lost less than 10 percent this year. A second fund, the High-Grade Structured Credit Strategies Enhanced Leverage Fund, lost about 20 percent.

The funds were hurt in March and April as CDO values dropped. Opposite bets the funds made on defaults of subprime mortgage bonds also went wrong.

Investors from hedge funds to pension funds and foreign banks have snapped up CDOs as a new way to invest in debt, making it the fastest-growing market and pushing the amount outstanding to more than $1 trillion.

CDOs trade infrequently and sales may have forced other investors to write down the values of their holdings, potentially causing billions of dollars in losses.

Bear Stearns shares, also the fifth-biggest U.S. securities firm by market value, rose for the first time in four days on optimism Merrill’s decision would stave off a large sale of the assets. The stock gained $2.61 to $145.81 in New York Stock Exchange composite trading.

Bear is arguably the most bloody-minded firm on the Street. For them to take back this much paper when they were under no contractual obligation to do so says they perceive it to be in their commercial interest. Why might that be so? Bear Sterns is the largest prime broker (the three top firms together, Bear, Goldman, and Morgan Stanley, together have an estimated 70+% market share). The profit in prime brokerage comes from lending to hedge funds.

A forced liquidation of so much hard to value and high risk paper would send prices plummeting and would force brokers to mark down the value of similar collateral aggressively, which in turn could feed a vicious cycle as other funds have to sell into an already falling market as they liquidate positions to meet margin calls. Bear, as the biggest prime broker, has the most to lose in this scenario.

One fund, admittedly a small one, appears to be a casualty of the Bear Stearns meltdown:

Hammered by exposure to a risky type of mortgage-backed security, Brookstreet Securities Corp. of Irvine, Calif., yesterday told its 500 or so affiliated reps and advisers that “disaster” had struck, and that the firm could close if it doesn’t come up with at least $5 million.
And in an unsigned e-mail note to its advisers, the firm blamed its clearing firm, National Financial Services, and too many accounts on margin for its poor fortune.

“Today, the pricing system used by National Financial has reduced values in all Collateralized Mortgage Obligation,” the e-mail said.

“Many of those accounts were on margin and suffered horrendous markdowns and unrealized as well as realized losses.

National Financial and the regulators expect Brookstreet to pay for realized liquidated losses and take a capital charge for unrealized (mark) to market losses. “

The e-mail continued, “It would take a capital infusion of at least $5,000,000 to keep the company in compliance with no additional guarantee that additional markdowns will no be forthcoming.”

Brookstreet Securities is a mid-sized, independent-contractor broker-dealer, and in 2006 generated about $70 million in gross revenue, according to one industry observer who asked not to be named.

According to NASD records, the Brooks Family Trust owns more than 75% of the firm, with Stanley Brooks the trustee.

Mr. Brooks did not immediately return a phone call on Thursday afternoon to comment.

Although the message was unsigned, it contained a personal message to each adviser, potentially from Mr. Brooks.

“I have told many of you that you are always in danger of not being paid on your last check when working for any broker-dealer. I will try to get enough money from our account at NFS to complete our upcoming payrolls.”

The note concluded with a plea: “All our family net worth is in the firm, please give me time to present a new plan.”

Another casualty is a Bear Stearns IPO of Everquest. Although the Wall Street Journal article on the failed deal is not as clear as one would expect, it appears to have been an actively managed CDO. Actively managed CDOs are blind pools, in which a manager (in this case the ill fated Ralph Cioffi) buy various debt instruments, which can be tranches of other asset backed securities, including pieces of other CDOs. Once the money committed has been invested, the manager trades it actively. And like regular CDOs, it is tranched into risk pools. The net result is you have no idea what you own.

And the Journal tells us Bear was putting nuclear waste into the vehicle:

To form Everquest, Mr. Cioffi’s funds last October transferred equity in 10 CDOs to the company, according to its prospectus. Equity portions of CDOs are the highest-yielding, but also riskiest part of these structures.

This raises the specter that Cioffi/Bear was stuffing Everquest with paper it couldn’t sell, but would put enough higher quality securities in to offset (or obscure) the terrible assets.

Some observers were critical of the deal even before the recent market turmoil. From the Journal:

Doubts surfaced over the value of Everquest’s assets because it’s not entirely clear how much is in bonds backed by risky subprime mortgages versus bonds backed by safer corporate debt. But the prospectus notes holdings of bonds backed by subprime debt as a “risk factor” that would need to be weighed by investors.

Additionally, any valuation of the company’s assets is colored by the fact that most were initially contributed last October to Everquest by Mr. Cioffi’s funds. This brings into question any value assigned to both the assets and the amount Everquest paid for them since Mr. Cioffi and Bear were essentially sitting on both sides of the table.

That, coupled with inherent difficulties in valuing the types of securities held by the company, made some observers wary from the get-go. “These things are extremely difficult to value, there’s no liquidity in them, no market price and you have to rely on the manager for their value and the manager’s fees are dependent on the performance of these assets,” said Janet Tavakoli, president of Tavakoli Structured Finance, a consulting firm in Chicago, who early on criticized the deal as being unsuitable for average investors.

Note this deal was intended for retail buyers.

We observed (see comment section) that given the supply/demand imbalance for subprime-related paper due to forced liquidations, that some of these assets might well be on offer for prices well below their current “fair” value. Even so, we didn’t think anyone would step to the plate until the markets had stabilized a bit and it was clear that there would be not other fund meltdowns (even if the prices are cheap now, they could be even cheaper soon).

We were wrong. A few university endowments are stepping forward to cherry pick among the rubble, as the Wall Street Journal informs us:

With Wall Street scrambling to offload risky mortgage-backed securities, potential buyers of subprime debt are emerging — among university endowments.

“There’s an opportunity out there to buy these loans at a discount,” says Lou Morrell, vice president for investments and treasurer at Wake Forest University in Winston-Salem, N.C. The university’s $1.2 billion endowment is in the process of placing about $25 million with a hedge fund to invest in subprime mortgages. Because these loans could sell for steep discounts, he says, “they will be popular with a lot of endowments out there.”

In recent days, two big hedge funds at Bear Stearns Cos. have been besieged by investors and lenders trying to recoup their money as the value of the mortgage-backed bonds held by the fund have tumbled.

Late Wednesday, Merrill Lynch & Co. — a lender to the Bear hedge funds — auctioned off some assets it had seized from the Bear funds. The investment bank sought bids for $850 million in securities, some of which were backed by subprime mortgage bonds, but ended up selling less than half that amount, according to people familiar with the matter.

Most of the trades Merrill made were at prices of 85 to 95 cents on the dollar. A person familiar with the auction said some bids — which didn’t result in trades — were as low as 30 cents on the dollar.

Yesterday afternoon, other lenders to the Bear funds put a further $800 million of the Bear funds’ assets up for auction, according to investors who reviewed the lists of assets. Those moves prompted speculation that talks had broken down that were aimed at finding a solution short of auctioning the assets.

In another sign of growing investor unease toward riskier classes of debt, Thomson Corp.’s Thomson Learning yesterday significantly restructured a planned junk-bond offering, reducing the amount of money it planned to raise to $1.6 billion from $2.1 billion. The textbook publisher also had to drop a feature — known as a payment-in-kind toggle provision — on some of its bonds that would have allowed it to pay interest in the form of additional debt if it ran short of cash in the future.

Such provisions are an example of the kind of easy terms for borrowers that have gotten some investors worried about loose lending terms in the corporate debt market.

The pushback could have broader implications for some of the other large debt sales slated to take place in the coming weeks to fund other takeover deals. Many acquisitions in recent months have been dependent upon an availability of cheap corporate debt. Any significant change in investor sentiment could slow a record-breaking merger boom that has played a role in pushing up stock prices in recent months.

In contrast to other types of investors, university endowments continue to show a greater appetite for risk. They have been at the vanguard among large institutions when it comes to investing in alternative assets, such as hedge funds, private-equity firms, and real estate. The top 53 university endowments, with nearly $217 billion in assets, have invested about 18% of that money into hedge funds, according to the data provider HedgeFund Intelligence. By contrast, the average public pension fund has around 5% in hedge funds.

Because endowments can tolerate more short-term volatility and face less-frequent scrutiny than most public pension funds, they often have been willing to invest in areas often considered too risky for many other institutional investors.

Scooping up subprime mortgages at depressed prices is the latest case of buying assets on the dips. It is a strategy that has generally served investors well over the years, though most of those who bought technology companies after the tech bubble burst in 2000 got crushed, proving this approach is far from foolproof.

Bill Spitz, chief investment officer for the $3.4 billion endowment at Vanderbilt University in Nashville, Tenn., says his fund currently has a “negligible” amount of money in debt backed by subprime mortgages. But he has earmarked $50 million to invest in these securities through a new fund from Trust Company of the West.

This fund of $1.5 billion, or possibly more, will invest primarily in subprime mortgage securities. The Los Angeles-based money-management firm has put up about $150 million of its own money into the fund. The fund is expected to close to investors in July.

Mr. Spitz says he has no expertise in the mortgage market, but is placing money with TCW as part of Vanderbilt’s strategy of putting as much as 5% of the fund’s assets into “opportunistic” investments they hope can boost returns.

“What typically happens when there is a scare of this sort, people disgorge assets quickly and they sink to a level below their true value,” says Mr. Spitz. “That creates opportunity.”

“Universities have the financial structure that encourages alternative investments, and this leads to a culture with a greater tolerance and understanding of risk,” says Allen Proctor, a private consultant in Columbus, Ohio, and the former chief financial officer at Harvard University. “Investing in subprime loans is in character with that.”

In previous years, he says, endowments turned to high-yield “junk” bonds and oil- or gas-well leases. Mr. Spitz says that his endowment profited from an investment in junk bonds during a selloff in 2002. Vanderbilt has also bet on the movements of the stock market in 2005 — known as betting on volatility — through the derivatives market.

Even so, not all endowments are eager to own bonds backed by subprime mortgages. At the University of Richmond in Virginia, where HedgeFund Intelligence estimates that nearly half of its $1.6 billion endowment is invested in hedge funds, chief investment officer Srini Pularvarti says the fund will be avoiding subprime. “We don’t think its something we want to play,” he says.

Separately, Rep. Barney Frank, chairman of the House Financial Services Committee, renewed calls for legislation that would make Wall Street brokerage firms more responsible for the quality of the loans that the firms buy, repackage and then sell to investors.

Mr. Frank argued that if the brokerage firms refused to buy these high-risk loans in the secondary market, lenders would have a harder time selling them in the first place.

Personally, I think these purchases are at best premature, and at worst foolhardy. But different points of view are what make a market.

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