Readers may recall that a Bear Stearns hedge fund, the High-Grade Structured Credit Strategies Enhanced Leverage Fund, scheduled an auction for $4 billion of mortgage securities to raise cash. That’s a pretty unusual move, a sign of acute distress. Although Bear Stearns officials initially denied that the big sale was to meet margin calls, we speculated that that was at least partly the cause (the other might be anticipatory fund raising out of concern of further deterioration in the speculative/subprime end of the market where this fund played).
An article on the Wall Street Journal’s website confirms that the fund was hit with margin calls in the last few days and had already lost 1/4 of its value.
The story makes clear the fund is not out of the woods; it has sold its best assets and it will be increasingly difficult to sell its remaining positions should that prove to be necessary. The very fact that this information has been made public says the fund, which perhaps not on the ropes, is still very much at risk. If the subprime market continues to falter, this fund’s condition will continue to deteriorate. And since traders know it is in trouble, they will take full advantage of it. In other words, this could merely be the early stages of a full liquidation.
But what does this mean for the rest of the market? Other players are rumored to be shaky; indeed, there were whisperings last February that had the markets not turned, some funds would have perished. My bet is that conditions on the risky end of the mortgage market are not getting better. Even though Treasuries rallied, they are still trading at higher rates than as of last week. Mortgage borrowers are facing higher rates, and holders of ARMs will be hit with even more costly resets. And we’ve seen reports of sharp increases in foreclosures. There is no reason to expect better news on the housing front, and more bad news means more weaker bond prices, particularly in the junky credits.
From the Journal:
At a financial conference in late February, Ralph Cioffi, a senior hedge-fund manager for Wall Street firm Bear Stearns Cos., said that a meltdown in the subprime-mortgage market was “unlikely to occur.”
He spoke too soon.
Five days after the conference, an index tracking subprime mortgages, the riskiest piece of the mortgage market, fell to its lowest point ever. And in recent months, the riskier of the two funds he runs for Bear Stearns, the $600 million High-Grade Structured Credit Strategies Enhanced Leverage Fund, tumbled in value amid a surge in home-mortgage defaults.
Mr. Cioffi, 51 years old, has been at Bear for 22 years and is a mortgage-market veteran. But his riskier fund lost nearly one-fourth of its value in the first four months of this year. In recent days, lenders led by Goldman Sachs Group Inc. and Bank of America Corp. began making margin calls on the fund, requesting additional cash or collateral.
Yesterday, seeking to raise the cash, Mr. Cioffi’s funds auctioned off nearly $4 billion in some of their highest-quality mortgage bonds. The auction went smoothly, but now Mr. Cioffi’s funds are left holding riskier investments that could be harder to sell. Wall Street was watching the sale closely yesterday, fearing the market could soon be flooded with low-quality mortgage securities in the weeks to come.
Mr. Cioffi didn’t return a call for comment.
Whether the Bear sale raised enough money to meet redemption requests and margin calls — requests from lenders for additional cash or collateral — remains to be seen. Late yesterday, a number of creditors for the two funds met with its managers, but the outcome of the meeting wasn’t known.
The downturn in the subprime market spilled over into Bear’s fiscal second-quarter earnings yesterday. The firm posted lower-than-expected earnings of $362 million, or $2.52 a share, for its second fiscal quarter, which ended May 31. After adjusting for a $227 million write-down on Bear’s exchange-floor trading business, the firm earned $3.40 a share, 9% lower than the same period last year and 10 cents lower than analyst expectations.
Contrasting with Bear’s woes, Goldman, which has less exposure to the mortgage market, beat analyst expectations by a significant margin. Buoyed by robust investment-banking activity and growth overseas, Goldman reported a profit of $2.33 billion, or $4.93 a share, a 1% rise from the same period last year and 14 cents a share above analyst estimates of $4.79 a share.
Yet, both Goldman and Bear yesterday sounded one common chord: that continued troubles in the mortgage market remain a big worry.
With the sort of weakness investors are seeing in the subprime market, “there’s no hedging strategy you’re going to be able to employ that’s going to completely immunize you,” said Sam Molinaro, Bear’s chief financial officer, in an interview. Investors have made big profits on subprime loans in recent years, and losses on risky mortgage loans “are to be expected,” he added. “While you don’t like to have them, it’s a fact of life in the business.”
In a call with reporters, Goldman finance chief David Viniar was even blunter. “I don’t think we’ve seen the bottom” of the subprime problems, he said.
Bear, which is known for its tough risk controls, has so far been unable to navigate its way out of the turmoil. This raises the specter that other Wall Street funds are sitting on big losses that could crop up in the days and weeks ahead. Bear itself and a handful of top firm executives have only $40 million invested in Mr. Cioffi’s funds, with the rest of the money belonging to clients.
Bear’s $4 billion auction was well-received by the market, according to mortgage traders, with a number of parties bidding for the portfolio of high-grade assets at prices fairly close to the loans’ estimated values. The bidders included brokers, managers of collateralized debt obligations and some hedge funds.
In a sign of the market’s stability, Merrill Lynch & Co. launched an offering of roughly $1.6 billion of new securities backed by subprime loans. It generated significant investor interest, according to one market participant.
Bear is selling 150 different bonds from the two of Mr. Cioffi’s funds. One of the funds had around $600 million in equity and $6 billion in loans to finance its bets. The other fund had more than $1 billion in investments, and the amount of leverage it has is unclear.
The assets on the block yesterday were the most stable and liquid ones, with very strong credit ratings of double-A and triple-A — meaning they have a very low risk of default. These assets, which are essentially bonds backed by thousands of home loans, have largely maintained their market value over the past few months and weren’t the cause of the losses in the Bear funds.
From January to the end of April, the fund with $600 million in equity has lost 23% of its value. The other fund, which is less leveraged, is down about 5%.
The funds still own a number of collateralized-debt obligations, pools of hundreds of mortgage-backed bonds. CDO securities, unlike the assets they hold, are less liquid and hard to trade or price in the secondary market.
Goldman, meanwhile, reported its slowest profit growth in three quarters, as net revenue, revenue minus interest expense, from its important fixed-income business fell 24% to $3.37 billion in the second quarter. Investment-banking net revenue rose 13% to $1.72 billion. Overall, the firm reported net revenue of $10.18 billion, down 1% from the year-earlier level.