When the story broke of trouble at a Bear Stearns hedge fund, the High-Grade Structured Credit Strategies Enhanced Leverage Fund, that led it to auction $4 billion of its holdings to raise cash, we speculated that this might wind up being the beginning of a liquidation. That scenario now appears likely.
The Wall Street Journal reports that Merrill Lynch has decided to seize $400 million of collateral from the fund, which is likely to precipitate similar moves by other creditors.
The irony is that fund manager Ralph Cioffi was generally correct: he had bet on the subprime market to deteriorate. But when you are playing in risky markets with a lot of leverage, you have to be specifically as well as generally correct. Mr. Cioffi’s fund was hit when the ABX index, a proxy for the subprime market, appreciated from its low of 62 to 72 in May. Compounding his woes was the fact that collateralized debt obligations expected to hold their value fell.
If the fund’s assets are sold, it will have broader ramifications. It appears that many of its remaining assets are not terribly liquid. Illiquid debt instruments are often marked to market (a requirement) by extrapolation from more liquid investments. If these assets go for a lower price than most investment banks have been valuing them at, it could lead to margin calls to other hedge funds, precipitating a wave of sell-offs.
So far, it looks as if any damage will be contained within the universe of funds that were significantly exposed to subprime assets. But if this saga has more chapters, it could be the beginning of investors demanding to be compensated for risk.
From the Wall Street Journal:
Concerned that an internal hedge fund at Bear Stearns Cos. wouldn’t be able to meet a margin call, Merrill Lynch & Co., one of the fund’s biggest lenders, seized $400 million of its assets and is preparing to auction them off.
The auction, in the coming week, could trigger the fund’s dissolution — the second blowup in recent months of a hedge fund that made dicey bets on the market for risky home loans, known as subprime mortgages.
Ralph Cioffi and Bear Stearns made bets both for and against subprime loans — but a recovery in the market hurt.
The surprise move involving the two Wall Street firms came as the Bear fund’s managers, led by bond-sales veteran Ralph Cioffi, scrambled Thursday and Friday to sell hundreds of millions of dollars in bonds to satisfy demands for cash and assets from creditors and stave off liquidation. Mr. Cioffi’s group had successfully auctioned off almost $4 billion in high-quality mortgage bonds Thursday morning. Later that afternoon at Bear’s New York offices, the fund managers presented lenders with a 30-day plan for selling more assets, a blueprint for meeting new margin calls that appeared to have been well-received.
Merrill opted not to wait. Friday afternoon, the firm’s bond traders began circulating a list of securities that had served as collateral, or security, for the credit it had extended to the Bear fund, High-Grade Structured Credit Strategies Enhanced Leverage Fund.
Bids for the securities are scheduled to be negotiated starting at noon on Monday.
The seizure by Merrill — which could spur other lenders to seize fund assets — may well mean the end of Mr. Cioffi’s two funds.
The Bear fund has different bets on the health of subprime mortgages, both positive and negative, but has been hurt particularly by a negative bet after a rebound on a key index that tracks the sector.
In the earlier blowup, in May, UBS AG shut down Dillon Read Capital Management after bad trades in subprime-mortgage loans led to a $124 million loss.
The latest auctions have been watched closely by Wall Street. Especially concerned are other hedge funds that may be forced to lower the value of their own assets if the Bear sale fetches bids that are well below what the fund says they are worth. Unlike the high-quality and liquid mortgage-backed bonds that Bear sold this past week, the assets up for sale this time comprise securities that are considerably less liquid.
Mr. Cioffi’s 30-day plan was a last-ditch effort to salvage his fund, which he has run since August and is geared to sophisticated investors. Built on about $600 million in investor capital, $40 million of which came from Bear and a group of firm executives, the fund had borrowed at least $6 billion in additional capital from a dozen Wall Street lenders, say people familiar with the matter, including Merrill, Goldman Sachs Group Inc., Bank of America Corp. and Deutsche Bank AG. It was run by Bear executives alongside a larger sister fund with relatively little borrowed capital.
The fund bet a popular index that tracks subprime mortgages, the ABX, would fall. Late last year and early this year, those moves bore good returns, says a person familiar with the matter. Then the tide began to turn. After reaching a low of 62 late in February, amid rising numbers of defaults and delinquencies in the subprime market, the ABX unexpectedly recovered in the months that followed, reaching 72 in mid-May. It has since gone back down to 61. This led to losses for Mr. Cioffi.
Mr. Cioffi’s team also bet collateralized debt obligations, or pools of mortgage-backed bonds, would keep their value. But some of them fell in value, leading to further losses.
During April, the leveraged fund began falling sharply. Its bearish bets on subprime securities had created paper losses, and some investors were getting antsy and asking to redeem their cash, says a person familiar with the matter. After getting wind of the redemption requests, some of the firms that had sold subprime securities to the fund asked to revalue them at a lower level, says this person. By the end of the month, the leveraged fund had fallen 23% for the year.
Mr. Cioffi’s team froze the redemption requests, hoping to stabilize the fund, and began selling off billions of dollars in its most valuable assets from both the leveraged and the less-risky funds. From the beginning of May through Thursday, the Bear funds had sold roughly $7 billion in assets, says a person familiar with the matter. Friday, the fund began auctioning hundreds of millions more. As this was under way, Merrill moved in and seized assets in an attempt to protect its investment.