John Gapper, in a Financial Times comment, “How Bear Stearns Put Itself First,” argues that even though Bear Stearns’ decision to step in to manage the unraveling of its two troubled hedge funds was self-interested, it was also bad for the hedge fund industry and for the CDO market.
I don’t agree with Gapper, and I believe he’s read the facts incorrectly.
The funds in question are the High-Grade Structured Credit Strategies Fund and the High-Grade Structured Credit Strategies Enhanced Leverage Fund. The second fund was newer and riskier, so we’ll refer to them as “original” and “high test” respectively.
Even though Gapper portrays Bear’s actions relative to the original fund accurately, he jumps to a mistaken conclusion. Readers may recall that Bear was pressured into putting up a $3.2 billion collateralized repo facility for this fund as a way to assume the liabilities of other Wall Street firms that had lent to it (note that the facility has already been reduced to $1.6 billion because Bear was able to sell some fund assets).
Gapper gets the first part right….
Having endured a week of howling from other Wall Street banks that had extended credit to the funds, Mr Cayne got them off his back by taking on their liabilities. He also relieved pressure on Bear’s huge business in securitising and trading mortgages. If the others had forced a fire-sale of the funds’ collateralised debt obligations (CDOs), it could have hurt.
….but then he goes off the rails:
For the market, however, Bear’s bail-out was a poor idea. It set a bad precedent for other Wall Street banks and hedge fund investors, no matter how much they wanted the cash. It also delayed the necessary reckoning for mortgage-backed CDOs, a market that grew by $131bn last year but which is rife with opacity, illiquidity and shady valuations.
First, everyone who stands to lose money from Bear’s hedge fund debacle can afford to do so. The funds’ investors were rich people with over $5m in liquid assets to invest, including some of Bear’s executives. Unlike the home owners who caused all the trouble by defaulting on their mortgages and disrupting the cash flows underlying the CDOs, they should be sophisticated enough to know that a roulette ball sometimes falls into the zero pocket.
Bear’s actions have absolutely nothing to do with salvaging fund investors. And there is no reason to believe that these investors will fare one iota better with Bear now in control of the fund’s assets.
Bear’s only motivation was to placate its trading counterparties. Securities firms depend on the good will and cooperation of their competitors (yes, it’s a peculiar business) because they trade with each other, and far more important, they extend significant amounts of credit to each other via repos. If push came to shove, if several big firms were angry enough at Bear to pull its credit facilities, the damage to the firm would be in the severe to irreparable range. I sincerely doubt that anyone made this threat explicitly, but with all the hedge funds’ creditors united against Bear, the firm had no choice.
Bear was willing to let the funds’ equity investors rot, and as things stand now, Bear’s motivation is to realize enough from selling the fund assets to make sure it comes out whole on its repo facility. It has no loyalty to the equity holders (even with employee funds at risk it had been willing to let both funds sink). Its main reason to do any better at this juncture isn’t economic, but regulatory. With the SEC probing the funds’ failure, it would look less God-awful if the investors got some money back.
Mind you, I am not saying there will be no equity recovery; this stuff is too opaque for anyone at a remove to have the foggiest idea. I’m speaking to motivations, not outcomes.
Gapper also makes an argument that makes less sense than appears on the surface:
The same accident is waiting to happen at other banks. Investors have been eager to place their money with Goldman and others, assuming that their expertise and brands will give them an edge in asset management….
The yield on CDOs clearly suggested – long before the subprime mortgage downturn – that if a little went wrong with these cash flows, a lot could go wrong with the securities. In other words, a fund investing in CDOs might achieve annual returns of 20 per cent when things were going well but would hit big problems in bad times. And so it proved.
Yes, this was a hedge fund. Yes, hedge funds are risky. But if you follow his logic, he is equating the performance of the fund with the performance of the asset type it is invested in. That is often, but not universally, true. This fund, like most hedge funds, was running long and short positions. In fact, Cioffi correctly believed that subprimes would fall, Rather than reduce his long positions (which might have been difficult to do in any volume, given the now-well-known illiquidity of this paper) he hedged it. But the hedge didn’t perform correctly and he lost money on the ABX put and on the fund assets.
Let me put it in simpler terms: the yield on CDOs being high could (and did) point to a lot of chumps being in this market. A hedge fund manager among chumps ought to be able to find ways to do well.
Gapper also makes incorrect assumptions about the “high test” fund:
Bear made a distinction between the funds: it rescued the ordinary one and let its highly leveraged counterpart fend for itself. That implied that the investors in the safer one deserved a bail-out more than those who took bigger risks for higher returns. But the reality is that even the former were taking a big punt by investing in an aggressive CDO fund.
Again, Gapper mistakenly assumes Bear’s decisions revolve around the funds’ investors rather than its creditors. The fund’s lenders told Bear to cut the fund loose.
Gapper may also be laboring under the incorrect impression that I once had, namely, that the “high test” fund had riskier assets. Another FT article, “Bear Stearns assured investors on leverage” clarified this matter. As I commented earlier:
The piece also cleared up a point I (and perhaps my sources) got wrong. I was perplexed that the Enhanced Leverage Fund, the bigger fund with what was reportedly riskier assets, was allowed to fail (the smaller fund is being worked out). “Bigger” and “riskier assets” presumably mean greater losses to the lenders, and if the rest of Wall Street forced Bear to salvage the other fund, ti was a mystery to me why they wouldn’t be even more insistent with this one.
It turns out the Enhanced fund was riskier all right, but not by having riskier assets (in fact, it had higher quality assets) but by being more leveraged. Remember, that was the fund that scheduled an auction for $4 billion of its assets that went off well. Apparently the lenders thought it best just to take the whatever losses there were on the loans against the remaining assets and call it a day.
In fact, from what I can tell, the creditors to this fund might get out close to whole, which explains their behavior. This fund was reported to have over $6 billion in assets as of mid June. $4 billion were auctioned successfully, leaving over $2 billion. Bear more recently reported that creditors had $1.2 billion outstanding. Now remember, per above, this fund’s strategy was to invest in less risky assets, so what’s left might just be worth 50 cents on the dollar, perhaps more.
Finally, Gapper thinks Bear’s measures were bad for the market:
Finally, the intervention prevented a ripple effect across the mortgage securities market as a bunch of CDOs were sold at low prices and investors had to mark down portfolios. It would have caused pain across Wall Street and the City of London, to where subprime problems have spread, but not any systemic financial problem that justified a bail-out.
Let’s get clear as to what happened. Bear did not inject capital. Bear let one fund collapse. For the second, it effectively allowed other firms to shift their liabilities to Bear. There was no net increase in risk assumption, only risk transfer. The only way this improved matters (and this is a benefit) is that you a central intelligence managing the effort to maximize value from the fund’s remaining assets, and that central intelligence happens to be the biggest player in the asset backed securities market.
And I disagree vehemently with Gapper as to the degree of systemic risk. The bond markets were already spooked by the sudden rise in long-term Treasury prices in a way that broke long-term trading patterns. Participants saw it as a historic watershed, of the end of the era of falling interest rates. The subprime market had been performing badly before Bear events. LBO deals were also encountering resistance.
In the wake of the 1987 market crash, regulators around the world established what are called circuit breakers, forced trading halts if prices fall by greater than certain percentages of market value, so as to prevent panicked selling by giving market participants time to collect themselves and regroup, rather than dump out of fear of not knowing when the market will bottom.
However, these circuit breakers exist only in the equity markets. There are no centralized exchanges in the bond markets (well, there is a teeny and irrelevant NYSE bond market). Thus there is no way to stem a bond market panic. So in lieu of circuit breakers, having Bear step in, under duress, to avoid dumping, seems like a cheap ounce of prevention.