New Flavor of Credit Market Fallout?

Many observers had expected quite a few hedge funds that had subprime exposures to report significant losses for June, and there have been rumors of funds that had begun the liquidation process because it was apparent they were too badly damaged to survive. But the specter of investors clamoring to pull funds out of a fund that is merely mortgage-related, as opposed to exposed to subprimes, is a new development. Admittedly, the fund in the headlines is a Bear Stearns fund, so the tsuris may merely be a negative branding issue. But it is unprecedented for investors to seek large scale redemptions from a hedge fund that is still (allegedly) profitable. This raises two new concerns:

1. Hedge funds by nature are not liquid, and if investors begin to become nervous about hedge funds in general (as opposed to very selected names), repeated occurances of hedge funds refusing to allow investor withdrawals would further impair market psychology.

2. Hedge funds may raise their cash levels on an anticipatory basis to allow for a modest level of investor withdrawals (no one wants the bad press of reneging on contractual agreements). But any selling to raise cash would increase pressure on the markets.

From Bloomberg:

Bear Stearns Cos., manager of two hedge funds that collapsed last month, blocked investors from pulling money out of a third fund as losses in the credit markets expand beyond securities related to subprime mortgages.

The Bear Stearns Asset-Backed Securities Fund had less than 0.5 percent of its $900 million of assets in securities linked to subprime loans, spokesman Russell Sherman said in an interview yesterday. Even so, investors concerned about losses sought to withdraw their money, he said.

New York-based Bear Stearns triggered a decline in credit markets in June when funds it managed faltered as defaults on home-loans to people with poor credit rose to a 10-year high. Federal Reserve Chairman Ben S. Bernanke said in July that losses on subprime-related credit products may reach $100 billion.

“There will be more pain,” said Felix Stephen, a strategist who helps oversee the equivalent of $7.5 billion at Advance Asset Management Ltd. in Sydney. “I’m giving it a couple of months at least. It’s not the subprime issue that really matters, it is the first card to fall in the tower of cards in this situation.”

Macquarie Bank Ltd., Australia’s largest securities firm, said yesterday that investors in two hedge funds may lose 25 percent of their money and Boston-based hedge fund manager Sowood Capital Management LP said this week that it lost $1.5 billion in July after declines in the corporate debt markets.

`Having Problems’

The latest developments may signal that the slump in the subprime mortgage market may not be “contained,” as officials including Treasury Secretary Henry Paulson have said.

“You don’t necessarily have to be a subprime fund now to be having problems,” said Bryan Whalen, a money manager in Los Angeles at Metropolitan West Asset Management, which oversees more than $21 billion in fixed-income assets.

Banks and insurers ranging from UBS AG in Zurich to CNA Financial Corp. in Chicago have reported losses related to subprime mortgage debt. UBS, the world’s biggest money manager, replaced Peter Wuffli as chief executive officer in July after three quarters of declining earnings and losses at one of its hedge funds that invested in securities linked to subprime mortgages.

The latest developments at Bear Stearns and Macquarie sent stocks tumbling in Asia and Europe. The Morgan Stanley Capital International Asia Pacific Index fell 2.75 percent and the Dow Jones Stoxx 600 Index lost 1.6 percent to 373.97 12:07 p.m. in London. Shares of Bear Stearns are down 25 percent this year.

Bond Risks

The risk of owning European corporate bonds soared. Credit- default swaps based on 10 million euros ($13.8 million) of debt included in the iTraxx Crossover Series 7 Index of 50 companies jumped as much as 80,000 euros to 480,000 euros, according to JPMorgan Chase & Co. An increase indicates a decline in the perception of credit quality.

Bear Stearns doesn’t plan to close the fund, which has $50 million in cash and gets about $13 million in principal and interest monthly, Sherman said. The fund, which probably lost money in July, can afford to wait until the slump in the mortgage market is over because it doesn’t have any debt, he said.

“We don’t believe it’s prudent or in the interests of our investors to sell assets in this current environment,” Sherman said. “The fund portfolio is well positioned to wait out the market uncertainty.”

Funds Collapse

Even though investors demand an extra 4.19 percentage points in yield to own high-yield, high-risk company debt, the most since May 2005, defaults on corporate debt are near record lows. Merrill Lynch & Co. index data show the spread narrowed to 2.41 percentage points on June 5, the lowest since at least 1997, when the index was created, and is below the peak of more than 10 percentage points in 2002.

Debt rated below Baa3 by Moody’s Investors Service and BBB- by Standard & Poor’s is considered high-yield, or junk.

The collapse in July of Bear Stearns’ High-Grade Structured Credit Strategies Fund and its High-Grade Structured Credit Strategies Enhanced Leverage Fund fueled concerns about subprime securities. As investors retreated from risky credit, more than 45 companies were forced to cancel or rework bond and loan sales, according to data compiled by Bloomberg.

The two funds, managed by 22-year Bear Stearns veteran Ralph Cioffi, 51, invested almost all of their assets in subprime mortgage-related securities. They failed when creditors demanded more collateral after the value of those securities dropped. Bear Stearns extended $1.6 billion in credit to one of the funds before seizing its assets last week.

`Uncertain’ Impact

Both funds filed for bankruptcy protection yesterday, two weeks after Bear Stearns told investors they would get little if any money back. Bear Stearns in June assigned its top mortgage trader, 45-year-old Tom Marano, to get the best prices for the funds’ remaining assets.

“It’s uncertain when we will see the full impact” from the subprime fallout, Craig Overlander, co-head of global fixed- income at Bear Stearns, said in an interview today in Hong Kong. “We can stress test, we can come up with possible scenarios but really we won’t know until we see what’s coming in the mortgage pipeline, the forms they are coming and the environment in which they will reset.”

Investors became more skittish last month as delinquencies on subprime mortgages grew. Blackstone Group LP stepped in to help Sydney-based Basis Capital Fund Management Ltd. avoid a fire sale of assets. Absolute Capital Group Ltd., partly owned by ABN Amro Holding NV, froze investor accounts.

“These are all continuing issues that don’t go away in one day or in one week,” said Ira Jersey, strategist at Credit Suisse Group in New York. The Bear Stearns announcement “won’t be good” for credit markets, he said. “It will take a number of weeks to resolve.”

Late Payments

Late payments on subprime home loans, those made to the riskiest borrowers with lower credit scores, rose in the first quarter to the highest level since 2002, the Mortgage Bankers Association has reported. At least 60 mortgage companies have halted operations, gone bankrupt or sought buyers since the start of 2006, according to Bloomberg data.

American Home Mortgage Investment Corp., which lends to homeowners with higher credit scores than subprime borrowers, said yesterday that it doesn’t have cash to fund new loans, stranding thousands of home buyers and putting the company on the brink of failure.

Shares of MGIC Investment Corp. had their biggest one-day loss and Radian Group Inc. tumbled the most in eight years yesterday after the home-loan insurers said their stakes in a subprime mortgage company once valued $1 billion may now be worthless because of “unprecedented” disruptions in mortgage markets.

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  1. a

    Here of course it’s the lack of transparency of the hedge funds that will do them in. They want to keep their positions super-secret for proprietary reasons; but then investors can’t know what’s in the damn things, so (naturally in these times) they assume the worse.

  2. Anonymous

    Most limited partnership offering documents that I’ve read allow the partnership to make “in-kind” payouts. Assuming that the margin debt has been paid off, the general partner can pay the withdrawing limited partners with their pro-rata percentages of investment positions. Of course, the GP would then lose the 2 of the 2 and 20.

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