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.
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“…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.”
Except perhaps when the market is pretty much hedge funds (and proprietary desks at IBs)?
I had thought that earlier too until Bloomberg magazine came out with some surprising stats (see http://www.nakedcapitalism.com/2007/06/more-cdo-factoids-who-owns-em-why-they.html for details). Amazingly, CDO buyers are representative of the normal bond buyer universe, which is pretty scary. Hedge funds own only 3% of investment grade CDOs and 10% of equity tranches.
thanks for clarifying what happened to the two different funds — the story (the bigger fund was move leveraged but had higher quality assets that could be sold off by the funds creditors) makes sense. i presume you are confident that this fund will be fully wound down, with the equity investors taking significant losses (on the assumption that the fund’s remaining assets aren’t all that great, and after it pays off its remaining liabilities, they initial investors will get very little back).
one question: why did the first fund’s hedges on subprime not work? what was the false assumption (it certainly seems like hedges that don’t perform under duress is a common feature of hedge fund failure — ltcm was hedged v. many things, but it was always long the more illiquid v the more liquid, which left it in trouble, so i guess it wasn’t a failed hedge so much as a risk that it failed to recognize … but there does always seem to be a key assumption that didn’t hold that creates trouble, and, from the outside, i don’t quite understand why bear fund 1’s subprime hedge didn’t work.
bsetser
The ABX hedge didn’t work because trading in that contract became extremely technical, divorced from fundamentals. It suffered a severe sell-off in Feb, then rallied in March and April. My sources say that BSAM added to their hedge during the sell-off and got whipsawed.
Ironically, just as the ABX index was rallying, BSAM’s actual assets started to perform poorly. With the sort of leverage they had, they couldn’t afford to have both sides of their trade go against them for very long.
Yves: I think you have much better and more accurate commentary on this story than 99% of the major blogs out there. I’ve been trying to go around correcting misinformation, but there is just too much of it.
TDDG,
Thanks for filling us in on the ABX trading (and the kind words); I was going to speculate that it had gotten oversold and then overcorrected, but better to hear from someone who really knows.
Also, although the serious trouble occurred in the fund with the better, and presumably more liquid assets, by all reports this paper isn’t very liquid. That usually means that any hedge is going to be very imperfect.
I assume they thought they could compensate by adjusting the hedge dynamically, but if you don’t have good marks on the assets you are hedging, it winds up being a guesstimate at best.
I have a sneaking suspicion the funds also had front office (trading system) – back office issues. That might be the reason that the more leveraged fund had to tell investors that its April losses were much bigger than originally thought. I heard of the same thing happening to a fund that was doing a lot of shorting in more liquid markets (European equities) and the valuation difference was surprisingly large (2 1/2% in one month, which for actively traded paper is massive). It led a lot of investors to withdraw funds over operational concerns.
Brad,
I wish I had a mole at Bear, but since I don’t, your guess is as good as mine as to how this all gets resolved. The reports are consistent that the more leveraged fund is not being worked out. I don’t know what that means in terms of the liquidation process (do they dump it? do they take a month?).
As of the end of April, as mentioned in the post, this fund was reported to have over $6 billion in assets. $4 billion has been sold, and $1.2 billion of debt is still outstanding against those assets.
I had commented before that the values being reported in the press didn’t add up (scroll to the latter part of http://www.nakedcapitalism.com/2007/06/bear-stearns-updates.html). At the same time the press was reporting the values above, the equity in the funds as of end of April was $538 million. $538 million plus $1.2 billion does not take you to the high side of $2 billion.
The most likely culprit is that the $4 billion sale was at a loss, say 90% of the value on the books. That still gives us no clue as to what that nominally over $2 billion of remaining assets is really worth, but it is certain the best assets were sold first, so you can expect deeper haircuts on what remains.
Hopefully one of these days we’ll get a more complete accounting.
$250 Billion in Subprime Losses?
http://www.frontlinethoughts.com/pdf/mwo062907.pdf
Let’s go to the latest issue of Bloomberg Markets magazine. In an explosive article called “The Rating Charade” (kudos to Richard Tomlinson and David Evans for a well-done piece), they discuss a Collateralized Debt Obligation (CDO) issued by Credit Suisse in 2000 (well before the current subprime crisis!) and composed of mortgages, loans, and other debt. Cutting to the chase, all three rating agencies rated the five tranches. 95% was rated investment grade. The unrated tranches went completely bust, the two mezzanine tranches (rated BBB and A!) lost everything as well. Those losses combined for $47 million.
The AAA tranche lost almost 25%, although those investors did have insurance, so they got their money back, as MBIA took the $73 million loss in the AAA tranche. A total of $120 million in losses in a $340 million CDO, with 95% of it rated as investment grade. Ouch.
As I have written since the fall of last year, these bonds are bought by various institutions because of the ratings from the credit agencies. And it is not just European and Asian institutions. Let’s make a short list of some US pension funds that buy the equity (toxic waste) portion of CDOs: The New Mexico Investment Council ($222 million and another authorized $300 million for 3% of its total fund), the General Retirement System of Detroit ($38.8 million), the Teachers Retirement System of Texas ($62.8 million), Calpers … the list is evidently long. 7% of all the equity tranches sold in the US in the past decade were purchased by US pension funds, endowments,s and religious organizations.
So, why did they buy them? Let’s be clear. They were looking for higher returns, and they took comfort in the ratings. Some of these CDO-rated tranches paid 10% over LIBOR. That is a huge difference and roughly double the return for similarly rated debt. The equity portions offered as much as 20%. Bear Stearns said in a marketing meeting that “The outside agencies that oversee these structures are the rating agencies.” I will bet you a few dollars against a donut that similar statements were made by other investment banks.
But what do the rating agencies say? Fitch: “It’s not accurate. We don’t provide any oversight.” Moody’s: “It’s a common misperception. All we’re providing is a credit assessment and comments.” S&P: “We disagree. We rate the transactions that issuers bring to us based on our published criteria.”
[…]
The rating agencies all have disclaimers which read something like this: “You should not make an investment based on our ratings.” That is of course laughable, as the only reason that anyone buys these investments is the ratings. It is going to be interesting to see what the courts say, as you can be sure of one thing: this is going to end up in court.
How large are the losses we are talking about? They could be quite large. From the Bloomberg article:
“As foreclosures increase, the subprime-backed securities in CDOs begin to crumble. Subprime mortgage securities make up about $100 billion of the $375 billion of CDOs sold in the U.S. in 2006, according to data from Moody’s and Morgan Stanley. Seventy-five percent of global CDO sales are in the U.S. Moody’s reported in March that about half of the CDOs sold in the U.S. last year contained subprime debt. On average, 45 percent of the contents of those CDOs consisted of subprime home loans, Moody’s said.
“In a certain class of CDOs, the concentration of subprime is even higher. S&P and Fitch estimate that subprime mortgage securities make up more than 70 percent of the debt in so-called mezzanine asset-backed CDOs, a type of CDO that repackages bonds, mostly mortgage debt, with low credit ratings. Investors bought $59.5 billion of these CDOs in 2006, according to Morgan Stanley. On average, as with all CDOs, more than 90 percent of the value in them is rated investment grade.”
The Center for Responsible Lending estimates that 2.2 million borrowers who got subprime loans since 1998 either have lost or will lose their homes through foreclosure over the next few years. This includes one of every five borrowers who got subprime loans in 2005-06, a default rate unmatched in the history of the modern mortgage market.
You can go to your Bloomberg quote machine and pull up residential subprime structured finance deals. What you find is one RMBS that was issued in 2006 that already has over 54% of its loans more than 60 days delinquent and 17% of them in foreclosure. Think the buyers of that equity tranche stand a snowball’s chance of getting anything?
Has this security been re-rated? No, because the ratings agencies say they cannot re-rate something until they know for certain there are losses. They can’t act on suspicion. However, I do remember them putting out warning notices for various bonds and corporate offerings prior to re-rating. I would think those are coming.
The problem is that if these offerings lose their investment grades, many institutions will be forced to sell, as they are limited by their charters to only invest in rated paper. But who will buy until the smoke clears? It will get ugly. This will end in tears…
Bottom line: no one knows how large the losses will be. Right now the “hope” is that they are spread out among hundreds or thousands of various funds, institutions, and agencies, and thus there will be no major failures or systemic risk.
BSAM will not be the first or last to under-estimate the basis risk of a cash portfolio relative to an index hedge where such composite or OTC hedge is manipulable – either as a result of lack of liquidity/depth or for darker/more nefarious purpose. That said, history will (yet again) view it as the pinnacle of fiduciary stupidity to apply the quantity of leverage under such circumstances.
Thanks for the great reporting though-out!
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