Bear Stearns (BSC) Fund Meltdown
Hedge Fund/Investment Bank/Subprime/Leverage Meltdown
For quite some time, I’ve warned about the following risks in the market:
1. Hedge Fund Scandal
2. Housing Bubble and Subprime Fallout
3. Investment Banking Accounting
4. Leverage in the Market
In one convenient New York Times article that was printed today about Bear Stearns, all four issues are conveniently addressed. The following are quotes from the article followed by my own editorial comments:
1. Hedge Fund Scandal
Bear Stearns [ticker symbol BSC] told clients in its two battered hedge funds late yesterday that their investments worth an estimated $1.5B at the end of 2006, are almost entirely gone…The more conservative fund, the High-Grade Structured Credit Strategies Fund, was down 91% by the end of June, investors were told. The High-Grade Structured Credit Strategies Enhanced Leveraged Fund, which used extensive borrowings and assumed more risk, has no investor capital left, the firm said.
First item of note. These funds were invested in Investment Grade CDOs (AAA/AA). Not high-flying internet or bio-tech stocks or some other absurd asset class. Investment Grade CDO’s (Collateralized Debt Obligations) backed by real-life mortgages (which I’ll cover later). This is not Amaranth investing in highly volatile Natural Gas futures. The implications of a bond fund getting completely wiped out are enormous. How did it happen? The next 3 points will explain how. (nice segue way, eh?)
2. Housing Bubble and Subprime Fallout
While risky mortgages are thought to have been central to the funds’ misfortunes, Bear’s letter said that “unprecendented declines in the valuations of a number of highly rated (AA & AAA) securities contributed to June’s woeful performance…Even before Bear Stearns made its disturbing disclosures, the ABX index, which tracks the price of insuring losses in subprime bonds, hit fresh lows. The part of the index that tracks A-rated [that’s the good, low-risk stuff] segments of the mortgage securities issued in late 2006 and early 2007 fell to 68.5 cents on the dollar, down from 72.36 cents Friday.
A-rated discounted 31.5% in less than a year! And Bear Stearns is deflecting the blame onto the credit rating agencies (Moody’s S&P, ect) that they paid to rate the securities that they in turn got paid to sell to their clients – some of whom were their own hedge funds. (Ironic!)
Despite countless assertions to the contrary by Wall Street and the NAR (National Association of Realtors), it’s well known that the housing market was in a bubble and now it’s popping. The first victim was homebuilder stocks last summer. The second victim was the lenders which got whacked in February. In my May 31, Portfolio Update, I wrote the following about the next victim in the subprime debacle.
In case you’re wondering who owns all those mortgages that we created in the US, the answer might surprise you because it is not the mortgage companies. They are owned by investment banks, foreign central banks, hedge funds and individual investors. In the last 12 months, homebuilding stocks have languished at multi-year lows and over 80 mortgage lenders have closed their doors. However, the securities that investment bankers created from these mortgages have continued to appreciate. It doesn’t make sense that homebuilders and mortgage originators have taken it on the chin but the at-risk existing mortgages have escaped unfazed. For this reason [I’m bearish on the Financial Sector] who will take the biggest hit if the sub-prime mess isn’t “contained” as Wall Street repeatedly claims that it is.
It didn’t take a genius to figure this out. It was just a matter of connecting the dots. First the Homebuilders got hit, then the Lenders and next the people in line were the ones toting the note – the investment banks. Clearly, the subprime mess is now taking its toll on the investment banks and other financial stocks as the I-shares Financials ETF, ticker IYF, lost 1.12% today – 0.9% more than the rest of the S&P 500. Actually, the S&P 500 would have been up today if it weren’t for the Financials. This fund is down 11% from its peak on February 20, 2007.
(BTW, the Spiders Homebuilders index hit a 52-week low today as of tomorrow. It’s current 52 week low was exactly one year ago on 7/18/2006, so after today, that previous low will be wiped out, making today’s low the new 52-week low)
3. Investment Banking Accounting:
I’ve been especially leery of the accounting practices of Investment Banks over the last several years. (I worked at Arthur Andersen, I think financial reporting is a sham and I’m leery of all it, but especially the stuff the Investment Banks have been reporting.) It seems their profits are just too high given that they are losing market share to other investment alternatives (like fee-only investment advisers such as myself – pardon the shameless plug). I’ve often quoted Charlie Munger who said “[He] likens derivative accounting to sewage waste but that’s an insult to sewage waste.”
Derivative accounting is a very gray matter. There are very few established practices for it. I’m assuming that the investment banks are taking every liberty possible (Again, I worked for Arthur Andersen, so I know how these things work). Combine sketching accounting practices with the fact that the combined markets for Derivatives exceeds the size of the US, German and Japanese Equity markets combined, the problem could become quite sizable. Here’s what the article says:
The drama surrounding the two funds began in May when investors in the more leveraged hedge fund were told losses through the end of April totaled 23%, not 10% as they had been told earlier.(emphasis mine)
Let’s look at the Timeline:
April – clients told the fund was down 10%
May – fund is reported to actually be down 28%
June – the fund is worthless – down practically 100%.
We need to read between the lines. This “misunderstanding” cannot take place if it weren’t for some shenanigans taking place in the accounting departments at these funds. I believe the same shenanigans are taking place at the firm level.
4. Leverage blow-up:
In my last update, I wrote the following about leverage:
There is still an unprecedented amount of leverage in the market… When this leverage is unwound, very bad things will happen! The most recent flare-up was the news of Bear Stearns Hedge funds that took a 28% hit due to subprime mortgage debt.
When a fund is levered up 10:1, as many are, a 10% loss in the underlying assets turns into a 100% loss for the fund. That’s how a fund filled with mortgage backed securities that own a claim on real property that has real value can go to ZERO in less than 6 months.
While the news of these funds has had an indirect impact on the market, they have not had a direct impact. These funds were likely 100% invested in CDO’s – nothing else. What happens when a fund that has a 20% position in CDO’s but the other 80% is invested in equities, futures and swaps. Their clients will start calling the fund to demand to know what kind of exposure they have to CDO’s. (Hedge Funds do not have to disclose their holdings so many do not.) Once the clients find out that their fund owns CDO’s and is up to the same sort of shenanigans as the BSC funds, they’ll likely liquidate their shares.
Now here is where it gets interesting. The fund can’t sell their CDO’s because a) the market is too illiquid and b) nobody wants them. A “firesale” of their CDO positions would cause a huge mark-to-market writedown of the funds’ assets causing the fund to report negative performance causing more redemptions. (Snowball effect) So the alternative is to liquidate non-CDO positions – like equities, futures and swaps. But the fund is levered 10:1, meaning that in order to redeem $1’s worth of shares, requires unwinding $10 worth of security exposure.
I’ll reiterate, when the leverage in the market is unwound, very bad things will happen! The massive amount of inflows into Hedge Funds was a fad that will end. As investors pull their assets out of Hedge Funds, the impact on all markets will be severe. I said earlier that the amount of leverage in the market is “unprecedented”. Therefore, nobody can possibly predict how this will end because we are in unchartered waters. What we do know is that extreme leverage always ends badly.
