Saturday, June 23, 2007

A Tale of Two Hedge Funds

by Tanta on 6/23/2007 11:24:00 AM

We begin to get some backstory on the Great Bear Hedge Fund Meltdown of 2007, courtesy of the New York Times. The leitmotif, which I prophesy will become the Unshakable Story That Everyone Will Stick To, is that this is all directly and apparently unproblematically related to subprime mortgage loans:

The crisis this week from the near collapse of two hedge funds managed by Bear Stearns stems directly from the slumping housing market and the fallout from loose lending practices that showered money on people with weak, or subprime, credit, leaving many of them struggling to stay in their homes.

Let's leave, for the moment, the question of the incredibly complex and opaque layers of leverage, synthetic structures, derivatives swaps, and mark-to-model valuations that transformed mere commonplace mortgage loan write-downs into 23% losses of $600MM invested equity in approximately 9 months on a fund created because its precursor fund, which had dawdled along for two years or so generating a mere 1.0-1.5% a month return, we are informed, just wasn't good enough for the high rollers who didn't damn well put their money in hedge funds to earn 12-18% a year. This is really all about a bunch of subprime loans.

Notice deployment of the Mozilo Defense:
The first fund, the Bear Stearns High-Grade Structured Credit Fund — the one bailed out yesterday — was started in 2004 and had done well, posting 41 months of positive returns of about 1 percent to 1.5 percent a month. But investors were clamoring for even higher yields, which would require more aggressive bets on riskier mortgage-related securities and significantly higher levels of borrowed money, or leverage, to bolster returns.

So, a bunch of first-time homebuyers with no money made Angelo write a bunch of regrettable loans. Angelo undoubtedly made Bear Stearns buy those loans. A bunch of insane hedge fund investors who aren't happy with 12-18% annual returns from investing in the first loss position on the loans Angelo was forced to make got out their pitchforks and "clamored" until Bear Stearns gave them a new fund that used 10x leverage to sell protection to somebody who is exposed to the losses on the underlying reference securities (you want to bet me that'd be Fund 1?) that were valued by Bear's nifty models to start with.

No, wait. All that stuff is way too complicated for any reader of the Saturday Times to follow. Let's stick with how this "stems directly" from Teh Subprime. Besides the fact that we all know what Teh Subprime is about (don't we?), which makes this story easier to understand, it helps us get away from the implications of printing things like this:
Bear Stearns is bailing one of the funds out because it is worried about the damage to its reputation if it stuck investors and lenders with big losses, said Dick Bove, an analyst with Punk Ziegel & Company.

“If they walked away from it, investors would have lost all their money and lenders would have lost all of the money,” Mr. Bove said. But “if they did that to everyone in the financial community, the financial community would have shut them down.”

You see, unlike those deadbeat subprime homebuyers, Bear Stears is honorable enough not to stick it to the bagholders. Sure, that aborted attempt at the Everquest IPO might appear to have been an attempt to find a different subset of the "financial community" to stick it to, but Bear obviously realized that its holy reputation might not withstand offloading the nuclear waste onto retail investors, so it dutifully fell on its own sword and bailed out the people who forced it to open such a stupid fund in the first place.

But horrors! cries the crowd. What about BSC's shareholders? Why should they pay for this fiasco?

The Times doesn't mention that part, but if Fitch is to be believed, the "bailout" of Fund 1 is not an equity infusion but . . . wait for it . . . a loan modification! Apparently BSC is offering Fund 1 a collateralized repo facility with which the "financial community" can be paid off and BSC can now be collateralized by fund assets that still do or do not have any value as far as we don't know.

Unfortunately, the earlier storyline we spent most of last week on, the question of how much of all this to-do was a mere strategem to avoid having to mark to market any of this fine "collateral," now appears to have retreated a bit. I must say I'm wondering how Bear Stearns can can offer a collateralized repo facility to a "troubled" hedge fund and not mark that sucker to market every day of its life. Can anyone explain how this is going to get unwound?

No, we can't explain how this is going to get unwound. Let us, therefore, focus obsessively on lenders making bad mortgage loans to subprime borrowers. If we do that, maybe people won't notice that there don't seem to be nearly enough reported principal losses on actual subprime loans to account for the magnitude of the BS Funds' losses on a dollar-for-dollar basis, which does kind of suggest to us simpletons that something out there is magnifying, rather than dispersing, all this credit risk.

Remember the Brookstreet story? Catastrophic mark-to-market losses on a whole mess of mortgage-backed bonds that seem to affect only one brokerage? And nobody else seems to be marking to that price? Or could it be that everyone else is, in fact, marking to that price, but no one else was either stupid or criminally insane enough to buy illiquid and hence somewhat fuzzily-valued bonds for customer accounts at 9 to 1 leverage?

Nah, it's those stupid subprime borrowers.

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