Wednesday, July 18, 2007

News Flash: You Can Get an AAA Rating on Tranches of Junk Loan Pools

by Tanta on 7/18/2007 09:13:00 AM

I know a lot of you people really like Gretchen Morgenson's reporting. I know this because every time I blow a gasket over something she's written, I get a bunch of comments to the effect that I should be nicer to someone who is the Friend of the Little Guy Investor.

I think it's really nice of Ms. Morgenson to be the Friend of the Little Guy Investor. I merely want her to 1) understand what she is writing about and 2) write about it clearly.

I jumped on her case several months ago for her apparent inability to understand the difference between the rating of a tranche and the credit quality of the underlying loan pool. She's at it again:

While risky mortgages are thought to have been central to the funds’ misfortunes, Bear’s letter said that “unprecedented declines in the valuations of a number of highly rated (AA and AAA) securities” contributed to June’s woeful performance.

The more conservative of the two Bear Stearns funds was the older; established three years ago, it generated monthly gains of roughly 1 percent to 1.5 percent until March. Bear Stearns started the more leveraged fund last summer, just as the mania for mortgage securities was topping out. At their peak, the funds were valued at $16 billion, including the leverage that they used.

The announcement that the funds are now almost worthless came as a surprise to many on Wall Street. “How did you go from reporting very high returns to suddenly now saying the collateral is worth nothing?” asked Janet Tavakoli, president of Tavakoli Structured Finance, a research firm in Chicago.

The Bear Stearns funds, like so many others, bought collateralized debt obligations, investment pools consisting of hundred of loans and other financial instruments. Wall Street divides the pools up in slices based on their credit quality and sells them to investors.
That first paragraph implies that AA- and AAA-rated securities are not backed by "risky mortgages." That last paragraph implies that loan pools are tranched by the credit quality of the underlying loans, rather than by priority of payments.

And I honestly don't think Janet Tavakoli is registering surprise that the funds are now worthless. My impression is that she's registering surprise that as recently as April they were asserted to be worth something. It seems to me that's rather an important part of the story.

Ms. Tavakoli said other hedge funds would face a tougher time justifying to both investors and regulators the value they have assigned to mortgage-backed securities they hold. “Depending on how aggressive the S.E.C. wants to be, this could get ugly,” she said.
Yes, indeed it could get ugly. But you'll have to forgive me for thinking that if it does, Morgenson is going to be surprised by it, until someone finally explains to her how MBS work.

I've also seen three separate reports just this morning that put the peak value of the funds, including leverage, at $20 billion, not $16 billion, but under the circumstances such discrepancies aren't that . . . surprising. Hedge funds are, well, secretive, and the numbers are hard to nail down. Still, quoting an "all in" number doesn't exactly get to the point about the relationship between leverage and losses here.

So much for the New York Times. At least the Financial Times got a mildly amusing quote from someone (thanks, Walt!):
“They are a big investment house. They are supposed to be professional,” said one fund of funds executive. “There is nothing to do now except maybe go shoot the guy who did it.”
Yeah, sure. They're hedge fund investors. They are supposed to be high net worth folks who can afford losses. There's nothing to do now except maybe go buy FDIC-insured bank CDs (apparently capital preservation strategies are worse than shooting yourself).