So... you got your reward and you're just leaving then?

In a move that surprises most Australian aboriginals and some (but not all) long-term coma victims, a high-profile hedge fund focused in the sub-prime mortgage area is liquidating. Bear Stearns put about $3.8 billion in bonds out for the bid today, a little bigger than your average BWIC. According to various people I've talked to, the bonds are predominantly AAA floaters, so despite the sub-prime stigma, these are pretty clean bonds which should garner demand from various types of investors.

I understand that Bear has riskier assets in the fund, called the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund. When these are to be sold, I don't know. Some of the CDO equity the fund was holding has already been liquidated.

This is classic Wall Street. Hang around while the product is hot, create as much in fees as you can, invent new structures or create your own investing vehicles if you have to, and cash your chips in at the first sign of trouble. You can decry it all you want, and I'm sure people like Tanta will, but I'm pretty sure that's how Wall Street has been operating since the days when there was actually a wall to keep the injuns out.

Anyway, let's talk about something more interesting.

Any time a hedge fund is liquidating, people start to think about Long Term Capital Management, and how much of a mess that created for the market. The Bear fund, which has about $500 million in capital, just isn't large enough to cause an LTCM type disaster on its own. But I think there are some real parallels to LTCM and what's going on in sub-prime today.

Long Term's primary bet was that markets would always be fairly efficient. I remember reading a quote from one of their partners, I think it was Merton, who described their strategy as picking up nickels the market was leaving behind. Their models consistently lead them to believe that owning a wide variety of high-risk assets would result in a low risk portfolio, which could then be levered 100-1.

In the fall of 1998, due in part to the Russian debt crisis, the market's risk appetite diminished markedly. This resulted in risk assets in all corners of the world to fall in value, from Taiwan to Brazil. Suddenly, assets which would have seemed to have no fundamental correlation were displaying a very high correlation. LTCM was suffering losses on everything at once, and their leverage was so high that the whole thing fell apart rapidly.

There are many parallels in various sub-prime strategies, be it CDO's, hedge funds, or REITs. First, the leverage is usually very high, because the spreads on most sub-prime securities just aren't that great. The majority of sub-prime backed bonds in the market today are investment-grade. In order to make the sexy returns the hedge fund crowd is looking for, you've got to leverage this stuff. Second, the correlation in sub-prime performance is converging toward 1. Whereas we might have once thought that the performance of a random loan in Ohio versus one in California had a low correlation, the pervasiveness of weak underwriting standards has changed that. In addition, the pervasiveness of adjustable-rate mortgages and the extreme upward move in interest rates is also creating a large degree of stress on a high percentage of loans, regardless of geographics or other factors.

As readers of this blog no doubt know, the unwinding of LTCM was extremely painful for the market. The types of bonds they owned were already trading weak, and their positions were leaking into the street. So the street was just killing their positions. When it came time to actually liquidate, the bids were scarce. The contagion was significant, if short-lived.

So are there any sub-prime funds large enough to cause a LTCM-type result? Maybe not. But its really not that hard to imagine a major contagion scenario:

1) A large number of investors in higher quality CDO tranches (A and AA) are burned by sub-prime defaults.

2) This causes a re-pricing of CDO spreads, and causes a drastic slow-down in deal flow.

3) In turn, this eliminates the "CDO Put" in the credit market. This is where any widening of credit spreads made forming new CDO's that much more attractive, thus creating a back-stop for spreads generally. If the CDO market disappears, even temporarily, this "put" is gone.

In that scenario, we finally see the widening of credit spreads everyone's been waiting for. And given that real money has been so reluctant to over-weight high-yield, the widening could be quite dramatic.

For the moment, I don't see this actually happening without the sub-prime default rate rising even higher than most expect. It takes a lot for A or AA-investors to start taking losses. And as long as the A and AA investors are mostly untouched, then a high level of defaults really just validates CDO technology rather than cause the market to question it. Watch the delinquency reports, though.