Wednesday, July 18, 2007

Revenge of the Street

In what feels like old news, Bear Stearns told investors that their troubled High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leverage Fund have "very little" and "effectively no" value remaining respectively. It had been whispered for a couple weeks that the funds were going to be worth between 0-10 cents on the dollar, so there is little surprise here.

A couple weeks ago I was trying to do the math of how Bear's funds could have lost so much money. Obviously not knowing the actual bonds held and the real leverage, I had to make some educated guesses. But there were enough people who I knew that had some knowledge of the situation that coupled with media reports, I thought I could get pretty close. I estimated that the Enhanced Leverage Fund was about 18x levered, and the Structured Credit Fund was about 10x.

The market for structured finance AAA-rated CDO's is about 10bps wider for senior stuff and about 100bps wider for junior stuff. While there were media reports that Bear was getting 30 cents on the dollar for the items, that just didn't fit with what was going on in the market generally. Remember that ABS CDO's usually have a spread duration in the 3-4 range, if not lower. So even if you assume their entire portfolio was 100bps wider, they should have only lost something like 60-70% of value, not 100%.

But there are two factors which exacerbated losses in these funds. First, apparently the funds increased their long protection position in the ABX BBB- index in early March. While recently the ABX has been hitting new lows, in March and April it rallied substantially.

This is a classic case of a highly technical move overwhelming what would have been a good fundamental play. Had Bear been given enough time for the technicals of the ABX to wash out, the hedge would have worked fine and the funds would probably still be in business, or at least would have been able to close before being wiped out. But as it happened, the hedge added to losses instead of protecting against them.

Then there is the matter of the Long Term Capital Management bailout. For those who don't know the story, here is the quick version. In the fall of 1998, things were so bad at LTCM that it really did threaten the stability of the entire financial system. Alan Greenspan got together all the heads of the big Wall Street firms, most of whom were LTCM's creditors, and basically locked them in a room until they agreed to buy all of LTCM's positions. This prevented LTCM from continuing its fire sale that was wreaking havoc on the Street. You can imagine how difficult that was: here was the most powerful men in all of finance being forced to take on positions that anyone would have agreed were dangerous, all in the name of some greater good. Wall Street isn't used to working for a greater good.

One firm refused to participate: Bear Stearns.

Not only did Bear skip out on what was likely the most painful, difficult, humiliating and frightening decision many of the men involved ever made, they in essence got a free ride on the result. Shortly after the bailout, the financial markets calmed down and within 6 months or so, most markets were back to where they were before the crisis. Bear benefited from that calm, but didn't take on the risk to make it happen. It was like all of Wall Street saw the river was going to over flow and struggled to pile up the sand bags. But one of their neighbors just sat inside his nice dry house sipping coffee while everyone else did the work. He knew that because everyone else was out there, his house would be spared anyway. Why do the work?

So I've heard from multiple sources that when Bear Stearns was going through their own private Long Term, the rest of Wall Street decided it was time for revenge. Normally when there are large bid lists of any kind, Street firms can do one of two things. They can either try to find customers who want to buy the bonds directly, or the brokerage can buy the bonds themselves first and then find customers to buy. Generally it depends on whether the firm wants to take the risk of owning the bonds, which normally results in bigger profits but with it the potential of loss. By soliciting customer bids initially, they just sell the bonds to the customer immediately. No risk, but generally a smaller markup for the dealer.

So you'd think with all the problems with the subprime market, dealers would be loathe to make lots of bids on subprime CDOs without having customers in hand. But supposedly when BSAM's bid list came out, big players like PIMCO or Western Asset were not shown the list. The Street bid everything directly. Lo and behold! The bids come in at ridiculously weak levels. Levels that eventually forced Bear Stearns to bail out its own fund, much in the way the rest of the Street bailed out LTCM in 1998.

Oh the irony.

(Note, Reader Robert points out that Lehman did not participate in the LTCM bailout either)


Robert said...

Excellent Post. There are many people who have forgotten about this aspect of the LTCM saga.

This is also the reason that I personally am not buying the "contagion" argument as being the ultimate reason why the markets "should" tank.

A lot of commentators are playing up these issues at Bear, but I just don't see the other houses sitting idly by if they felt that this was going to be a serious problem for the markets in general.

They must believe that their book will be fine regardless of what happens to Bear. We'll see, but I would tend to think that if they are not worried about it, I am not going to be worried about it.

FWIW, didn't Lehman also decline to participate? And it is my understanding that they may be more exposed to some of the same issues currently affecting Bear than most of the other houses. Will they be the next to be hung out to dry? We shall see.

Accrued Interest said...

You are right about Lehman. I looked it up on Wikipedia. Has to be right if its on Wikipedia right?

I remain in the "bad but not that bad" camp. I don't buy the contagion story. This stuff about banks struggling with LBO debt is interesting though. I'm going to write more about that today. Did everyone see Jamie Dimon's comments from today? I think he read my post from Friday.

Anonymous said...

Excellent post again,

could you please make an educated guess on how much money did BSC put in to rescue those funds ?

there are few varying ideas about the 1.4 bn $ that they have promised to put in ?

will BSC go broke acc to you ?

Accrued Interest said...

Well the BB story says $1.6 billion, but I heard it was far less, maybe like $800mm of BSC's own money.

That money was entirely to get the creditors off their back. Obviously it didn't help actual investors one bit.

Robert said...

I have heard the drawdown was actually as low as $200 Mil, but I would tend to agree with tddg that it is probably closer to $800Mil.

Even if it was $1.6Billion, $1.6Billion sure isn't what it used to be. Regardless, I think that they quickly recover or become a target. We shall see.

Robert said...

...And we have Lehman subprime rumors today...

Anonymous said...

Lehman have now denied it.

What are the chances that other funds are close to liquidation...from your market experience and sources

Dr. Dan

Accrued Interest said...

Dr. Dan:

I'd really be surprised if other funds didn't wind up closing. I haven't heard much about mortgage REITs lately, but I'd think there will be some bankruptcies there as well.

However, I'll bet that BSAM winds up being the poster child for overly aggressive hedge funds during this period. I'll bet that other funds manage to unwind before the value is zero. I think BSAM ran into a confluence of factors, which I describe in the post, that other funds wouldn't face.

I also suspect some people involved in fund of funds or even just generalized hedge funds may find out they had more money in subprime than they realized. Hedge funds are major buyers of CDO equity and lower-rated tranches. Maybe they don't lose 100% of value, but they take a 10-15% hit in a short period? Investors won't like that, especially if they were sold on a "low vol" strategy. When your average HNW individual sees a pie chart of what their hedge fund is invested in, and sees 25% in "Structured Finance" do they know what that means? I doubt it.