Thursday, June 21, 2007

Mark to market

The almost collapse of two Bear Stearns hedge funds investing in mortgage-backed securities is sending a tremor through Wall St. A last minute bailout by creditor Merrill means that $800 million in CDOs is about to be marked to market. In other words, some complex, illiquid securities are about to have a meaningful price, as opposed to the theoretical value on the books. Insert words about Long Term Capital Management and "systemic risks" here.

``Nobody wants to look at the truth right now because the truth is pretty ugly,'' Castillo said. ``Where people are willing to bid and where people have them marked are two different places.''

I've written several posts about CDOs here. This and this are getting a lot of traffic right now. Word is that Gaussian copula models are **way** off from real market prices :-)

June 21 (Bloomberg) -- Merrill Lynch & Co.'s threat to sell $800 million of mortgage securities seized from Bear Stearns Cos. hedge funds is sending shudders across Wall Street.

A sale would give banks, brokerages and investors the one thing they want to avoid: a real price on the bonds in the fund that could serve as a benchmark. The securities are known as collateralized debt obligations, which exceed $1 trillion and comprise the fastest-growing part of the bond market.

Because there is little trading in the securities, prices may not reflect the highest rate of mortgage delinquencies in 13 years. An auction that confirms concerns that CDOs are overvalued may spark a chain reaction of writedowns that causes billions of dollars in losses for everyone from hedge funds to pension funds to foreign banks. Bear Stearns, the second-biggest mortgage bond underwriter, also is the biggest broker to hedge funds.

``More than a Bear Stearns issue, it's an industry issue,'' said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York. Hintz was chief financial officer of Lehman Brothers Holdings Inc., the largest mortgage underwriter, for three years before becoming an analyst in 2001. ``How many other hedge funds are holding similar, illiquid, esoteric securities? What are their true prices? What will happen if more blow up?''

Shares Fall

Shares of Bear Stearns, the fifth-biggest U.S. securities firm by market value, and Merrill, the third-largest, led a decline in financial company stocks yesterday, and the perceived risk of owning their bonds jumped on concerns losses related to subprime home loans may be bigger than initially thought. Both companies are based in New York.

The perceived risk of owning corporate bonds jumped to the highest in nine months today. Contracts based on $10 million of debt in the CDX North America Crossover Index rose as much as $10,000 in early trading today to $178,500, according to Deutsche Bank AG. They retraced to $171,500 at 8:28 a.m. in New York.

U.S. Securities and Exchange Commission Chairman Christopher Cox said yesterday that the agency's division of market regulation is tracking the turmoil at the Bear Stearns fund. ``Our concerns are with any potential systemic fallout,'' Cox said in an interview.

Bankers and money managers bundle securities into a CDO, dividing it into pieces with credit ratings as high as AAA. The riskiest parts have no rating because they are first in line for any losses. Investors in this so-called equity portion expect to generate returns of more than 10 percent.

Fivefold Increase

CDOs were created in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc., the home of one-time junk-bond king Michael Milken. Sales reached $503 billion in 2006, a fivefold increase in three years. More than half of those issued last year contained mortgages made to people with poor credit, little loan history, or high debt, according to Moody's Investors Service.

New York-based Cohen & Co. was the biggest issuer of CDOs last year. It has formed 36 CDOs since 2001, including 15 worth a total of $14 billion in 2006, according to newsletter Asset-Backed Alert.

Not since 1994 have mortgages with past due payments been so high, according to first-quarter data compiled by the Federal Deposit Insurance Corp., the agency that insures deposits at
8,650 U.S. banks. Lehman analysts estimated in April that the collateral backing CDOs had fallen by $25 billion.

``The big question is whether these forced liquidations represent a tipping point in the market,'' said Carl Bell, who helps manage $63 billion in fixed-income assets as head of the
structured-credit team at Boston-based Putnam Investments. It ``may put pressure on other hedge funds pursuing similar strategies'' as the Bear Stearns funds, he said.

Biggest Names

The Bear Stearns funds are run by senior managing director Ralph Cioffi. One of the funds, the 10-month old High-Grade Structured Credit Strategies Enhanced Leverage Fund, lost 20 percent this year, the New York Post reported. Officials at Bear Stearns and Merrill declined to disclose the losses.

The funds had borrowed at least $6 billion from the biggest names on Wall Street. Aside from Merrill, other creditors included Goldman Sachs Group Inc., Citigroup Inc., JPMorgan Chase
& Co. and Bank of America Corp. All of the firms are based in New York, except Bank of America, which is based in Charlotte, North Carolina.

As the funds faltered, Merrill sought to protect itself by seizing the assets that were used as collateral for its loans. JPMorgan planned to sell assets linked to its credit lines before
reaching agreement with Bear Stearns to unwind the loan, people with knowledge of the negotiations said yesterday.

Bear Stearns was still in talks late yesterday with creditors to the funds to rescue the funds, said the people, who declined to be identified because the negotiations are private.

Russell Sherman, a Bear Stearns spokesman, and Jessica Oppenheim, a spokeswoman for Merrill, declined to comment.

`Pretty Ugly'

Merrill's decision yesterday to accept bids on $800 million of bonds it took as collateral for its loans further stifled trading in CDO securities, said David Castillo, who trades asset-backed, commercial-mortgage and CDO bonds in San Francisco at Further Lane Securities.

``Nobody wants to look at the truth right now because the truth is pretty ugly,'' Castillo said. ``Where people are willing to bid and where people have them marked are two different places.''

The perceived risk of holding Bear Stearns bonds jumped to a three-month high, according to traders betting on the creditworthiness of companies in the credit-default swaps market.

Contracts based on $10 million of its bonds rose $5,800 to $45,500, according to composite prices from London-based CMA Datavision. An increase in the five-year contracts suggests
deterioration in the perception of credit quality. Contracts on Merrill jumped $4,700 to $33,000, CMA prices show.

Long-Term Capital

Shares of Bear Stearns fell for a fourth day, declining 19 cents to $143.01 at 9:32 a.m. in New York Stock Exchange composite trading. The stock was down 12 percent this year before
today, compared with the 0.4 percent advance of the Standard & Poor's 500 Financials Index. Merrill dropped 20 cents to $87.48 and Citigroup fell 13 cents to $53.31.

The reaction to the Bear Stearns situation is reminiscent of Long-Term Capital Management LP, which lost $4.6 billion in 1998.

Lenders including Merrill and Bear Stearns met and agreed to take a stake in the Greenwich, Connecticut-based fund and slowly sold the assets to limit the impact of its collapse.

``We're not surprised to find the principal circle of players is pretty interconnected,'' said Roy Smith, professor of finance at New York University Stern School of Business and
former head of Goldman's London office. ``What we're looking for is whether the interconnection creates a negative domino effect: Whether Hedge Fund A creates a problem for other hedge funds,
which in turn creates a problem for the prime brokers that are lending to them.''


Anonymous said...

10 month old hudge fund? That was quick. Betting on the subprime market? Doh, obviously betting the wrong direction!

Here is a claim that a conflict of interest with credit rating agencies is what has been keeping the CDOs from taking massive losses:

Anonymous said...

To be fare to credit quants -- it was almost immediately known that Gaussian copula is just an approximation, financial engineering went past it...

Anonymous said...

Every time one reads a story about a hedge fund blowing up (or at least taking big losses), it seems that it's always presented as a case of "bad bets".

But I wonder how often it is bad bets that were intentionally made ("I think that the subprime risks are overhyped, so I'm going to take a contrary position"), and how often it is a case of bad risk modeling ("I think that my subprime risks are well-hedged by my positions in X. Oops, I guess that X wasn't a good hedge after all")?

JJ2000426 said...

Unrelated. But I am sure you will be interested, Steve, or any one reading here.

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Do your own DD, Steve.

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