3 July 2007

When hedge funds implode

By Axel Merk

The US trade deficit with the rest of the world leapfrogged in recent days. Aside from goods and services, the United States is now importing "consensus-based crisis management" from Japan.

Out of fear that a cleanup of bad loans would trigger widespread defaults, Japanese banks got themselves deeper and deeper into trouble by hushing up the problems. We are talking about the crisis at Bear Sterns' subprime hedge fund. The crisis shows that major adjustments on how the market prices risks are overdue; this may have negative implications for stocks, bonds, and commodities, as well as the US dollar.

Bear Sterns is a leading provider of services to hedge funds; it is also one of the largest originators of subprime-backed collateralized debt obligations. CDOs are what their name implies: a security backed by collateral. CDOs are created when mortgages with various risk profiles are grouped into different tranches or segments. Among others, Bear Sterns would create a CDO in a bundle according to a client's specifications. Indeed, Bear Sterns would work with a rating agency, such as Moody's, to obtain the desired rating (a practice likely to face more scrutiny as some allege that Moody's no longer acts as an independent rating agency, but as a syndicator in the offering).

The explosive demand in this sector has attracted ever more creative structures. Investors should have grown concerned when dealmakers started suggesting that one can create a higher-grade security by grouping together a couple of lower-grade securities; it is rare that 1 + 1 = 3. As these instruments have grown more complex, the clients buying these instruments often do not have a full understanding of what they buy.

How do you make a best-seller better? You introduce leverage. Not only can leverage be introduced in the credit derivatives that define some of these securities, but brokers eager to attract hedge-fund business may also accept CDOs as collateral to lend money. The hedge fund now attracting so much attention is Bear Sterns' High Grade Structured Credit Strategies Enhanced Leverage Fund, launched only 10 months ago. It shall be noted that Bear Sterns did not put much of its own money into the fund, but supplied many of the CDOs. A total of US$600 million in invested capital was boosted with borrowings of about $6 billion.

The collateral provided by the fund had the highest ratings by Moody's. However, a high rating does not ensure that the CDOs are liquid, ie, that they can be sold off on short notice. This became painfully clear as bets of the fund were creating heavy losses and some lenders asked for more collateral for the loans extended. In the industry this is called a margin call. Bear Sterns told other lenders, including Merrill Lynch, JPMorgan and Citigroup, that the fund was unable to provide more collateral. On a side note, it is rather grotesque that Merrill, JPMorgan and Citigroup are among the larger investors in a fund managed by Bear Sterns. The company put little of its own money into the fund.

In the brokerage industry, when a margin call is not met (when the borrower cannot provide sufficient collateral), the broker may seize the collateral and liquidate open positions. While a forced sale of the collateral may be painful for the borrower, it protects the system as a whole. Such forced sales happen all the time in the futures market, where positions are "marked to market" every day to evaluate the profitability and risk of open positions.

But the CDO market is not a regulated futures market; there is no daily market price that would allow one to assess the value of the collateral. The primary methods used to value CDOs are called "mark to market" and "mark to model". In the more conservative "mark to market" approach, independent parties are asked to value the securities; as the name implies, the "mark to model" approach is more aggressive and uses a computed, theoretical value.

But because these instruments are sold in privately negotiated transactions, rather than a regulated and liquid market, neither valuation method is suitable in case of a forced liquidation. In the case of Bear Sterns' fund, Merrill Lynch sent bid sheets to numerous parties, soliciting prices for their holdings; as everyone knew that Merrill wanted to get rid of the securities at any price to cut its losses, it is fair to assume that the prices offered were significantly below the value assumed for the collateral.

As Merrill went public with its plan to auction off the collateral, others tried to rescue the fund. There was talk that Citigroup would inject $500 million and Bear Sterns might inject $1 billion. And the Blackstone Group was very interested in supplying much-needed capital. Blackstone's offer required the brokers to abstain from further margin calls for 12 months. Such restrictions may be common in the private-equity world that Blackstone is active in, but was not acceptable to Merrill.

As the rescue plan fell through, Merrill stated that it would go ahead with its auction yet again. In the meantime, JPMorgan was front-running Merrill by trying to unload collateral it held for the Bear Sterns fund. When all was said and done, it wasn't clear how much which broker was able to sell, but the sales were halted once again, and the parties seem to have agreed on an "orderly unwinding" of the positions.

This had the hallmark of the biggest financial crisis since the bailout of Long Term Capital Management. In 1998, the US Federal Reserve coordinated a bailout that led to the orderly unwinding of a fund that threatened the stability of the financial system. But this time is different: the instruments involved are so complex that journalists have had difficulty relaying the issues to the public, but the multiple calling and canceling of auctions by Merrill highlight the behind-the-scenes maneuvering to avoid fallout to the rest of the industry and beyond.

The risk to the financial system was not merely that some large brokerage firms may have been forced to write down a couple of hundred million dollars - they may still have to do that. But had the fire sale gone through, market values would have been available to the securities sold. This in turn would have forced other lenders to revalue the collateral they hold, and as the collateral is worth less, the brokers will lend less money. That would have triggered further margin calls, further forced liquidations.

When hedge funds implode, they tend to sell off more liquid assets first. At the end of the sale, the prices of the liquid assets are depressed, yet the fund may still be left holding illiquid securities. To illustrate this, take the example (this is not the Bear Sterns fund) of a hedge fund that may make bets on CDOs and, say, the price of oil. As such a fund needs to raise cash, it would close out the more liquid oil positions, causing a spike (or drop - depending on which way the unwinding works) in the price of oil. The resulting volatility in the markets would be most painful for leveraged investors in the oil market, although the crisis originated in the CDO market.

Too many leveraged investors have become complacent because of the low volatility enjoyed in recent years. Aside from the short-term volatility, the high leverage employed by many hedge funds would need to be reduced permanently. As speculators pare down their leverage, they sell off assets to raise cash.

The well-intended attempts to unwind the Bear Sterns fund in an orderly fashion are highly problematic. The fund's problems have clearly shown that the credit extended to the industry is too large. The bankers involved commit similar mistakes to those of bankers in Japan in the 1980s and 1990s, where clearly bad loans were kept afloat with artificial means; those involved had the best intentions, but caused more than a decade of pain to Japanese banks, corporations and consumers.

It may well be that the value obtained in a fire sale is less than that obtained in an orderly liquidation. But the lesson to take home from this is that CDOs must not be used as collateral for 10:1 leverage. In our assessment, the unreasonable leverages employed by many hedge funds have contributed to a global liquidity glut that has driven up all asset classes, from stocks to bonds to commodities and other hard assets. As lenders have ignored risk, volatility reached abnormally low levels in 2006. Markets need risk to price assets properly; it is urgently necessary that volatility come back into the markets, so that lenders make more reasonable decisions.

The Bear Sterns debacle highlights that the industry has gone too far, and that it is high time that credit be reined in. So far, the first good that has come out of all this is that the planned initial public offering (IPO) of Everquest Financial seems to have been aborted: Bear Sterns was the underwriter in Everquest, a firm that specializes in buying CDOs from hedge funds.

Another hope is that traditionally more conservative investors, such as pension funds, will reduce their exposure to overly leveraged hedge funds. If such investors are told that they should not "rock the boat" with a rushed decision, they may be well served to take their losses now rather than potentially even greater losses later.

Federal Reserve chairman Ben Bernanke is particularly proud that regulators have extensive experience on how to manage crises. The danger of superior crisis management is that you take the "danger" out of investing. Without risk, speculators have no restraint; in recent years, we have called this the "Greenspan put", named after the reputation of former Fed chairman Alan Greenspan to allow bubbles to be created, and then bail out those who suffer from the bursting of the bubble. The Fed is shooting itself in the foot with such an attitude, as the Fed loses control of the money supply in a world where risk is underpriced.

When European Central Bank president Jean-Claude Trichet was recently asked whether the latest interest-rate hike in the euro-zone meant credit was now tight, he mused that higher interest rates mean little when sources of credit are abundant. His comments came before the recent selloff in bond prices. But as bond prices sold off in recent weeks, lower grade bonds fell not significantly more than government bonds. A healthy market requires a greater risk premium for junk bonds. The collapse of an overly speculative fund must be allowed, so that investors have an incentive to demand higher yields for riskier investments.

In summary, we expect volatility to pick up in all markets. As volatility picks up, speculators may sell assets to raise cash. Given the gains experienced in just about every asset class, there may be few places to hide. As bond prices may be under further pressure, the cost of borrowing goes up; this in turn may have implications for American consumers whose spending habits are interest-rate-sensitive because of their high levels of debt. This is where the circle to the trade deficit is closing.

The US dollar is dependent on inflows from abroad, as Americans import more than they export. If higher borrowing costs cause consumers to spend less, foreigners may redeploy more of their investments to other, more robust areas in the world. While Treasuries tend to be the first safe haven in times of increased volatility, the dollar no longer is the safe haven it used to be. In our view, a diversified approach to something as mundane as cash is something investors may want to evaluate. Gold is one such diversification; a basket of hard currencies is another.

Axel Merk is the portfolio manager of the Merk Hard Currency Fund.

No comments: