Levered Bear Funds: A Peek into the Black Box |
Date: Wednesday, June 27, 2007
Author: Chidem Kurdas, HedgeWorld
NEW YORK (HedgeWorld.com)—It seems that Bear
Stearns will salvage some portion of its failing structured credit
portfolio by de-levering slowly after buying the debt back from
creditors.
So far the bank has bought the debt of only the less geared-up version
of the strategy—the High-Grade Structured Credit Strategies fund. There
may or may not be a deal for the more leveraged fund, the High-Grade
Structured Credit Strategies Enhanced Leverage Fund. But even the less
leveraged fund's investments were large compared to its equity capital.
How large? There isn't enough information to gauge a long-term
leverage, but a snapshot rough estimate is possible.
The two funds went long and short on collateralized debt obligations,
including notes on pools of subprime mortgage bonds. Overall they were
heavily bullish. One way to measure the leverage is to compare the net
long investments to capital.
By this yardstick, the less debt-dependent pool, High-Grade
Structured Credit Strategies, had net long investments equal to six
times its equity in March, according to a calculation by HedgeWorld.
The corresponding rate for the more heavily geared-up High-Grade
Structured Credit Strategies Enhanced Leverage Fund was 11 times
equity.
Taking the two Bear funds together, total equity capital added up to
$1.6 billion. To get another perspective, total exposure to the
structured credit market on both the long and short sides by the two
funds was nearly $30 billion in March. That indicates the effect of all
sources of levering. Total net long positions for the two funds
amounted to $12.7 billion.
A leverage ratio of six or even 11 is not unusual in this era of easy
credit. It is certainly possible to find funds levered 20 times.
Leverage moderated after the Long-Term Capital Management crisis in
1998, but by some estimates it has gone up again Previous HedgeWorld Story.
Nouriel Roubini, a professor at New York University's Stern School of
Business, has been warning against excessive borrowing. Mr. Roubini's
favored example to illustrate the danger is a fund of funds that levers
up three or four times to invest in hedge funds that are themselves
levered up three or four times.
The hedge funds invest, say, in highly levered collateralized debt
obligations. Through all these layers of credit, $1 of equity buys $100
of assets.
Then, as Mr. Roubini pointed out, a 1% fall in the market value of the
final asset—the CDO notes—wipes out all the equity. His point is that
counterparties see their individual exposures but not the systemic
risk; in other words they see the trees, but not the forest. He favors
greater regulatory oversight and some type of disclosure of fund
positions to all relevant counterparties.
The market for subprime bond-based CDOs became illiquid as mortgage
defaults rose last year. The difference between buyers' bids and
sellers' offers widened and trades were sparse. Mispricing is very easy
under such circumstances, whether intentionally or not Previous HedgeWorld Story.
"People forget that even when there's careful mark-to-market pricing,
portfolio valuation does not necessarily reflect the actual price
you'll get at execution," said Leslie Rahl, president of Capital Market
Risk Advisors in New York. "There can be a huge difference between
honest mark-to-market price and execution price."
The wide spread in price can obscure losses. Bear Stearns was
relatively early to acknowledge the adverse market conditions and their
impact on the value of the CDO assets, notwithstanding reports that
regulators are examining a restatement of the enhanced leverage fund's
returns Previous Reuters Story .
Other holders of CDO notes have yet to disclose what their portfolios
are worth in the current market. When they do, a segment of the hedge
fund sector will crater because of leverage, wrote Christopher Whalen
in the Institutional Risk Analyst. He anticipates that with the value of CDO collateral falling, creditors will force other hedge funds to liquidate.
To ward off creditors, you have to be a big bank like Bear Stearns,
capable of putting up $3.2 billion in a matter of days. Bear Chief
Executive James Cayne said in a statement that the secured financing
will reduce uncertainty in the marketplace and allow for an orderly
process to de-leverage the High Grade Structured Credit Strategies
Fund.
If that fund did not have a bank behind it, no doubt the creditors
would have held an all-out fire sale rather than limited auctions, and
the prices of the notes would have plunged further. As a result not
only this particular fund but other portfolios would have sustained
heavier losses. Mr. Roubini described as a "black box" the wide-reaching
systemic effects of hedge funds' search for higher yields aided by
extremely easy credit and massive use of structured finance
instruments. What we got with the Bear Stearns experience is a brief
glimpse into that black box.
Next time we may see more of it. Not all hedge funds are
attached to deep pockets; Mr. Cayne won't always be there with $3.2
billion.
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