Subprime risks come home to roost for hedge funds |
Date: Sunday, July 8, 2007
Author: Al Yoon, Reuters
Some managers have resisted accepting market views on their assets, claiming
declines represent short-term market volatility and not underlying financial
value in their subprime bonds, analysts said. Since the bonds trade
infrequently, managers' have turned to pricing models that may ignore market
sentiment, buoying prices.
But with delinquencies rising on mortgages granted to less creditworthy home
buyers, and the
Declines in indices tracking the values of subprime mortgage backed bonds in
June mean managers valuing portfolios on a monthly basis have to reveal losses,
analysts said.
"The interesting thing is the varying stages of denial that the street
finds itself in," said a university endowment manager who asked that he
not be named. Some, he said, are "very willing to mark prices down and
take the lumps."
Braddock Financial Corp. on Thursday said it will liquidate the Galena
Street Fund after news and losses led investors to draw down the fund by a
quarter. Losses at the $300 million Galena Street Fund, a leader in its hedge
fund category in recent years, came as its managers marked their holdings down
to market levels, using models provided by its Wall Street dealers.
United Capital Markets' halted redemptions on its Horizon Funds group after
investors also demanded their money back.
Earlier in June hedge funds run by Wall Street investment bank Bear Stearns
Cos. reported losses on leveraged investments in subprime bonds.
Turmoil within Bear's funds were highlighted when creditors, including
Merrill Lynch & Co., tried to sell billions in collateralized debt
obligations supported by the mortgages. Many sales were pulled at the eleventh
hour and managers with access to lists of CDOs for sale suggested prices bid
did not meet modeled levels.
Pricing on CDOs is arguably difficult for money managers because the risk in
the vehicles is diversified across slices of asset-backed bonds, which
themselves are backed by thousands of loans.
But based on the falls in subprime mortgage indexes, price declines this
year may have wiped out some $20 billion in value on the $135 billion in CDOs
created using the riskier portions of subprime mortgage bonds since 2003.
ABX-HE indexes, rated "A" to "BBB-", have declined as
much as 35 points this year as hedge funds increased bearish bets to offset
their positions. A fair assessment of losses for these classes in sum is
probably closer to 15 points, however, given smaller drops in "A"
debt and the poor quality of bonds in the ABX relative to the broader market,
said Jeffrey Gundlach, a CDO manager and chief investment officer at Los
Angeles-based TCW Group, which manages $160 billion.
He warned against painting the industry with a broad brush since some
managers are heavily weighted toward the higher, "A," rated portions
of deals, and others toward "BBB-" parts.
Braddock's Mortgage Opportunity Fund VI, for instance, is up about 5 percent
this year, outpacing the 2.3 percent return on Merrill Lynch's Asset-Backed
Master Index.
"There is great diversity in the world of subprime to begin with, and
then great diversity of CDOs," Gundlach said. But "the market is
clearly pricing in some probability of some price loss of some "A"
rated classes."
Braddock Chief Executive Officer Harvey Allon, who started Nomura
Securities' mortgage trading unit in 1987, said pricing assumptions used by
dealers he uses may be nearing a bottom.
Marking securities down in the first quarter created losses of about 3
percent for the Galena Street Fund, compared with gains of 7 percent in 2006
and 14.0 percent in 2005, he said.
"A lot of the pricing assumptions now are worst-case scenarios,"
Allon said. "Times like this create opportunity."
Meantime, painful markdowns at other hedge funds may soon become apparent,
especially those that leverage their holdings with borrowings. The ABX indexes
fell steadily to new lows in June, after holding a narrow range from March to
May.
The ritual at hedge funds of placing a new value on securities held at month
end, rather than daily, appears to worsen the blow to investors if prices have
fallen over the period, said Jason Brady, a fund manager at Thornburg
Investment Management in
"When investors redeem, the leverage unwind is awful," he said.
"They redeem when they see their statement. That happens over the next
week or so."
Reproduction in whole or in part without permission is prohibited.
