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Subprime risks come home to roost for hedge funds

Date: Sunday, July 8, 2007
Author: Al Yoon, Reuters

NEW YORK (Reuters) - Bad bets revealed by some hedge funds in recent weeks may mean other funds will be forced to accept the market's deteriorating views on subprime mortgages and report their own losses soon.

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 U.S. housing market slump seen extending into 2008, dealers are increasingly accepting the reality of market values.

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 Santa Fe, New Mexico.

"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."