How a fat tail comes home to roost

Date: Monday, July 30, 2007
Author: Jonathan Davis, Financial Times

Will the problems at the two Bear Stearns hedge funds roll over into a wider crisis for debt markets and in turn for the price of all financial assets?

The choppy reaction since the news of the Bear Stearns losses first came out suggests that investors have yet to make up their collective minds whether this is the real deal, the prelude to a full-blown credit crunch, or merely another squall on the way back to relative normalcy.

The weight of evidence points to it being the latter and that a full credit crunch is some way off. But who is brave enough to bet on that outcome, given the deteriorating backcloth of rising bond yields and increased loan defaults, not just in sub-prime mortgages but in other parts of the lending jungle as well?

This is the market argument that needs to be settled over the remainder of the year. As always, it will be what investors actually do, rather than what they think, let alone what the talking heads say, that will determine the outcome.

The spectacle of two large hedge funds going under with the apparent loss of virtually all the investors' equity is clearly no laughing matter for those involved.

Jimmy Cayne, head of Bear Stearns, has called the episode "a body blow of massive proportions". Barclays, which is nursing a reported loss of $400m, is presumably not that amused either.

However, pratfalls such as these, when portentously named funds with wise guys at the helm self-destruct, are a legitimate source of amusement for those not directly involved.

Ian Rushbrook, who runs a small investment trust in a basement office near Edinburgh's Charlotte Square, noted drily at his AGM last week the comical euphemism with which Bear Stearns chose to describe the almost total wipe-out of the two hedge funds. It is, reads the letter to investors, "a difficult development for investors in these funds".

Counting up to 0 - which is the estimated residual value of one of the two funds' portfolios - is the easy part of the exercise. It is much harder to compute the potential knock-on effect, not just of these funds' losses, but those of others with exposure to this kind of toxic debt.

The sharp market reaction to the warning last week by Countrywide, a big US mortgage lender, suggests that investors are understandably jittery.

Mr Rushbrook, who first zeroed in on the dangers of credit degradation in the US mortgage market more than 18 months ago, has some back of the envelope calculations about the multiplier effect of losses in the sub-prime mortgage market.

The $100bn of losses that funds and banks are currently nursing on CDOs could lead, he estimates, to a credit contraction of more than 10 times that amount.

So, while sub-prime on its own is just a small part of the overall market for mortgages in the US, the multiplier effect makes it potentially far more significant. The value of outstanding mortgages in the US has doubled in the past seven years to $10,000bn, where it now dwarfs even the government bond market. Contagion could be both expensive and painful.

The story of the Bear Stearns funds is a perfect example of the hidden risks of hedge funds. These risks are inherent in their structures, but rarely become known to investors until it is too late.

The older of the two Bear Stearns funds had 50 consecutive months of positive returns before it suddenly imploded - a perfect example of how a fat tail distribution can quickly come home to roost in an over-leveraged vehicle.

Note too, how Bear Stearns was able to reassure its own shareholders that the failure would have little immediate impact on its own earnings.

In fact the shares of Bear Stearns have fallen less in the past few weeks than those of many investment banks. While the firm has offered the two funds collateral to help achieve an orderly liquidation, its own losses will probably be smaller than the chunky management fees it has extracted from investors over the past four years for the privilege of skating on thin ice.

The Bear Sterns funds are an interesting example, concludes Mr Rushbrook, of "how it is possible to outperform any market by over 10 per cent per annum, provided investors are prepared to accept a 10 per cent probability of being wiped out (not that anyone ever told them that was the risk they were running)".

Unless you assume that Bear Stearns was willing the failure of its funds, which seems impossible, the question remains: Did it not know the underlying risks it was running, or did it know and turn a blind eye? Neither answer offers much comfort.

jd@independent-investor.com