CDO Hedge Funds = Enron ?

Thursday, June 28, 2007 | 06:48 AM

Last night's discussion of the Bear Stearn's Hedge Fund melt down was remarkably sanguine.

I guess to those who look at the blow up of a small hedge fund -- it was only $684 million in equity, albeit leveraged up 10-to-1 to $6.8 billion. Hey, sometimes, losses happen.

And Wall Street has been terrific about managing risk, haven't they? I mean, they did a great job with the dot coms, and they are doing a terrific job with housing, right? There may be 49 Trillion dollars worth of derivatives -- thats trillion with a "T" -- so what if 1 or 2% goes belly up?  It's well contained.

Um, not exactly.

There are several issues here that deserve closer scrutiny. Here's how I connect the dots:

1. Side Pockets: A way to move toxic holdings "Off Balance Sheet," to a netherland, hidden from investors and perhaps regulators. This lack of transparency does not exactly comply with truth-in-reporting to your investors or FASB accounting standards.

Sound familiar? It should: Its remarkably similar to Enron Off Balance Sheet Special Partnerships. The WSJ's Scott Patterson went into the details last week:

Even if Bear's pain spreads through the market, other hedge-fund investors might not feel it, at least right away. Sometimes, hedge funds move big pieces of their holdings into separate accounts known as side pockets to keep declining assets from hurting a main fund's performance record -- and managers' wallets. They can also block investors from cashing out.

2. Mark-to-Model: The similarities to Kenny boy's outfit don't end there:   What do we do with illiquid holdings where the fund is both the buyer and seller, and the parent company is the buyer of last resort? Unlike most mutual and hedge fund, who mark-to-market based upon the closing price pof their assets, holders of these CDOs get to indulge their "creative" side. Instead of writing the great American novel, they derive a model that optimistically prices these illiquid assets.

Why optimistic? Because the theoretical returns to investors and actual fees to management are based on the pricing of these (non-priced) assets!  Keep those Enron parallels coming!

Indeed, the reason Bear was originally willing to pony up $3.2 billion dollars was what would happen if there was an actual public auction price: The entire complex would have to reprice all oft heir holdings. Buy bye investor returns, buy bye fees!

3. Crimping Copious Consumer Lending: What does all this esoteric derivatives and murky hedge fund operations have to do with me, Al Franken the ordinary investor?

First off are lending standards: They have tightened -- in some instances, dramatically. That means any debt fueled consumer purchases -- most especially, homes -- have a reduced pool of buyers. That will pressure prices further, reduce MEW, leading to decreasing consumer spending. The spigot that has been open wide for so long is now reducing its flow.

4. Crimping Copious Corporate Liquidity: Mr. Market has enjoyed a delightful wind at his back, funded  by corporate buybacks, Leveraged buyouts, M&A activity. The issue rates front page coverage in this morning's WSJ: Market's Jitters Stir Some Fears For Buyout Boom.

Remember, this is all courtesy of lots of Fed induced liquidity, and a willingness of lenders to provide lots of cash to high risk borrowers at low rates with easy terms. In Tuesday's FT, Lombard Street Research's chief economist, Charles Dumas noted what could happen as this dries up:

“With this mortgage-backed crisis we could simultaneously see market-price liquidity implode just as banks are forced to shrink their books by capital losses.”

“Banks’ capital is about to be slashed, and with it excess liquidity in the global system...Suppose the CDOs held by banks were valued at “market” rather than “model” levels (a fancy new euphemism for  illusionary historic book values). Their capital would turn out to be lower. Preservation of capital  ratios against loans would require fewer loans: liquidity would have imploded...  better to let the Bear flounder than reveal just what a low value the Street puts on even the A-rated paper.  A bunch of hedge funds may have problems, but that is the tip of the iceberg for “Titanic” Wall Street."

Mr.Duma may be overstating the case somewhat -- he's more Bearish than I -- but he raises very significant issues that have very real risks -- the same risks most of the bullish crowd seems to be overlooking.


How might this play out? Well, Mortgages at banks with past due payments are at the highest level since 1994, according to first-quarter data compiled by the Federal Deposit Insurance Corp. Mortgage defaults are accelerating, not getting better.

Oh, and a whole slew of Sub-prime ARM Mortgage Resets are scheduled to hit in the 2nd half of 2007.

To say the least, this is going to get increasingly interesting . . .

UPDATE: June 28, 2007 2:12pm

Caliber Global, which controlled almost $1 bln in assets, to shut down

Caliber Global Investment Ltd., a London-listed fund that controlled almost $1 billion of mortgage assets, said on Thursday that it's shutting down after turmoil in the subprime market cut demand for its shares.

Caliber (UK:CLBR: news, chart, profile) , run by Cambridge Place Investment Management, plans to sell all of its assets over the next 12 months and return as much money as possible to shareholders, the fund said in a statement. The plan needs to be approved by investors at an extraordinary meeting in August, Caliber added.

Caliber is the latest casualty of rising delinquencies in the subprime mortgage market, which caters to poorer borrowers with blemished credit records. Bear Stearns Cos. is trying to salvage two of its hedge funds that focus on the space, while another run by UBS AG shut down earlier this year.


Recent Woes Cast Light on Hedge Funds' Murkiness
Scott Patterson
WSJ, June 21, 2007; Page C1
Is Cheap Debt Drying Up?
Breaking Views
WSJ, June 27, 2007; Page C14

Market's Jitters Stir Some Fears For Buyout Boom
Takeover-Related Debt Gets Chilly Reception;  Hearing 'Wake-Up Call'
WSJ, June 28, 2007; Page A1

Market insight: Liquidity under threat
Charles Dumas
Finacial Times, June 26 2007 17:47 | Last updated: June 26 2007 17:47

Thursday, June 28, 2007 | 06:48 AM | Permalink | Comments (29) | TrackBack (1) add to | digg digg this! | technorati add to technorati | email email this post



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Tracked on Jul 1, 2007 10:57:57 PM


Re mortgage resets: Some of these loans had a 10 year interest only feature (can you believe it) FED (the ticker) offered these. While the interest rate reset, the payment (even if it were interest only) would reset to a cap of 7.5%. Despite that, most of their loans required a reset anywhere from 36-60 months that would require full amortization of loan within the remainder of the loan period. They offered 40 year mortgages. (It's worth noting, too, that their loan interest rate reset MONTHLY based on a 12 month rolling average).

The point....there were so many of these "flexible" mortgages, that I think that there will be alot of deferred pain. The hand wringing should continue for another 24-36 months (if you assume that most of these designer terms were offered in the 2005 through current time frame).

Heck, I'm still waiting for the fallout from New Century. Don't lose site of that--there is a bankruptcy provision that could provide all sorts of additional issues for bondholders---the collateral in the REIT can be reconstituted as collateral into the issuing agency. No press on this. Perhaps I misread the prospectus, but I don't think so.

Posted by: Leisa | Jun 28, 2007 7:45:49 AM

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