VIRUS by Mike Offit
July 2, 2007
To most people, the recent meltdown of Bear Stearns’ “High-Grade Structured Credit Strategies Enhanced Leverage Fund,” which focused on subprime mortgages and structured mortgage securities, seems a dispatch from an alien world. The reaction of the financial services industry, however, indicates otherwise. The Street acted quickly to attempt to quarantine the fund’s problems before the virus spread. While the jury is still very much out on the repercussions, an understanding of what happened and what is at stake might be good for your financial health.
Hedge funds like the Bear vehicle are nothing more than microcosms of the big investment banks with which they do business. They use their partners’ or shareholders’ equity to buy huge blocks of bonds, stocks and derivatives from the investment banks, leveraged with massive loans from the same bankers. Bear’s High Quality Fund held at least $9 billion or more of bonds on some $600 million of equity (15:1.) [By comparison, a major investment bank like Goldman, Sachs runs a balance sheet of about $1 trillion on roughly $35 billion of equity (28:1).] Many of the bonds Bear’s fund held were further risk-leveraged within their structures (the “subordinated” or “mezzanine” slice of a Collateralized Debt Obligation might be a $20 or $30 million tranche that absorbs the credit risk from a pool of $500 million or more of risky loans.) Through buying these higher-yielding, risky bonds with borrowed money, hedge funds can leverage their returns into the twenty or thirty percent range without expending much “trading expertise.” If they bother to hedge these exposures (which is almost impossible) at all, any negative change in the bonds’ values can have a devastating impact.
When something goes wrong with such highly-leveraged bonds, it happens very quickly. A default, downgrade or devaluation of just one bond can start a cash crisis at the hedge fund. Their lenders revalue the fund’s bonds every day (just as they do their own trading positions). If the value erodes, the lender demands an immediate influx of cash to meet their loan margin requirements. If the fund does not have the cash, it has to start selling bonds, paying off their lenders first and then using any equity left to satisfy the margin call. Generally, funds sell their highest-rated, most liquid bonds first. If that isn’t enough, they start selling their lower-rated and highly structured bonds and derivatives. The problem is, the bidders (generally the same investment banks who lent them the money to buy them) hate buying this toxic stuff back, and they lower their bids dramatically, in order to buy them cheaply enough to insure they can resell them eventually.
Once this happens, the sales create a new “market value” for all the bonds sold, and all related or similar issues. These markdowns apply to all holders, virtually all of whom have to “mark-to-market” daily. The resulting decrease in values triggers more margin calls on other hedge funds that own them, and a vicious cycle has begun. But now, the big investment banks are in the same bind. Their trading desks’ inventories have to be marked down as well. This requires an influx of regulatory capital to satisfy the SEC. They have to start selling and moving around capital, just when their customers all want to sell and no one wants to buy. A virus like this can spread from subprime mortgages to CDO’s to CLO’s to CBO’s to high yield and to investment grade bonds very quickly. As cash moves into safe Treasuries, credit spreads (yield differentials) widen, and the problem accelerates. This is almost exactly what happened in 1998 when hedge fund Long Term Capital Management imploded. Wall Street lost billions just on inventory markdowns, and without a bailout aided by the Federal Reserve, the situation would have been far, far worse. The Bear fund has been bailed out for now by a huge loan from Bear, Stearns, likely under a lot of peer pressure. Another major credit collapse could take many big lenders and players down. What makes it ironic is that many of these structured securities need only perform in line with their historic norms to blow up. Subprime (read “deadbeat”) borrowers are supposed to default a lot on their mortgages. Russia was considered a terrible risk in 1997-8. So, the fate of some of our biggest financial institutions may rest on the highly-leveraged shoulders of some of our least credit-worthy borrowers.
Viruses have a habit of not stopping at artificial borders. Most investors assume they are immune to this sort of contagion. However, their fortunes, quite literally, are tied to their investment banks’ more closely than they might think. There are some major risks associated with holding your savings at brokerage firms. Suffice it to say I started the process of moving my own investment assets out of a major securities firm and into a trust bank this week. It will cost me a small administrative fee, but I won’t be relying on an investment bank to keep straight books in a crisis or look out for me first if the going gets rough.