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.

>

Sources:
Recent Woes Cast Light on Hedge Funds’ Murkiness
Scott Patterson
WSJ, June 21, 2007; Page C1
http://online.wsj.com/article/SB118238374972442738.html
 

Is Cheap Debt Drying Up?
Breaking Views
WSJ, June 27, 2007; Page C14
http://online.wsj.com/article/SB118291029012849552.html

Market’s Jitters Stir Some Fears For Buyout Boom
Takeover-Related Debt Gets Chilly Reception;  Hearing ‘Wake-Up Call’
SERENA NG, TOM LAURICELLA and MICHAEL ANEIRO
WSJ, June 28, 2007; Page A1
http://online.wsj.com/article/SB118299592168350999.html

Market insight: Liquidity under threat
Charles Dumas
Finacial Times, June 26 2007 17:47 | Last updated: June 26 2007 17:47
http://www.ft.com/cms/s/2b7e102a-2401-11dc-8ee2-000b5df10621.html

Category: Credit, Data Analysis, Derivatives, Finance, Hedge Funds, Markets, Psychology

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

30 Responses to “CDO Hedge Funds = Enron ?”

  1. Leisa says:

    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.

  2. Moira says:

    the fed will be cutting rates before year end no doubt.

  3. dblwyo says:

    All good points, at least to think about, but before we get to enrononomics first lets think about the core here – which is custom-designed and built financial instruments constructed on math models of STATIC market relationships and not just thinly traded but not traded; each CDO, CLO, etc. is a thing unto itself. Now the last two major times that hypothesized math models were used to look at risks within bounds were in circa ’87 and circa ’97/’98. In the first case it was called portfolio insurance and the gyrations of the market broke the models. In the 2nd case it was both currency speculation ala Asia and our friends at LTTC (by the way Wikipedia of all places has excellent summaries). Now it’s not just sub-prime mortgages but almost every major asset class that’s riding on a see of liquidity constructed from artificial, model-based derivatives.

  4. dblwyo says:

    All good points, at least to think about, but before we get to enrononomics first lets think about the core here – which is custom-designed and built financial instruments constructed on math models of STATIC market relationships and not just thinly traded but not traded; each CDO, CLO, etc. is a thing unto itself. Now the last two major times that hypothesized math models were used to look at risks within bounds were in circa ’87 and circa ’97/’98. In the first case it was called portfolio insurance and the gyrations of the market broke the models. In the 2nd case it was both currency speculation ala Asia and our friends at LTTC (by the way Wikipedia of all places has excellent summaries). Now it’s not just sub-prime mortgages but almost every major asset class that’s riding on a see of liquidity constructed from artificial, model-based derivatives.

  5. jmf says:

    Moin from Germany,

    this from Minyanville about Mark to Model
    is a must read :-)!

    http://tinyurl.com/2mspm7

  6. alexd says:

    I think there are at least two different issues working themselves out here.

    The first is the mortgage mess. One of those examples of how capatilism without enough restraints or oversites can lead to excessive problems. Like the hot cars that BR covets. Br driving them even with a little excessive zeal is not likley to result in much more than a speeding ticket, if that. Get the car going 90 mph and put an over enthusiastic kid behind the wheel who just got a big load of japanese anime…. Same car , same road,not so safe a situation. In other words it matters who is behind the wheel.

    Then we have hedge funds. When Hedge funds are run by the competant or lucky everything is fine. But the reward structure typicly will reward those who run it no matter if they are competant or lucky. So this encourages really big leveraged bets by those who might figure that one large win and they are rich. If the fund blows up the next year they do not have to return any money. Sure it’s buyer beware but there are a lot of smoke and mirrors used to sell things.

  7. Greg0658 says:

    Leisa – are you saying that buying a stock/bond certificate in some REITs – that your personal financial assets are collateral in bankruptcy proceedings?
    To who? The builders leins? Taxes? An exempt manager?

  8. Eclectic says:

    Enron – Begin with a good, productive and stable utility company, and then have it run with a new purpose…

    …the purpose being to magnify unique, obscure, hyphenated and phantom sources of revenue and net income.

    CDO/CMO Industry – Begin with a good, productive and stable industry… one with a dedicated purpose and a sound service to the nation for diversification and syndication of 30-year mortgage/corporate risk, and then have it run with a new purpose…

    …the purpose being to magnify unique, obscure, hyphenated and phantom sources of revenue and net income.


    Here’s what Kenneth Lay had to say in his trial testimony about Michael Milken, Drexel and their financial innovations:

    Go here first:

    http://www.kenlayinfo.com/public/default.aspx

    …then to this particular testimony:

    http://manage.kenlayinfo.com/upload/transcriptd060501_57203.pdf

    See page 16, beginning with line 15:

    I’m not attacking Kenneth Lay in this, but only illustrating that part of what brought down Enron was apparently a spirit of fancy regarding financial transactions that Mr. Lay seemed never to realize had been the very reason for the demise of Drexel.

    Barringo, you mentioned the word “sanguine” regarding the trek last evening to Kudlowvia.

    I’ve illustrated the reason for that sanguine nature before, here on this blog, and in this way:

    Imagine a crowd of cars, bumper-to-bumper and doing 65 mph and faster, maybe much faster, on an Interstate in thick fog. None of the drivers will ever be forced to recognize the folly of their actions until an accident piles them into wrecked stacks of dozens of cars… and the reason is because the fact that they transit a distance and a time without having an accident is reinforcement enough for them that they’ll transit the next section of distance and time without an accident as well.

    It’s the peaceful, blissful ignorance of danger, that has no means of forewarning, that generates the sanguine attitudes.

  9. ECONOMISTA NON GRATA says:

    This is it… The music is about to stop… Keep your eye on the fat guy and give him a good fore arm across the neck on the way to the chair… Look he’s got sweat beading all over his face…. Gross….!

    Speaking of Gross… He seems to have a pretty goog handle on the sittuation. However, I think the Fed has it’s rudder stuck in the mud and it’s going to be a long time before they can move either way without manifesting a lynch mob…

    They’re just going to have to let the shit hit the fan.

    Best regards,

    Econolicious

  10. DD says:

    If a Quake Hits Markets, At Least Shock Absorbers Have Improved Since 1987

    http://online.wsj.com/article/SB118298231245450684.html

    blah blah blah….bring it on…i dont mind being homeless…

  11. michael schumacher says:

    It’s too bad that you have to go outside our media to even begin to understand this whole mess.

    http://www.telegraph.co.uk/money/main.jhtml;jsessionid=OPXAKKXYVQDL1QFIQMFCFGGAVCBQYIV0?xml=/money/2007/06/26/cnusecon126.xml

    If that story was written, like that, in say the New York Times or WSJ, you’d have a panic in retail.

    No where else has it been put in those terms…yet.

    Ciao
    MS

  12. scorpio says:

    Greenspan refused to allow any federal or other oversight of the derivatives explosion, or the “mark to model” issue. same w Bernanke. quite aside from their actual occasional interventions in support of the bubble in equities and debt, the Fed is RELYING on financial institutions never realizing a loss.

  13. michael schumacher says:

    BTW I wish I could move some of my stocks “off-balance” sure wouls make it easier to get to that concept of NET WORTH-Spending=Great!!

    or inflation ex inflation.

    What makes me cringe is that somewhere over at Bear Stearns there was a meeting about “making a killing in sub-prime CDO’s”. In the face of the mounting data, slow bleeding of mortgage apps., slow rate increases, some “braniac” manager said “Looks good to me” and pulled the trigger……and he still has a job.

    Ciao
    MS

    Ciao
    MS

  14. spongetoddsquarepants says:

    Barry,

    A lot of people have been hollering about this for the last 18 months. These whistle blowers should be running the country. Instead we have the Enron cronies running it.

    ~~~

    BR: I have only heard very select whining about this over the past few Qs — certainly, nothing warning nearly as much collateral damage as we have seen so far — and nothing remotely like what could happen if this starts to spiral . . .

  15. MarkTX says:

    MS

    which story at the telegraph should that link go to?

    I get the money home page/section of which there are many links/sections to choose from
    and of which I read 3+ stories relating to the credit/sub prime crap here in the US (all interesting).

    As for spongetoddsquarepants,
    you win the coveted

    Nail on Head Award

    “Enron cronies run the country”.

  16. RW says:

    MarkTX, try this for the Telegraph article:
    http://tinyurl.com/ypl6vm

  17. MarkTX says:

    Thanks RW !!

    Great article

    and a “cone of silence” reference ta boot..!

  18. michael schumacher says:

    sorry…did’nt know it was broken….you’ve got it from REW…

    Ciao
    MS

  19. As Lord Acton said, “power corrupts; absolute power corrupts absolutely.”

    The Enron case is a prime example of corruption — averice at its finest. The mission of Enron evolved from “We want to be the biggest energy company in the United States” to “We want to be the biggest company in the World”(Not just the biggest energy company but the biggest company, period)!

    When the curtain is pulled on the impending market crisis, we’ll know the details. Until then, we will speculate as to its unfolding. The least we can do is speculate in an intelligent manner, which I’ll leave to those of you more intellegent than I…

  20. johnd says:

    BR,

    Please add to the parallels the willing, fee-generating accomplice. The ratings agencies get to play the role of Arthur Anderson in this summer blockbuster re-make of the Enron saga.

  21. lauteus says:

    A few questions for the folks in the KNOW…

    1) Do the “Mark to Model” Valuations get included in the huge Q profits of the financial institutions?

    2) I read that some pension funds are tied to these CDO’s, could a price re-evaluation break these pension funds? (Baby Boooomers are getting to that age)

    3) It would seem the economy has become as bipartisan as our government. Housing will need to reset (I really only look at the Median Prices vs. Median Income) and the longer they wait to raise interest rates, the harder inflation will slap everyone in the face (as personal incomes need to start increasing soon). Question is, why couldn’t the FED become more aggressive with interest rates? Everything else has become more dynamic. Why won’t the fed raise interest rates 2 basis points now and lower it 1 or 2 in the fall? Why do they just sit on their thumbs and always end up chasing the economy…

  22. Norman says:

    The Bear Stearns fiasco shows us again that there really isn’t a functioning market for these derivative securities. When Buffett was liquidating his Reinsurance portfolio a few years ago it took him one-two years to do it.

    So, if it comes to pass that there is either an economic or market dislocation many if not most of these massively leveraged ‘partnerships’ will go up in smoke.

  23. michael schumacher says:

    This is as funny as it is scary:

    http://paul.kedrosky.com/archives/2007/06/27/beware_congress.html

    We elected ‘em..

    Ciao
    MS

  24. GS says:

    Great blog, Barry. Where else can I read about Blade Runner (best movie ever!) and CDO problems on the same page. Apologies for the length of the comment, but I wanted to reply to:

    “BR: I have only heard very select whining about this over the past few Qs — certainly, nothing warning nearly as much collateral damage as we have seen so far — and nothing remotely like what could happen if this starts to spiral . . .”

    I was actually waiting for something like this to happen, as I’m sure others have been as well. This is one of the reasons my bookmarks are filled with blogs run by traders, financial and banking nerds and economists of all sorts. I felt this was well telegraphed and have been reading about risks in the structured finance/toxic lending pipeline for the last couple of years. Blogs, as you know, have an enormous advantage over traditional financial media in that comments sections, especially when civil, with a decent number of experienced, educated and/or in the know participants, can reveal far more and delve far deeper than standard reporting or commentary. As an example, these posts and comments from 2005 sent me into far more research about CDO/MBS/CDS than I would have gone into otherwise:

    http://www.rgemonitor.com/blog/setser/104172
    http://www.rgemonitor.com/blog/setser/106539/

    which in turn got me to read far more IMF, BIS and other research/commentary than I would have otherwise. For example from 2005:

    “I have presented to you the possible triggers for rising bond yields and other asset price losses. The price losses could then be amplified by potential liquidity issues. The liquidity risk is particularly acute in all areas with “narrow markets,” but particularly relevant in the area of complex and leveraged financial products, including credit derivatives and structured products such as collateralized debt obligations (CDOs). The pricing and trading of many of these complex products depends to a large extent on models that may be constructed too similarly from institution to institution. If market conditions turn negative, many investors in these products could rush to exit at the same time, causing market liquidity shortages that could amplify price movements.”

    http://www.imf.org/external/np/speeches/2005/040505.htm

    Blogs are upping the ante for being informed before the crowd. I still read WSJ, the Economist and FT, but I rarely miss a day without a perusal of the financial blogosphere. I’m not saying it’s all great. You have to select for quality, pick and choose the good posts and comments versus the bad ones, verify info on your own, and exercise skepticism and a critical viewpoint, just like anything else, but in my view, blogs have completely changed the financial information game.

    GS

  25. Eclectic says:

    BTW… Barringo,

    All that head stuff and the fingers last night was really cute… particularly the bob and weave with Laffer’s last comment.

    I agree with you… but we’re all just drivin’ in fog. No blood…. no need for recompense.

    But you’d be cuter on or about Jan 1, El Ocho, cluckin’ in one of these with the 10-y-T under 5.250:

    http://www.ragstock.com/assets/images/chic.jpg

  26. abe says:

    Barry, did you see this piece: http://www.freakonomics.com/blog/2007/06/28/another-look-at-sellers-concessions-in-real-estate/
    I shared office space with a Mortgage broker in Lake Success for 8 months last year. Savvy group, what you would expect. It paid dividends, as I was able to leverage their knowledge re NEWC for a couple nice trades. the practice mentioned in the linked piece is news to me, however. More or less, it seems banks were making 10% loans that were in fact negative equity from the closing. Wow. Despise the jokers in DC, but these hearings cannot come soon enough.

  27. Barry — As if you needed any more reading material in connection with your post, here is another perspective:

    http://epicureandealmaker.blogspot.com/2007/06/marks-in-sand.html

    Cheers,
    TED

  28. Casey Serin, Enron and the CDO Hedge Fund Debacle

    Still can’t stay away from the Casey Serin debacle, which is perhaps the most compelling train wreck I’ve ever seen. Either that or it’s the most elaborate troll in the history of the internet. As I was reading Barry Ritholz’…

  29. Barry,

    As always, excellent coverage and comments.

    FYI…

    Average Collateral Pool Exposure To Subprime RBMS by vintage:

    Cash Flow & Hybrid Mezzanie CDO of ABS by year 03:41.2%; 04:44.5%; 05:52.4%; 06:70.6%

    Synthetic Mezzanine CDO of ABS by year 03:37.1%; 04:48.5%; 05:64.5%; 06:77.1%

    Hit the link for more, if you dare.

  30. The major relationships constructed unto itself. The risk with these kind of funds is that it must be planned out in order for it to work.