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Generational Dynamics Web Log for 24-Jun-07
Bear Stearns bails out defaulting hedge funds, preventing broad market meltdown

Web Log - June, 2007

Bear Stearns bails out defaulting hedge funds, preventing broad market meltdown

At the end of a dramatic week described by pundits as a "bloodbath," investment firm Bear Stearns caved in to other investment firms, and loaned $2.3 billion of its own money to stave off default of two of the hedge funds that it manages. Both of the hedge funds had heavily invested in credit derivatives related to subprime mortgage loans.

The near-collapse of these two hedge funds reflects a larger trend in the economy that the entire subprime mortgage industry may finally be close to collapse.

The turning point occurred at the beginning of this month as home foreclosure rates kept increasing, and it became apparent that the subprime mortgage industry was much worse off than officials had been saying. It's still deteriorating, as I discuss my the companion article on the real estate market.


Index price of ABX-HE-BBB- 07-1 from Jan 19 to Jun 22, 2007 <font face=Arial size=-2>(Source: Markit.com)</font>
Index price of ABX-HE-BBB- 07-1 from Jan 19 to Jun 22, 2007 (Source: Markit.com)

The resulting industry-wide investor loss of confidence is measured by the ABX-HE-BBB- 07-1 index, whose value started falling sharply early in June, as the adjacent graph indicates. I discussed this index in my February 22 article, How to interpret and price the ABX derivative table.

This index represents the value of certain derivative certificates known as CDOs, or collateralized debt obligations. These CDOs provide a kind of insurance that homeowners will pay off their subprime mortgage loans, but as the number of foreclosures increased, the CDOs lost value. The value of the CDOs corresponds to the ABX index shown in the graph.

The two Bear Stearns hedge funds had invested heavily enough in CDOs that when they collapsed in value, the entire hedge fund was in jeopardy. The CDOs had been purchased on a leveraged basis, which is similar to individuals buying stocks "on margin," something that was identified as a major cause of the 1929 stock market crash.

As the value of the CDOs kept falling, the hedge funds had to meet margin calls by supplying more and more cash to make up the loss in value. Within the last two weeks it became apparent that the hedge funds wouldn't be able to meet margin calls much longer, and the hedge funds were close to default.

Cutthroat negotiations

During the last two weeks, cutthroat negotiations have been taking place between Bear Stearns and the hedge funds' principal investors, including J.P. Morgan Chase & Co., Merrill Lynch & Co., Goldman Sachs Group Inc. and Barclays PLC. Not all the details are known, but a Saturday Wall Street Journal article and a Saturday New York Times article provide a number of details:

The Bear Stearns debacle is far from over, because the housing market crisis is far from over.

According to one pundit quoted by Bloomberg: "It's a blood bath. We're talking about a two- to three-year downturn that will take a whole host of characters with it, from job creation to consumer confidence. Eventually it will take the stock market and corporate profit."

This means that CDOs will continue to lose value and that the hedge funds will continue to default. So Bear Stearns will lose its $2.3 billion loan as well.

The Mark to Market scam

Convincing the Bear Stearns negotiators to put $2.3 billion into a failing hedge fund must have required quite a bit of arm-twisting.

The crisis was triggered by a fall in the value of CDOs, and the way that we know that the value of CDOs has fallen is by looking at the ABX-HE-BBB- 07-1, discussed above.

According to John Succo at minyanville.com, the published ABX index is being held artificially high, much higher than the "real" market value of CDOs. This indicates that CDO values have a lot farther to fall, with consequent impact on other hedge funds invested in CDOs.

Succo wrote his article six weeks ago, before the recent fall in the ABX index. He was wondering why CDO valuations were so high, in view of the continuing deterioration of the housing market. In a fair, transparent market, where everyone knows what's going on, the deteriorating housing market should cause CDO valuations to fall much more quickly. Well, why weren't they falling faster?

The reason is that there's a kind of scam going on. If the value of a stock share falls, then you can check the price on the New York Stock Exchange, or whatever stock exchange the share is traded on. There's an open, transparent market on stock shares. And according to the "Mark to Market" rule that I described above, anyone using stock shares as collateral must valuate them according to current market prices.

But what if your assets are in CDOs, rather than stock shares? How do you valuate them for Mark to Market purposes? There's no public market for CDOs; in fact, most CDO deals are done in smoke-filled back rooms of financial firms by men wearing green eyeshades. The ONLY publicly available gauge of the values of CDOs is the ABX index, and that index is set by agencies marketing the CDOs themselves. This is called "Mark to Model," but an online correspondent refers to it as "Mark to Myth."

The problem is that setting the ABX index involves a conflict of interest, as described by Succo on May 17:

"I asked a large broker firm to send over its smartest math person on Collateralized Debt Obligations (CDO) structuring. I wanted to know what I am missing: why is the market so sanguine in the face of deteriorating collateral values in the mortgage market? One of my firm's theses has been that, as the mortgage market deteriorates, investors holding CDO as an investment would realize losses and this would feed into other risky asset classes. Why arenít losses being seen when the market is clearly deteriorating?

The team that came over was headed by a very smart gentleman. He was very good at math and very straightforward. Working for a broker I was prepared for some sugar coating. I didnít get any.

The answer is simple and scary: conflict of interest.

He explained that due to the many layers of today's complicated credit products, the assumptions used to dictate the pricing and outcome of CDO are extremely subjective. The process is so subjective in fact that in order to make the market work an "impartial" pricing mechanism must exist that the entire market relies upon. Enter the credit agencies. They use their models, which are not sensitive to current or expected economic activity, but are based almost entirely on past and current default rates and cash flow to price the risk. This of course raises two issues.

First, it is questionable whether "recent" experienced losses over the last few years really represent the worst of the credit market (conservative). But even more importantly, it raises a huge conflict of interest: the credit agency's customers are the very issuers of the tranches they rate. The credit agencies, therefore, need to compete for business based at least in part on the ratings they are willing to give these tranches. As a result, they will only downgrade when forced to by experienced losses; not rising default rates, not a worsening economy, but only actual, experienced losses. Even more disturbing, they will be most reluctant to downgrade the riskiest tranches (the equity tranches) since those continue to be owned by the issuers even after the deal is sold.

So even though the mortgage market has deteriorated substantially, mark-to-market losses by those holding the CDO paper have generally not been realized simply because the rating agencies have not changed their ratings for all the above reasons. Accounting rules only require holders of the paper to mark prices according to the accepted model, not actual prices. For example, below is a chart of the actual BBB minus tranch of the mortgage-backed securities pool from November '06 to present. [Note: See the chart of the ABX index near the beginning of this article, and note that on May 17, which is when Succo was writing this, the index value was considerably higher than it is today. - JJX] Actual prices where traders can really buy and sell is substantially lower than where investors are marking their positions.

The levels at which investors are carrying the paper is not reflecting underlying reality as the holders simply hold their collective breath and the rating agencies ignore a worsening environment.

I asked them what would force the rating agencies to change their ratings and the response was "it's just a matter of time if the market continues to deteriorate, for the agencies at some point will be forced by the cumulative losses to acquiesce." Because these losses have been compressed, any re-adjusting of ratings by these agencies are likely to result in a massive repricing of risk."

Succo's analysis, written a month before the Bear Stearns debacle, shows why Wall Street was so anxious to avoid a default; the CDO portfolio held by the Bear Stearns hedge funds would have to be sold off at fire sale prices. This would force the valuation of ALL CDOs in ALL hedge fund portfolios throughout the industry to be revalued, according to Mark to Market rules.

Let's repeat a brief portion of the above article:

"The credit agencies, therefore, need to compete for business based at least in part on the ratings they are willing to give these tranches. As a result, they will only downgrade when forced to by experienced losses; not rising default rates, not a worsening economy, but only actual, experienced losses. Even more disturbing, they will be most reluctant to downgrade the riskiest tranches (the equity tranches) since those continue to be owned by the issuers even after the deal is sold."

A Bear Stearns default would provide actual "experienced losses," forcing the credit agencies to downgrade their ratings.

The scam I've been describing is based on a conflict of interest that credit agencies have. But in fact, all the parties to this entire deal have conflicts of interest.

J.P. Morgan and the other bankers used extortion techniques ("Pour $2.3 billion of your own money into the hedge funds, or we'll shut your whole firm down!") to get Bear Stearns to comply. Was Tony Soprano one of the J.P. Morgan negotiators? I guess the Bear Stearns negotiator should consider himself lucky that he wasn't whacked.

The reason that Morgan and the other bankers used illegal extortion techniques is because of their own conflicts of interest. They're in the same position as the credit agencies -- they want to keep CDO valuations and the ABX index as artificially high as possible, in order to protect their own portfolios and the portfolios of their clients.

This is, once again, the Principle of Maximum Ruin in action. Every day that the global financial bubble is propped up by such subterfuge and extortion techniques, the bubble gets worse. This means that more people are put at risk, and more of their money is put at risk. In the end, the maximum number of people will be ruined to the maximum extent possible -- the Principle of Maximum Ruin.

Let's take one more look at the last paragraph of Succo's analysis:

"I asked them what would force the rating agencies to change their ratings and the response was "it's just a matter of time if the market continues to deteriorate, for the agencies at some point will be forced by the cumulative losses to acquiesce." Because these losses have been compressed, any re-adjusting of ratings by these agencies are likely to result in a massive repricing of risk."

That's the situation in any bubble. As long as financial officials keep propping the bubble up, it just gets worse, with even more disastrous results when the bubble bursts.

In fact, that's the simple conclusion of the Bear's decision on Friday to pour $2.3 billion of its own money into a hedge fund that's going to fail anyway. That $2.3 billion is good money going after bad, which is what we're going to see a lot more of in the weeks and months to come.

The collusion and extortion that went on this week with the Bear crisis (which, as we've stated, is not over) is being accepted now, because people are desperate to believe any fairy tale that tells them that the market can be saved. After the crash occurs, these people will be blamed for harming the economy, and many of these high-flying financiers will be subject to criminal investigations and perhaps jail.

From the point of view of Generational Dynamics, a generational stock market crash is overdue. If you go back through history, there are of course many small or regional recessions. But since the 1600s there have been only five major international financial crises: Tulipomania bubble (1637), South Sea Bubble (1721), French Monarchy bankruptcy (1789), Hamburg Crisis of 1857, and 1929 Wall Street crash. We're now overdue for the next one.

It could happen next week, next month or next year. But when it happens, massive numbers of people will become unemployed, bankrupt and homeless. Many high-flying financiers will be subject to criminal investigations, but mostly they'll stay out of jail because they have the resources to hire big law firms to defend them. The real problem is that many ordinary people will go to jail because of crimes they committed out of desperation, because they had listened to the high-flying financiers, and "borrowed" money that wasn't theirs, hoping to stave off homelessness and bankruptcy. This result will be made much worse by actions like this week's bailing out of the Bear Stearns hedge funds. (24-Jun-07) Permanent Link
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