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What caused Bear Stearns' hedge fund problems?
By JEREMY HERRON
Associated Press, June 20, 2007
NEW YORK — A big Bear Stearns hedge fund is close to collapse. That would mean heavy losses for the investment bank and lots of buzz on the New York financial scene. That's bad for Bear Stearns, but for the average person, what's the big deal?
In this case, the problem is that the fund invested heavily in bonds backed by risky mortgages and its dissolution could have implications far beyond Wall Street. On Wednesday, investor Merrill Lynch & Co. launched a fund asset auction.
Some questions and answers follow about what the fund is, why it is in trouble and what its demise might mean for homeowners and investors.
Q: What does this Bear Stearns hedge fund do?
A: Like any hedge fund, its goal is to generate outsized returns using complicated investment strategies that are typically risky.
This one, called High-Grade Structured Credit Strategies Enhanced Leverage Fund, was started 10 months ago and invested mostly in securities related to risky mortgages, known as subprime loans. It is estimated to hold invested capital of more than $600 million and total borrowings of about $6 billion, although specific figures are not available.
Q: So does the fund own individual mortgages? Could it own my mortgage?
A: No. The fund invests in things like bonds that are backed by individual mortgages. Banks and other mortgage originators make the loans to consumers, package groups of similar mortgages together and sell them to investors in a process called securitization.
Q: What went wrong with the Enhanced Leverage fund?
A: The fund reportedly lost 23 percent of its value in the first four months of the year. The specific reasons are not clear, but starting earlier this year, there was a sharp increase in the number of delinquencies and defaults on loans made to borrowers with spotty credit histories. Bonds backed by these subprime mortgages lost much of their value, before stabilizing somewhat in April and May.
The decline led one big investor, Merrill Lynch & Co., to ask for its money back. When Bear Stearns balked, Merrill Lynch requested its collateral for the loan — at least $800 million in bonds.
Q: Why is that a problem for a $6 billion fund?
A: Because the bonds Merrill took have high ratings, leaving the fund with a higher percentage of risky investments. And if an investor as prominent as Merrill wants out, it is possible that other financiers will, too.
Q: What would the fund's collapse mean for the broader market?
A: It will likely not lead to any major correction, but could signal the start of a shift in how the market values risk.
During the recent bull run, lenders have charged a low premium to borrow money to make risky investments. As more of these securities falter, lenders will start asking for more in return. That would lead to higher volatility in the prices of securities.
Q: What does this mean to potential home buyers?
A: Big losses in subprime investments are likely to make investors more reluctant to risk their money on these instruments in the future.
That will make it harder for mortgage originators like banks to sell these types of loans in bundles to the bond markets, which will, in turn, reduce the availability of funds for subprime loans.
Bill Gross (Pimco's Chief) says that the fallout of subprime debt is likely to hit Main Street harder than Wall Street
Top ten list of hedge fund manager quotes
Hedge funds may not be as crash-proof as once thought
Hedge Funds Mystify Markets, Regulators
Deeply Powerful, Largely Unchecked
By David Cho
Washington Post Staff Writer
Wednesday, July 4, 2007
Wall Street chroniclers one day could look back at the early 21st century and easily dub it the Era of the Hedge Fund. The question is whether it will be remembered as an age of reason or irrational exuberance.
Hedge funds hold unparalleled sway over the financial markets, as confirmed by the recent unraveling of $20 billion in Bear Stearns funds. Portrayed as the new masters of the universe by author Tom Wolfe, hedge-fund managers are responsible for more than a third of stock trades and control more than $2 trillion worth of assets, according to industry researchers. Each of the top hedge-fund managers earned more than $1 billion in 2006 alone.
But like the Wizard of Oz, these funds hide behind a cloak of mystery as they pull the levers that make Wall Street go. "To a great degree they're unregulated and hardly understood or not understood at all," said James Grant, publisher of Grant's Interest Rate Observer.
Understanding the impact of this secretive world gained urgency in Washington after the crisis at the two Bear Stearns hedge funds sent the Dow Jones industrial average down 279 points and prompted the Securities and Exchange Commission to begin an informal investigation last week.
The Bear Stearns funds were on the cutting edge of the hedge-fund world that reaps billions of dollars from slicing up corporate loans, mortgages and other kinds of debt into pieces that can be traded like shares on the stock market. This process is considered by many bankers and regulators to be one of the great advances in finance over the past five years. With hedge funds acting like shock absorbers, investment banks and lenders have been able to make massive loans to freewheeling borrowers and feel less impact from the risk.
Money became easy to get and was easily lent. Banks offered huge mortgages to people with questionable credit. The business of borrowing billions of dollars to buy troubled companies boomed. Backed by hedge funds, insurance companies could offer coverage to homeowners in New Orleans after Hurricane Katrina.
Some analysts say hedge funds have become more important financiers than the long-established investment firms of Wall Street. Greenwich, Conn., where more than half of the biggest hedge funds are based, has earned nicknames such as "The New Wall Street" and "Hedgistan." It also has become one of the most important stops along the presidential campaign fundraising trail.
Yet the trouble at Bear Stearns is revealing that the system may not be as crash-proof as once thought. And it has left Washington regulators and Wall Street analysts with questions: How dependent has the new financial system become on hedge funds? Are their trades getting more risky? If one of them unravels, who absorbs those losses?
The answers are unclear, even to top economists. Part of the problem is that most hedge funds do not reveal much about their trading activities. Many operate offshore. Even for the ones that are based in the United States, no federal agency is empowered to regulate or watch their activities.
The SEC in 2004 passed a rule requiring hedge-fund managers to register with the agency and submit to some oversight. But a U.S. Court of Appeals struck down that rule in June 2006. Later that summer, SEC Chairman Christopher Cox testified to the Senate Banking Committee that hedge funds were operating in a "gap" in the SEC's authority, but he fell short of asking Congress to address the issue through legislation.
The President's Working Group on Financial Markets, which was founded after the collapse of hedge fund Long Term Capital Management in 1998, said in February that hedge funds needed no regulation.
Yet many market watchers worry that, shielded from regulators and operating in the dark, the biggest and most influential hedge funds might be making bets that put the entire financial system at risk. As the two Bear Stearns funds demonstrated, some hedge funds are investing large amounts of money in complex securities that are difficult to value accurately. And much of it is being done with borrowed money -- or "leverage" -- which can magnify returns but also exacerbate losses.
"There's been a fundamental change in the debt markets that I don't think people appreciate yet," said Richard Bookstaber, who has managed hedge funds and recently wrote a book on the topic, "A Demon of Our Own Design."
"I don't think anybody knows how much leverage a particular [group] of hedge funds is using or how much leverage has grown. . . . We are running the risk of making the markets more levered and more complex so that something can go wrong all of a sudden," Bookstaber said.
So what is a hedge fund?
For starters, hedge funds take money only from those with deep pockets. They pool huge amounts of money mainly from super-wealthy investors, Wall Street banks and other hedge funds. About 25 percent of their money comes from pension funds and endowments, according to data from Greenwich Associates.
In the late 1940s, managers of the first hedge funds invented ways to make money no matter which way the stock market was moving. They used terms like "short the market" -- a technique for profiting when stocks go down -- and "going long" -- which means selling stocks after their prices have gone up. The trick was figuring out how many "short" and "long" positions a manager should have in a portfolio.
But to understand what hedge funds do today, it could take "two PhDs and an MBA," as Greenwich Associates hedge-fund analyst Karan Sampson put it.
Some funds bet on how stocks, gold prices and interest rates will move. Others turn almost any kind of cash flow -- including credit card payments, home mortgages, corporate loans, plane leases, and even movie theater revenue -- into bonds and trade them.
One of the most successful fund managers, Edward S. Lampert of ESL Investments, runs an $18 billion fund that makes money in part from what are called "total return swaps." These provide insurance for traders holding risky investments. If the investment goes down, Lampert absorbs the loss, but if it goes up, he enjoys the gain. In exchange for agreeing to the swap, the trader gets regular cash payments from Lampert.
Lampert's fund reportedly has earned returns of 30 percent every year by trading in swaps and other obscure financial tools. He personally made more than $1 billion last year. Most fund managers get their pay by taking a 20 percent cut of the profits from their trades and collecting from investors a 2 percent annual fee based on the total value of a portfolio.
Former Federal Reserve Chairman Alan Greenspan was an advocate for how hedge funds help spread investment risk across many partners. The concept of "risk dispersion" has been described by Federal Reserve Governor Donald L. Kohn as a pillar of the "Greenspan doctrine." Over the past five years, advocates say, it has created a more stable financial system.
In 1998, just when hedge funds were starting to become big, Long Term Capital Management collapsed, nearly paralyzing the U.S. bond market. The disruption was so severe that the Fed had to organize a temporary rescue. The fund lost about $3.6 billion before closing in 2000.
But when the Amaranth hedge fund imploded in September 2006, losing about $6.4 billion on bad bets in natural-gas commodities, federal regulators stayed on the sidelines. Returns plummeted for a few hedge-fund managers and a pension fund in San Diego, but the markets generally shrugged off the news.
The new financial system seemed to be working.
Still, a growing number of market watchers wonder whether the system is encouraging hedge funds to take on too much risk.
"It's a weird dynamic that the market has now," said Dan Freed, a senior writer at Investment Dealer's Digest. "You used to have a small number of institutions taking a lot of risk. Now you take something that's toxic and you divide it into a thousand pieces and you say, okay, well, it's not toxic anymore. . . . But if it's toxic, isn't it [still] toxic?"
The Bear Stearns hedge-fund managers not only made risky bets but also did so with massive loans. They raised hundreds of millions of dollars from wealthy investors and other hedge funds, and borrowed many times that amount from Wall Street banks. With $20 billion at their disposal, they traded obscure securities backed by mortgage loans made to homeowners with shoddy credit histories.
The securities were so exotic that few knew whether the managers were getting good prices as they traded them.
The problem is similar to what happens in the housing market. Because houses are "traded" infrequently, homeowners often struggle to figure out the right price to attract interest. An appraisal can help, but a house's actual value is established only when a buyer and seller agree on a price.
Stocks, on the other hand, are exchanged every day, so their prices generally are considered accurate.
In the case of the Bear Stearns funds, the managers appeared to struggle to value their assets accurately or find buyers for them. In May, they said the funds had lost 6.75 percent of their value in April. In June, they revised that loss to 18 percent. The revision spooked traders, and ultimately some of their assets had to be dumped in a fire sale. Bear Stearns also lent $3.2 billion to bail out one of the funds after Wall Street banks demanded their money back.
Analysts worried about the ripple effects. Other hedge funds holding similar securities had to mark down the value of their assets. Banks suddenly got skittish about making big loans...
[Note: The article was slightly shortened to fit ASF]
Thanks very much!!
This information is all very helpfull.
Not much talk about Australia's largest hedge fund(s) OMIP run by MAN group. All I know is that I took out 8 of these funds and they have all made heaps the first 2 have now matured and have quadrupled in price, the rest going along quite well. porkpie
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Excellent Info there, drillinto, much appreciated!!!!!
All these concerns from the articles does give me a new insight on how risky some of these large hedge funds really are.
The thing that got me REALLY alarmed is how all these hedge funds are playing with asset classes such as Mortgage Backed Securities (MBS), Collateralised Debt Obligations (CDO) and Collateralised Loan Obligations (CLO).
I am a firm believer that most first world countries, like the US and the UK, and even Australia, are enjoying their economic propersity by taking on too much debt for both the public and private sector. (refer to another thread listed on this forum) And I am a firm believer that sooner or later, such explosion in easy credit and increase in debt will not sustain itself and everything will come down in a massive crash when us "rich" first world countries goes bankrupt or default on their huge loan.
As noted in those articles, big hedge funds collapsed due to the default of their loan tied to their trading bonds and thus, some of these hedge funds whom heavily invested and leveraged in such risky assets may sooner or later found themselves in deep trouble as defaults on loan become more prodominately common as the economy can no longer support the mountain of debt.
Australian hedge fund warns about withdrawals
By James Mackintosh / Financial Times
July 11, 2007
An Australian hedge fund manager with $1bn in structured credits and junk-rated loans warned investors yesterday it could restrict withdrawals to ensure its survival as it reported losses of 14 per cent in one fund in June.
Basis Capital, based in Sydney, said in a letter to investors it had been hit by “indiscriminate” repricing of “otherwise fundamentally sound collateral” amid the crisis in US home loans to less creditworthy investors. It said it had deliberately avoided the worst-hit 2006 subprime loans.
The warning that redemptions can be restricted comes as a series of hedge funds in the US and UK have run into trouble from the collapse in price of illiquid, or hard-to-trade, securities linked to subprime loans.
Restrictions on redemptions are closely monitored by hedge fund investors as an indication of trouble.
Any limit tends to prompt a rush for the exit by other shareholders, forcing a fire-sale of assets to raise cash to meet the pay-outs.
Braddock Financial, based in Denver, said last week it would close its $300m Galena Street fund because of redemption requests, while United Capital Holdings, in Florida, suspended redemptions.
Basis Capital, run by Steve Howell and Stuart Fowler, said the quarterly limits it imposed on redemptions – known as gates – were “designed at inception to ensure the [fund’s] survival through periods of extreme dislocation such as this”.
Rick Bernie, a director, said he expected the gates to be used, although redemption requests had not yet come through. “We’ve always said when the world blows up, if you don’t have a tight enough gate it is like saying, ‘Pick us first’ [to redeem],” he said.
Mr Bernie said structured credits were cheap but Basis was not buying because it had to keep enough liquidity to anticipate redemptions.
Basis Yield Alpha fund was down 13.93 per cent in June, only its second monthly loss since it was set up in 2003. Basis Pac-Rim Opportunity fund, with less structured credit exposure, was down 9.2 per cent.
Both funds demand 90 days’ notice for redemptions, which are allowed each quarter, with an extra fee to redeem between those dates.
Hedge fund investors warned that more funds were likely to limit redemptions to prevent forced sales of illiquid assets at low prices, but that the true scale of the problem might not become clear until September.
David Smith, chief investment director of multi-manager funds at GAM, said most funds had quarterly withdrawals, and they would not need to tell investors they were imposing restrictions until the money was due to be repaid.
“It is the end of September, or even December, that everyone will see just how bad it is,” he said.
I just invested in this fund like....in late June, but I haven't heard anything yet...and the latest account statement I got (from my wrap portfolio) has not shown the drop in value yet. (actually, not even know if my wrap provider actually invested into it....since I just started and haven't even receive access to my online account yet!)
This is such a coincidence and utter bad luck for me. I didn't knew about the dangers of such hedge funds until your posts here. And only till I realised the dangers, I already decided it to invest into it (via margin lending too) and allocate almost 40% of it due to its high sharpe ratio performance.
Now it is time to redempt it and get out at a lost asap. Don't care about it anymore....sigh..
Hedge Funds are a huge scam, avoid them like the plague, unless of course you like blowing all your money...
"Don't Fight City Hall when you can BE City Hall"G. Edward Griffins
Must-read from the WSJ
Blind to Trend,
Pay Heavy Price
Computer Models Failed
To See Risk Increasing
By HENNY SENDER and KATE KELLY
WSJ, August 9, 2007
Computers don't always work.
That was the lesson so far this month for many so-called quant[quantitative] hedge funds, whose trading is dictated by complex computer programs.
The markets' volatility of the past few weeks has taken a toll on many widely known funds for sophisticated investors, notably a once-highflying hedge fund at Wall Street's Goldman Sachs Group Inc.
Global Alpha, Goldman's widely known internal hedge fund, is now down about 16% for the year after a choppy July, when its performance fell about 8%, according to people briefed on the matter. The fund, based in New York, manages about $9 billion.
The fund's traders in recent days have been selling certain risky positions, according to these people. Early this week, those moves sparked widespread rumors on Wall Street that the entire fund might be shut down. A Goldman spokesman has said the rumors are "categorically untrue."
Campbell & Co., an $11 billion hedge fund that trades in the futures market as well as in stocks and bonds and is completely driven by such computer programs, was down 10% to 12% by the end of July.
Quant funds -- "quant" stands for quantitative -- generally operate by building computer models of market behavior and then allowing the computer programs to dictate trading. A recurring characteristic of the recent trouble in financial markets is that many lenders, funds and brokerages were following statistical models that grossly underestimated how risky the market environment had become.
"Our risk models failed to pick up the fact that we were due for a correction," says Keith Campbell, founder of Campbell & Co. "We were highly diversified. It was the perfect negative storm."
Campbell's losses occurred because of wrong bets on interest rates, currencies and stocks. While Mr. Campbell declined to disclose just how much leverage was behind his trades, he says Campbell isn't "a highly levered house."
He told investors that the losses stemmed from "a unique combination" of factors. These included the unwinding of the world-wide carry trade -- where investors borrow money in low-interest-rate currencies to invest in higher-yielding assets -- an investor flight toward less-risky investments and the stock market's reversal.
Mr. Campbell called the recent market turmoil "very unusual." Critics say that is one of the drawbacks of the investing style. Much of the time, the market can be accurately modeled by computer programs. The times when they don't work are treacherous.
"All [computer-driven] managers say the models make sense and look like they are working," says Bill Johnston, founder of Bayon Capital, an investment fund based in San Francisco that isn't computer-driven. "But then something happens which statistical probability suggests would never happen."
Rumors of forced selling in the wake of losses contributed to the volatile ride in the stock market yesterday.
Renaissance Technologies Corp., the most successful quantitative-hedge-fund manager, is holding up despite the market's downturn. Renaissance's flagship Medallion hedge fund is up about 25% so far this year, while the firm's Renaissance Institutional Equities Fund is down slightly, according to a person close to the firm, though the gains have been cut in recent days. Medallion made money in July, though it hasn't fared as well so far in August, the person said. The Institutional fund lost about 3% in July, in line with the overall market.
Other hedge funds declined to disclose to brokers or portfolio managers in charge of so-called funds of hedge funds just how badly wounded they have been by the recent extreme swings.
In most cases, their losses had nothing to do with the meltdown in the subprime-mortgage market and occurred across all strategies. Moreover, in many cases, those losses were magnified by the use of borrowed money.
Yesterday, many fund managers were watching for additional knock-on effects of recent losses, which have forced funds like Global Alpha to liquidate certain risky positions. Some think the pain will next be felt overseas, in places such as the United Kingdom and Japan, where asset managers are also likely to begin offloading riskier bets.
The reliance on models can be especially problematic because many quant hedge funds have very similar models. That means they are often doing the same trades and buying the same shares. Moreover, because the strategies are supposed to be market-neutral, with no net positive or negative bent, the funds often borrow large sums so they can bet more and achieve better returns when things go their way.
That massive borrowing adds to the pressure when markets reverse course several times in the course of a single day, as the stock market has done repeatedly in recent weeks, or when tried-and-true relationships between different markets suddenly break down.
Some hedge funds are quite good, actually. They actually aim to deliver positive returns in all market conditions. Surely, they lose out in strong bull markets, but their returns continue to pile in bear markets. It doesn't matter what assets they trade in (or do not trade in), they should still achieve reasonable positive returns for most (if not all) of the time.
Of course, you also have some less disciplined funds that would bet their whole account on an event - e.g. some funds have used their total equity in their derivative accounts to short the whole market. If they get lucky (which they did the past few days), then it's all good... everyone's happy. Although, if there were any unexpected good news... wipe out!
How To Speak Hedgie
Article URL: http://www.slate.com/id/2172224/