Thursday, June 21, 2007

More of "Why the Bear Stearns Hedge Fund Story is So Important"

From Bloomberg:

Merrill Lynch & Co.'s threat to sell $800 million of mortgage securities seized from Bear Stearns Cos. hedge funds is sending shudders across Wall Street.

A sale would give banks, brokerages and investors the one thing they want to avoid: a real price on the bonds in the fund that could serve as a benchmark. The securities are known as collateralized debt obligations, which exceed $1 trillion and comprise the fastest-growing part of the bond market.

Because there is little trading in the securities, prices may not reflect the highest rate of mortgage delinquencies in 13 years. An auction that confirms concerns that CDOs are overvalued may spark a chain reaction of writedowns that causes billions of dollars in losses for everyone from hedge funds to pension funds to foreign banks. Bear Stearns, the second-biggest mortgage bond underwriter, also is the biggest broker to hedge funds.

`More than a Bear Stearns issue, it's an industry issue,'' said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York. Hintz was chief financial officer of Lehman Brothers Holdings Inc., the largest mortgage underwriter, for three years before becoming an analyst in 2001. ``How many other hedge funds are holding similar, illiquid, esoteric securities? What are their true prices? What will happen if more blow up?''

This reminds me of the Japanese bank problem that started in the late 1980s/early 1990s. Banks had a ton of assets that were not continually repriced as the market decreased. Instead, the banks had assets on their books that reflected a higher price. As the value of those assets decreased, the value of banks collateral decreased as well. Eventually, the problem was dealt with, but it took 10+ years of major problems in the Japanese economy for the problem to get corrected.

This problem is directly related to the problems in the housing market:

CDOs were created in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc., the home of one-time junk-bond king Michael Milken. Sales reached $503 billion in 2006, a five-fold increase in three years. More than half of those issued last year contained mortgages made to people with poor credit, little loan history, or high debt, according to Moody's Investors Service.


Not since 1994 have mortgages with past due payments been so high, according to first-quarter data compiled by the Federal Deposit Insurance Corp., the agency that insures deposits at 8,650 U.S. banks. Lehman analysts estimated in April that the collateral backing CDOs had fallen by $25 billion.

One of the reasons for the big increase in the mortgage market over the last 10 years (and pretty much the last 25) is the creation and development of the Mortgage-back securities market. This market has created a ton of liquidity which allows an increase in mortgage underwriting.

CDOs are theoretically an insurance policy against a blow-up in the mortgage industry. However, these investments have never been tested by a real problem in the market. That does not mean they won't work as advertised. It simply means that the market has never tested them.

People are understandably worried about how these hedging tools will perform if the market goes belly-up.

Merrill's decision yesterday to accept bids on $800 million of bonds it took as collateral for its loans further stifled trading in CDO securities, said David Castillo, who trades asset- backed, commercial-mortgage and CDO bonds in San Francisco at Further Lane Securities.

``Nobody wants to look at the truth right now because the truth is pretty ugly,'' Castillo said. ``Where people are willing to bid and where people have them marked are two different places.''

The real question is "why is Merrill doing this?" They most likely have a dog in this hunt somewhere and know the real stakes involved -- a massive repricing across the hedge fund universe that would have a negative impact on a ton of investors. My initial thought is Merrill is using this as a negotiating tactic so they can talk to Bear from a position of strength and exact some major concessions. However, I am sure there are other possibilities.