Wednesday, June 20, 2007

Mortgage Market May Take A Big Hit This Week

Today's WSJ has an article the gives more detail about the Bear Stearns hedge fund that is having problems in its mortgage portfolio.

First, here's the root of this hedge fund's problems.

On Wall Street, the Bear Stearns hedge funds' problems point to another sensitive issue: Markets for exotic investments like derivatives linked to subprime mortgages have exploded in size in the past few years, but it is often hard to attach an accurate value to those assets.

Last month, Enhanced Leverage reported that its value fell 6.75% in April after the fund's bets on the mortgage market went wrong. Two weeks later, it put the loss at 18%, spooking already-nervous investors and creditors and sending many of them running for the exits.

The huge revision at least in part reflected conversations Bear Stearns hedge-fund managers had with bond dealers, three of which told them in late April that some of the funds' assets were worth less than the values stated on the funds' books, according to a person familiar with the matter.


Unlike stocks and Treasury bonds, whose prices are continually quoted and easily obtained, many of these derivative instruments trade infrequently and don't have clear market prices. To come up with market values for these investments -- a process known as "marking" their positions to market -- investment funds often rely on their own valuation models.

While the bond market is liquid -- that is you can usually buy and sell securities freely -- it's more of a market where the individual players negotiate price on a regular basis. When I was a bond broker, portfolio managers would call dealers every month to get a quote on all the bonds in their portfolio for end of the month pricing (I'm assuming this is still the practice, but I haven't been in the market for over 5 years so it could have changed). This means there wasn't a central market where managers could simply pull up a screen and get a market-wide accepted quote. As a result, bond portfolio values have some play in them.

Notice the huge drop in the value of Bear's portfolio holdings over a two-week period. The drop in value went from 6.75% to 18%. That's a really big drop.

"There's some real concern about how realistic dealer quotes are," said Andrew Lo, a finance professor at the Massachusetts Institute of Technology who is also a principal in AlphaSimplex Group LLC, an asset-management company that also runs a hedge fund. "You're talking about quotes during normal times that are very different from quotes during stress times."

There is no indication that Bear Stearns's fund managers sought to mislead lenders or investors about the value of the funds. Indeed, the firm's approach to valuing its securities seems to be in line with guidelines set up by Moody's Investors Service, which evaluates hedge-fund practices. But the crisis does point to the kinds of valuation problems hedge funds and their investors or lenders can run into, even when they follow sound practices.

A forced sale of the Bear Stearns funds' assets now could trigger a broader repricing of mortgage-backed bonds and lead to losses and margin calls -- demands for additional cash or collateral -- at other funds. That prospect might have given some of Bear Stearns's lenders, which include Merrill, Citigroup Inc. and Barclays PLC of Britain, an incentive to help out the funds. But Merrill and others decided to bail out of the funds yesterday.

These paragraphs are very important.

1.) There doesn't appear to be any deliberate wrongdoing.
2.) Hedge Funds were pricing their securities based on a liquid market that had confidence in the value of the securities it traded. Now it appears that model was too optimistic when it came to the actual value of the bonds it traded.
3.) Because Bear is selling the underlying securities over the next few days, the market will get actual prices from buyers and sellers. These will be far more accurate than the prices based on models.
4.) The prices Bear gets for the bonds it sells may be below the prices on the books.
5.) This could force other hedge fund to reprice their mortgage portfolios at lower prices.
6.) If the repricing is severe other hedge funds could have the same problems that Bear is having, essentially creating a ripple effect throughout the industry.

I want to caution on a few points:

1.) This is not financial Armageddon. Securities markets are incredibly resilient and are almost always able to deal with stressful events like this.
2.) That being said, this could be an incredibly stressful event for all the players involved.
3.) We had the sub-prime shakeout earlier this year. A ton of sub-prime players went belly-up or sold portfolios. This could be the beginning of a shake-up in the hedge fund industry with similar results. We're going to have to watch this situation very carefully to see what happens.