Bear Stearns, Hedge Funds, and the Mortgage Fallout

Book: Structured Finance and Collateralized-Debt-Obligations | Author: Janet M. Tavakoli | Publisher: John Wiley & Sons (2008) | ISBN: 978-0-470-44344-6

The first part of Chapter 8 covered how the subprime house of cards was built. This half covers who saw it coming, how they made money from it, and what happened when the collapse started spreading.

Investors and Misrated Products

Here’s the core investor problem with misrated subprime CDOs. It wasn’t just about losing money to defaults.

Many investment-grade bond funds had strict limits on how much downgraded-below-investment-grade product they could hold. If ratings dropped, they were forced to sell. Retail investors held much of this product through mutual funds. Pension funds and insurance companies bought the investment-grade tranches. Banks held the AAA and AA tranches.

When rating agencies finally started downgrading, it triggered forced selling. That selling pushed prices down further. Spreads widened. Even highly rated tranches experienced mark-to-market losses, not because they were defaulting but because everyone was repricing the risk of the asset class.

Shoddy ratings had economic consequences beyond defaults. Liquidity dried up. Investors couldn’t sell without realizing losses. Funds were less competitive because newer investors could buy the same assets at lower prices, generating better income for identical misrated risk.

Some AA tranches backed by subprime debt were also genuinely at risk of principal loss from defaults. That illustrated how badly the original ratings were off.

The agencies claimed ratings had nothing to do with liquidity. Tavakoli’s response: that’s true when liquidity impairment comes from general spread widening or interest rate moves. It’s not true when liquidity dries up because the initial ratings were wrong from day one. Failure to account for material deterioration in collateral quality is a job failure.

Hedge Funds and the ABX Short

Not everyone was caught flat-footed. Some hedge funds saw what was coming and positioned accordingly.

By summer 2006, certain funds were quietly buying credit protection on the ABX.HE 06-2 BBB- index - the index referencing BBB- tranches of 20 home equity loan ABS deals. This was effectively shorting the index.

Tavakoli was one of the people recommending this trade. Her reasoning: given the fundamentals of the subprime lending market, the probability of the index rising was very low. Even if it rose, it would be minimal and temporary. The probability of a substantial price drop was very high.

The trade required patience. After putting on positions in summer 2006, hedge funds waited. The index barely moved through October. By late November it had drifted to 98.2. Not enough movement to feel good about. Clients talked about pulling the plug before year-end.

Then, on November 27, 2006, Markit reported the first interest shortfall on bonds underlying an ABX index. It was tiny - $105 per million at index level - but it showed the available funds cap had kicked in. The index dipped slightly.

In early December it drifted lower for no discernible reason.

On December 31, 2006, Aaron Krowne launched Implode-o-Meter, mystified that dozens of subprime mortgage lender bankruptcies were not making headlines.

In January 2007, when the Wall Street Journal reported on OwnIt’s December bankruptcy, the market learned that JPMorgan had pulled OwnIt’s credit line in mid-November - right around the time the index started its slight downward drift. Merrill Lynch had also asked OwnIt to repurchase substandard mortgages.

The index started dropping like a stone.

By January 26, 2007 it had fallen to 90.34. By February 13 it was at 80.35. Tavakoli recommended covering the short on Valentine’s Day. The payoff: for every $10 million notional shorted at end-November when the index was at 98.20, a hedge fund pocketed net profit of more than $2.7 million.

In retrospect the trade seems obvious. In summer 2006, almost no one had the conviction to put it on and wait.

A Good Year for Some

By February 2007, investors and investment banks were asking for deep discounts on CDOs backed by subprime collateral. The ABX index headed lower. Some funds covered their shorts. Others kept positions or reopened them as the higher-rated ABX indexes also started falling.

Bethany McLean at Fortune wrote about the dangers of investing in subprime debt in March 2007. Quoting Tavakoli: “No one believes the ratings have any value.”

By summer 2007 the ABX.HE 06-2 BBB- index dipped below 40. Other ABX series were deeply depressed. By January 2008, the index was around 15.

Paulson & Co., an $11 billion hedge fund, organized a group of funds to complain to regulators about potential market manipulation. Their concern: under certain deal terms, banks could renegotiate and modify mortgage loans. John Paulson worried that investment banks might manipulate the market by writing loans against former home values without actually restructuring them in a way homeowners could afford, simply restarting the clock on noneconomic mortgages.

Tavakoli notes the concern wasn’t far-fetched. The ABX index had only 20 underlying deals. Cornering the market on $20 billion worth of CDOs might cost only $2 billion in first-loss and BBB- tranches. The complaint probably put a halt to any such consideration.

The irony: two Bear Stearns Asset Management funds later imploded partly due to leveraged exposure to subprime risk. That caused further depression in ABX prices. Paulson’s funds benefited enormously. Its largest credit hedge fund gained 40 percent in June 2007 alone. Paulson & Co. was rumored to have made around $15 billion. Goldman Sachs reported billions in hedging gains.

BSAM’s Hedge Funds: Undone by Leverage

Bear Stearns Asset Management managed the Bear Stearns High Grade Structured Credit Strategies fund and, launched in August 2006, the Bear Stearns High Grade Structured Credit Strategies Enhanced Leverage fund.

The name “high grade” is doing a lot of work here. Both funds invested in first-loss tranches of CDOs - the unrated equity pieces that absorb losses before any rated investor gets hurt. Some of these were very small first-loss slices of AA-rated collateral portfolios, leveraged as much as 60 to 1. Others were unrated first-loss equity in portfolios of lower-quality assets.

In May 2007, BSAM posted the Everquest IPO proposal (the S-1 filing) on the SEC website. Everquest would purchase some of the riskiest assets of the two funds at prices determined by BSAM itself. It proposed a public offering, meaning shares could eventually reach retail investors.

The conflict-of-interest list was long:

• Managers’ fees depended on asset performance
• Managers priced assets with no ongoing third-party verification
• Managers had broad substitution powers
• The breakup fee to replace managers was one to three years of management fees - a massive hurdle
• Fees were high: 1.75 percent per annum plus 25 percent above an 8 percent hurdle

53 percent of Everquest’s assets were in Parapet, a Bear Stearns CDO of CDOs. The substantial majority of its ABS CDOs were in RMBSs backed by subprime mortgages. Several other structured finance CDOs also appeared to have subprime exposure. 42.8 percent of Parapet’s CDOs were invested in preference-share and income-note tranches - the riskiest pieces.

Tavakoli’s assessment: the SEC filing fully disclosed the risks, even if she didn’t like what it was honest about.

The Everquest IPO was set aside when the funds suffered a triple whammy:

1. Investors who noticed declining asset values in March and April 2007 asked for their money back
2. Lenders to the funds noticed collateral values had declined and demanded more margin
3. Leverage made it nearly impossible to raise cash without putting further downward pressure on asset prices

BSAM had reportedly used leverage of around 10 to 1 on average. Investors in one fund were told their investment was worth around 10 cents on the dollar. Investors in the Enhanced Leverage fund were told their investments were worth almost nothing.

The Bear Stearns Bailout

Bear Stearns initially opposed bailing out Long Term Capital Management in 1998. Tavakoli says that was the correct position.

When Bear Stearns bailed out BSAM’s hedge fund creditors - initially reported as $3.2 billion, quickly scaled to $1.6 billion - it set a troubling precedent.

The lenders were nervous about losing money. That’s the risk you take when you provide credit to a leveraged fund. If a hedge fund puts up 10 percent collateral, the lender has risk if assets decline more than 10 percent. Investors in the fund bore the first-loss risk; credit line providers had much less.

But Bear Stearns was under no obligation to bail out the creditors. The bailout made the funds look like just another of the bank’s trading desks - using outside capital and outside financing temporarily.

The problems: the bailout created a moral hazard. If an investment bank knows it will be called on to rescue a hedge fund, it may feel entitled to interfere with that fund. It also gave regulators an excuse to consider hedge fund offshoots as part of regulated entities. How can an investment bank claim off-shoot hedge funds are independent or off-balance-sheet if it acts as lender of last resort?

The investors did sue. They questioned the ongoing mark-to-market protocol of the funds. The prior years of high returns from the first fund had encouraged many investors to put money into the Enhanced Leverage fund. High leverage cut both ways.

Prime brokers responded to the crisis by making radical increases in margin requirements on hedge funds with leveraged subprime-backed CDO exposure. But the margin increases often reflected the fact that underlying collateral wasn’t properly marked down. Asking for 20 percent margin on an asset that’s priced at 98 when you have reason to believe the actual price is closer to 88 isn’t doubling your margin requirement - it’s asking for the appropriate amount because you’re fudging prices.

Lawyers and the Securitization Mess

Tavakoli has a direct section on lawyers in this chapter.

The headline is a Shakespeare quote from Henry VI: “The first thing we do, let’s kill all the lawyers.” Tavakoli clarifies she doesn’t recommend that literally. Her recommendation: sophisticated investors should dispense with lawyers more often when resolving securitization disputes. Business problems are best solved with business solutions.

Lawyers have poor understanding of these deals. They have conflicts of interest with clients. They drag disputes out for years while billing for inexpert work. They try to write expert reports for actual experts, withhold documents from those experts, and interpret documents on behalf of experts who need to read primary sources themselves.

In one securities fraud case she describes, an expert witness had not read the primary documents and was unfamiliar with the report he had signed. The lawyers had co-opted the work. The client paid a large settlement rather than proceed to a trial it would have lost. The lawyers billed tens of millions of dollars.

The lawyers who drafted documentation in the original deals also bear responsibility. Securitization professionals should instruct lawyers on what documents should include - not leave drafting to lawyers with limited understanding of the structures.

The practical advice: if you have a dispute with a deal arranger, try talking to their senior management directly. Many disputes are resolved more quickly and cheaply in business conversations than through lawyers. Many investment bank managers would rather solve a problem than carry a contingent legal liability on their balance sheet.

Market Fallout

Both the US and UK had mortgage market problems by mid-2007. Similar issues appeared elsewhere in Europe. All related to some combination of: lax underwriting, fraud, risky products, poor bank and investment bank lending decisions, somnolent regulators, shoddy rating agency practices, and excessive optimism about perpetually rising housing prices.

UK regulators issued a statement in July 2007 expressing belated dismay at poor underwriting practices.

Total mortgage losses were still unclear when Tavakoli wrote. Mortgage defaults were expected to increase through 2008 as ARM loans continued resetting to higher rates. Approximately 80 percent of 2006 loan originations were ARM products with resets coming in 2008 to 2011. After teaser rates of around 8 percent, many would reset to LIBOR plus 600 basis points - potentially 11.4 percent or higher at actual reset time.

Redlining and Red Ink

The chapter closes with a historical callback.

Redlining was an illegal practice where banks denied sound mortgage products to eligible minorities based on their neighborhood’s demographics. It kept minority communities locked out of home ownership.

The subprime boom replaced redlining with red ink.

Some high credit score borrowers were steered into risky subprime products. Low credit score borrowers were lured into loans they had no hope of repaying. Denying someone a mortgage they cannot pay is not discrimination - it protects them from bankruptcy and homelessness. But destroying the credit records of naive people and driving them into homelessness is, as Tavakoli puts it, a blot on the securitization industry.

The United States had squandered credibility and legitimacy in the global financial community. Wall Street’s standard - your word is your bond - had been replaced by spin. Alternate-reality spinning from investment banks, commercial banks, hedge funds, traditional investors, and rating agencies followed indefensible behavior.

Tavakoli’s proposed fix: insist on sound underwriting standards and traditional mortgage products for low credit score borrowers. This would cool the housing market temporarily but lead to a healthier economy. Restructure mortgages for honest homeowners who were misled, reappraising homes to their actual distressed values. Don’t reward borrowers who gamed the system or those who willfully overextended. Don’t compensate sophisticated finance professionals for risk they themselves enabled.

The losses, she argues, should be borne by subprime mortgage bankers, investment banks that provided their financing, and investors in subprime mortgages and CDOs backed by them. There was no reason for US taxpayers to bail out sophisticated financiers.

That argument got tested in 2008. The results are history.

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