Page 2 of 3 Of termites and index
mania By Julian Delasantellis
not particularly profitable option for the
lenders (not to mention being absolutely
catastrophic for the borrowers).
Indeed,
late May saw reports that some hedge funds (those
without ongoing relationships with public
relations firms, no doubt) were actually unhappy
with what they saw as the sluggish pace of lender
foreclosures. These funds had initiated trades
that hoped to
profit from a further fall in
the ABX; for them, foreclosures would have in
essence represented a climactic consummation of
the act of seeking bliss from the gathering
financial misery of the subprime borrowers.
And so, as June began, the sound of corks
popping out of champagne bottles drowned out the
sound of the termites continuing to eat through
the foundation underneath US finance capital. Then
it happened. Somebody put his hand through the
wall, or tried to nail a picture, and all the
sawdust started pouring out.
In my July 6,
2006, article Hedge funds: Playing dice with the
universe, I explained that one of the
major reasons hedge funds were able to exert such
disproportionate market influence was that,
besides the substantial pools of money the hedge
funds were raising from their investors, they were
also funding the huge positions they were taking
in the markets with substantial borrowing, what
the markets call leverage, in amounts sometimes up
to 20 times their capital base.
The Bear
Stearns brokerage house thought it had come up
with some really neat ideas. It would set up two
in-house hedge funds, the Bear Stearns High-Grade
Structured Credit Strategies Fund and the High
Grade Structured Credit Strategies Enhanced
Leverage Fund. The funds' strategy for achieving
those juicy hedge-fund-type returns would be to
invest in pools of subprime mortgages bundled
together with other loans into bond packages
called collateralized debt obligations (CDOs).
Then, Bear Stearns had an even better
idea. It would not just buy the CDOs and then sit
on them until the mortgages were paid off in 10 or
20 years or so; that would have earned the funds a
return roughly equal to the coupon yield of
mortgage bonds, about 8-10% a year. That's a
decent enough return for us average investing
mortals, but for hedge-fund managers obsessed with
having their names and pictures at the top of the
performance rankings, it wouldn't even get them in
line to rent a chaise longue at a public beach in
the Hamptons - a popular vacation spot on New
York's Long Island - this summer.
In
today's era of turbo-finance, the distinctions
between who the borrowers are and who the lenders
are have become blurred; many borrowers borrow so
they can immediately turn around and lend the
proceeds to others, who will then do likewise. For
Bear Stearns, instead of just buying the CDOs and
sitting on them for a decade or two, it would now
have the funds use them as collateral for big new
loans from other financial institutions.
With the borrowed money, they could go
back into the market and buy lots more
high-yielding subprime-mortgage-based CDOs, in
essence using the borrowed money to do more
lending. Their high yields would substantially
boost the reported returns of the funds and, since
returns are measured against the percentage
appreciation of the fund against its capital base,
not the leveraged base, the funds would
instantaneously be able to report much higher
rates of return. For the fund managers, the
temptation was irresistible - a better life and a
shiny trophy wife were just the next reporting
period away.
As long as the CDOs that Bear
Stearns borrowed against maintained their value.
As long as the ultimate money behind the CDOs, the
homeowners who actually took out the subprime
mortgages that made their way into the CDOs, kept
making the mortgage payments that got passed
through to the owners of the CDOs.
Uh-oh.
By early June, Bear Stearns and other
titans of US finance had, both as borrowers and
lenders, their subprime-based paper spread all
over Wall Street, and that definitely presented a
problem. The lenders who had accepted Bear
Stearns' paper as collateral saw the price of the
ABX index heading south once more, and knew that
it meant that more subprime mortgage holders were
becoming delinquent, and thus facing foreclosure,
on their loans.
Of course, this implicitly
reduced the value of the CDOs that Bear Stearns
had proffered to be used as collateral. (I say
"implicitly" because no one really knows what
these CDOs are worth at any given moment - they
are not traded, with reportable trade results, as
are stocks and bonds. In financial-markets lingo,
this is said to make them "illiquid".)
This put the lenders in a fairly tricky
position. Written into the loan agreements in
which they lent money to Bear Stearns' hedge funds
were covenants that in essence allowed the lenders
to seize the collateral that Bear Stearns put up
as security, the CDOs. In essence, the lenders had
the right, like Harry Dean Stanton and Emilio
Estevez in the 1984 cult classic Repo Man
(but without the glowing aliens or the weirdo
nuclear scientist) to repo the CDOs and take them
back to the yard.
This presented the
lenders with another dicey situation. Much like
the players in the classic game-theory exercise
Prisoner'S Dilemma, there was a tremendous
incentive for the lender who acted first; later
lenders might find that quicker players might have
already seized all Bear Stearns funds' capital
away.
It was Merrill Lynch that sent the
tow trucks in first.
So what did they get
when they lowered the CDOs down from the hook?
Do you want to borrow some money from the
bank, using the equity in your home as collateral?
Fine, "just write us at the bank a check for about
$500, so we can hire an appraiser to check your
home's current worth". A core way that will be
done is to have the appraiser check the recent
sales prices of comparable homes in your
neighborhood, what the trade calls "comps". No way
will the bank allow you to borrow anywhere near
what your house is worth. If you default, the bank
wants to be sure it can get back the value of the
loan through a foreclosure sale of your property.
Bear Stearns had to go through no such
indignity. As CDOs are not actively traded in any
secondary market, there were no available comps to
compare their value against; in market jargon,
they cannot be "marked to market". Instead, the
international bank capital reserve regulations
known as Basel II allow CDOs to be valued through
an arcane process called "marked to model".
This involves Bear Stearns hiring some
hungry underemployed math PhD, and having him
construct a CDO pricing "model", in essence a
series of complex algorithms, that allowed the
company to enter a CDO's particulars on the front
end, and then having the model spit out a SWAG
(scientific wild expletive-for-posterior guess)
value to Bear Stearns' liking out of the back end.
The lenders, Merrill Lynch among them, knew full
well the questionable nature of the process that
valued the loans; then again, Bear Stearns was
paying them a whole lot more on their loans than
US Treasury bills were paying.
Merrill
Lynch's traders virtually tripped over their Bruno
Maglis in their rush to sell the seized CDOs. When
they did, boy were they in for a surprise.
The CDOs were not fetching anywhere near
the values the pricing models said they should. On
June 24, New York Times finance columnist Gretchen
Morgenson wrote an article about this; her editors
gave it the title "When models misbehave";
evidently, the Old Gray Lady's honchos were hoping
to get some interest from
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