CDO losses for Bear Stearns hedge funds

http://www.smh.com.au/news/business/stearns-offers-to-take-over-loans/2007/06/22/1182019375970.html

Don't know if people saw this, since the SMH tucked it into an inner page.

The short version is: two hedge funds run under the Bear Stearns banner recently suffered big losses on their sub-prime mortgage bets involving CDOs (debt derivatives). Bear is now going to bail the funds out instead of just letting them go bust, even though it has no legal obligation to help them.

The interesting points are:
1) Bear is bailing them out, and the hedge funds' lenders didn't quickly call in their loans when the losses appeared because they are concerned about what would happen to the MARKET if the funds had to liquidate their positions. Many CDOs are very specific OTC instruments and therefore very illiquid.

2) If the hedge funds had to liquidate their CDOs, it's likely they will be sold at a crap price. The key is that if this happens, OTHER CDOs of this type will have to be marked to market and take (unrealised) losses. It's like when the house next door sells at a low price because the vendor is desperate. The problem is that affects YOUR house price. In finance this is a legal requirement (you price your CDO, for example, at the latest traded price).

3) This illustrates just how much is built on confidence in this market, especially with illiquid securities. If the hedge fund liquidation went ahead, OTHER funds with such CDOs will be affected. It's like when Long Term Capital Management blew up and the banks came in and supported it because they didn't want it to take down the whole system.

4) Hedge fund compensation (paid in cash) is based on unrealised gains as well as realised gains. You have to wonder how much of the gains racked up by hedge funds in illiquid securities is just because nobody has gone bust yet. i.e. a confident market begets higher prices which begets more confidence. A crash (whether justified or not, and in this case you can argue it's just the hedgies betting too big compared to what they had) will force OTHER funds to mark down their holdings, and hence drag down THEIR returns.

Hedge funds get paid based on the results for that year only. e.g. Fund A makes 40% one year and a 40% LOSS the next year. What do the managers get? Other than asset management fees, they would get maybe 8% the first year in profit share and nothing in year 2. The year 2 loss doesn't affect the year 1 bonuses.

This means hedgies are encouraged by their pay schemes to go crazy and bet big. If they fail, they can just close up shop.
Alex

Hedge funds get paid based on the results for that year only. e.g. Fund A makes 40% one year and a 40% LOSS the next year. What do the managers get? Other than asset management fees, they would get maybe 8% the first year in profit share and nothing in year 2. The year 2 loss doesn't affect the year 1 bonuses.

Hi Alex lee

The industry standard is 2% management fee and 20% of profits which really makes the big bet worth their while. If you want to look at returns and other data of funds this is a good site.

http://www.iasg.com/

The problem lies with the collateralised effect of these products that are spread through the investment banks during the real estate investment boom. This is the one of those possible catalyst factors for a "black swan" event due to the leverage involved and the broad market risk that the buyers of these CDO's have when they are forced to mark these loans to market.

Cheers

Shane

plusnq said:

This is the one of those possible catalyst factors for a "black swan" event due to the leverage involved and the broad market risk that the buyers of these CDO's have when they are forced to mark these loans to market.

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The key observation, for me, is that in the modern world of finance a crash feeds upon itself and may have nothing to do with fundamentals. A hedge fund can go down because leverage magnifies losses, liquidate which causes securities prices to go down, causing returns on other funds to go down and people pull money out of the market. The fundamentals can mean nothing.

The market is sometimes supported only by confidence. Most of our currencies, after all, are supported by nothing more than our confidence in the issuing government.
Alex

plusnq said:

The industry standard is 2% management fee and 20% of profits which really makes the big bet worth their while. If you want to look at returns and other data of funds this is a good site.

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Exactly. The 2/20 fee structure makes markets more volatile because the hedgies have an incentive to swing for the fences. The significance for me is that this is just one more source of volatility in the market. Though my opinion is coloured by the fact that I expect a recession in the short to medium term.
Alex

alexlee said:

Don't know if people saw this, since the SMH tucked it into an inner page.

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There's been a couple of posts in the ASX - where to next? thread.

CDOs is one of the left of field events that may (in a few years) be pinpointed as the beginning of the end of the current bull market. Or maybe it'll be the harder than expected US housing landing. Buffet & Bank England (among others) have warned about the dangers of derivitives & their complexity & lack of transparency.

alexlee said:

The significance for me is that this is just one more source of volatility in the market. Though my opinion is coloured by the fact that I expect a recession in the short to medium term.

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If you keep telling us the recession will be in the short to medium term, we might start wanting to know what you call the short to medium term. I call it sometime between tomorrow and in 5 yrs time.

I feel there will need to be a few more bumps in the road before the end of this cycle. However, I agree that we are one incident closer......

alexlee said:

The key observation, for me, is that in the modern world of finance a crash feeds upon itself and may have nothing to do with fundamentals. A hedge fund can go down because leverage magnifies losses, liquidate which causes securities prices to go down, causing returns on other funds to go down and people pull money out of the market. The fundamentals can mean nothing.

The market is sometimes supported only by confidence. Most of our currencies, after all, are supported by nothing more than our confidence in the issuing government.

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The same happens with margin calls - when what should be a small correction turns into a big one. However, the fundamentals are still meaningful - that's the nirvana that value investors are hanging out for.

keithj said:

If you keep telling us the recession will be in the short to medium term, we might start wanting to know what you call the short to medium term. I call it sometime between tomorrow and in 5 yrs time.

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I'm not selling and building a bunker, but I'm wary of putting any new money into the market.

keithj said:

The same happens with margin calls - when what should be a small correction turns into a big one. However, the fundamentals are still meaningful - that's the nirvana that value investors are hanging out for.

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The key is just HOW bad confidence gets. Normally, in a crash prices find a floor when enough people feel confident that the worse is over. Unfortunately there's no way to tell where that level is since it's all psychological. We talk about fundamentals but we also have to recognise that the fundamentals themselves are affected by psychology. If you buy for the long term it won't be a problem, of course.
Alex

alexlee said:

The key is just HOW bad confidence gets. Normally, in a crash prices find a floor when enough people feel confident that the worse is over. Unfortunately there's no way to tell where that level is since it's all psychological. We talk about fundamentals but we also have to recognise that the fundamentals themselves are affected by psychology.

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I can see how price is affected by sentiment. What fundamentals do you see affected by pyschology?

keithj said:

I can see how price is affected by sentiment. What fundamentals do you see affected by pyschology?

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Note the below are just rambling thoughts. Usually I think through my posts on markets and economics a bit more, but I haven't though this completely yet:

I would view fundamentals as, say, basic demand for goods and services. The problem is how to define 'wants'. Fundamentals can shrink if you include 'wants' into your fundamental baseline. i.e. you might find the fundamentals are lower than you originally thought because you include 'wants' into your fundamentals and 'wants' are affected by consumer psychology.

You would think a zero interest rate would be enough to get people and companies to consume and invest and borrow to do so, but Japan has shown that even a zero rate policy may not be sufficient to stimulate demand.

i.e. in Japan I would say the 'fundamentals' baseline actually fell, partly because the 'fundamentals' assumed 'normal' consumer behaviour, and that can change in certain situations. The main reason in Japan for this was deflation and general fear of losing their jobs.

Ironically this stemmed from the govt not letting companies go under: consumers started wondering how long the govt could keep doing it. While waiting for the other shoe to drop, they kept their wallets closed. As it turned out, the govt has managed to keep it going, but consumers still have the fear, so they haven't been consuming. This lack of consumption makes the economy worse, which increases the fear businesses will go under. In a boom, of course, the reverse happens.

Over the long term, fundamentals should underpin the market. However, Japan managed to go through a decade of everyone keeping their hands in their pockets. What I (think) I'm saying is that what we view as fundamentals may not actually be as solid as we think, and therefore the level of support can be lower. Derivatives and so on makes this worse as derivatives will force funds, for example, to sell because their returns are more volatile.
Alex

alexlee said:

Note the below are just rambling thoughts. Usually I think through my posts on markets and economics a bit more, but I haven't though this completely yet:

I would view fundamentals as, say, basic demand for goods and services. The problem is how to define 'wants'. Fundamentals can shrink if you include 'wants' into your fundamental baseline. i.e. you might find the fundamentals are lower than you originally thought because you include 'wants' into your fundamentals and 'wants' are affected by consumer psychology.

You would think a zero interest rate would be enough to get people and companies to consume and invest and borrow to do so, but Japan has shown that even a zero rate policy may not be sufficient to stimulate demand.

i.e. in Japan I would say the 'fundamentals' baseline actually fell, partly because the 'fundamentals' assumed 'normal' consumer behaviour, and that can change in certain situations. The main reason in Japan for this was deflation and general fear of losing their jobs.

Ironically this stemmed from the govt not letting companies go under: consumers started wondering how long the govt could keep doing it. While waiting for the other shoe to drop, they kept their wallets closed. As it turned out, the govt has managed to keep it going, but consumers still have the fear, so they haven't been consuming. This lack of consumption makes the economy worse, which increases the fear businesses will go under. In a boom, of course, the reverse happens.

Over the long term, fundamentals should underpin the market. However, Japan managed to go through a decade of everyone keeping their hands in their pockets. What I (think) I'm saying is that what we view as fundamentals may not actually be as solid as we think, and therefore the level of support can be lower. Derivatives and so on makes this worse as derivatives will force funds, for example, to sell because their returns are more volatile.

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OK, you're talking about the general publics sentiment, rather than stock market specific sentiment.

House prices affect public sentiment, which may affect consumption. I'd have thought the public don't care so much about CDOs ATM.

keithj said:

OK, you're talking about the general publics sentiment, rather than stock market specific sentiment.

House prices affect public sentiment, which may affect consumption. I'd have thought the public don't care so much about CDOs ATM.

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Given that a lot of hedge fund money comes from 1) pension funds and 2) loans from other banks, if hedge fund losses start impacting on bank profitability and pension fund returns, the public will start noticing. Also derivative losses may affect sharemarkets, and almost everyone (if only via their super funds) will be affected. Just as a drop in housing returns will decrease spending, if the sharemarket hits a bump, that will be affected as well.

In any case, I'm just saying that's one potential source for a bust. It might not be an issue but it really does depend on the psychology of the finance world as well as of the ordinary person. I'm not stopping my investing or anything: I'm looking to buy my PPOR in the next 6-12 months.
Alex

Given that a lot of hedge fund money comes from 1) pension funds and 2) loans from other banks, if hedge fund losses start impacting on bank profitability and pension fund returns, the public will start noticing.

Absolutely correct. But usually the public are the last to know (hence distribution tops). I'd rather be leaving the party early than heading for the exit with everyone else once the fire starts.

CDO's are are a great example of the failure of fundamentals. No-doc and lo-doc loans packaged up and rerated into higher grade investments. Then sliced and diced and repackaged and rerated again. Suddenly high risk, low quality investments are sold to funds and banks as high grade investments. When someone turns the music off ala Merrill Lynch taking 50c in the dollar, the "investments" start to be rerated by the market. Funds which are only allowed to hold investment grade packages suddenly are forced to sell due to the rerating of the CDO's. Forced selling accentuates and eventually reaches the attention of the general public ala LTCM. Add in rising interest rates (anyone looked at bond prices recently?) and the mix is a heady volatile mixture looking for a spark.

As a trader who trades technically but manages leverage via macro fundamental analysis, I reduced all leverage a while ago. I don't know when someone is going to turn of the music, but by reducing my leverage at least I am closer to the exit than someone who is still margined up. Obviously someone who is a buy and hold investor and who has a large margin of safety, has less issues than fund managers who use leverage to wring every last drop of return from their trading.

Those who understands economic cycles will have an appreciation that this bull run in resources probably has a fair way to go yet (with its obvious bumps along the way). There certainly are world economic growth forces via Asia and Latin America that will continue to persist as they become more middle class and urbanised. There are several worries present on the horizon as I see it. Energy supply issues (oil, coal, natural gas), Geo-political tensions (Iran, Russia, China, Israel) regarding access to energy and resources, and ever expanding $US debt are all able to significantly slow or derail the current economic expansion. The US investor has seen their purchasing power decline by a third since the start of the decade (see $US index). If the Asian central banks decide to reduce their level of support for the dollar either by allowing rerating of the yuan or buying less Treasury bonds, then this will be exacerbated. I am sure that the American public will be aware of the issue then!

Finally from a technical viewpoint the XAO is forming a broadening wedge which is a reversal pattern. The percentage of shares above their 150 day moving average have been falling and the pattern looks ready for a correction soon. When...who knows?

Cheers

Shane

Shane, what's your view on China using some (a very small amount, granted) of its reserves to invest in things other than T-bills (such as Blackstone)? Do you think this signals the start of lowered demand for t-bills, resulting in higher interest rates for the longer maturities?
Alex

hi alexlee
I did have a read a bit about this market and you need to understand this type of hedging market.
usually market hedges hedge against a rise and a loss in a market but this is very different.
the american market is very different to here in australia and so is there hedging funds .
you are right with regard to a property impacting on next door pricing but this is not unusual, thats why alot of aust banks are holding stock at the moment and if they release they will bring down their book price on their holding product.
for instance if you are holding a 10mil property and next door comes on the market at 5 mil you have to buy to hold your position.
this is the same as is happening in the us market
the problem is that there are to many holes and because they have companies that have what you would understand as margin lending on resi property.
they are hold large tracks of land ( and why I have not looked at the us market)
and the market is looking at going west.
the funds have over stretched and have not started bleeding yet.
this is not the end to a market its a movement and fund will get burnt and if its a requirement to buy to hold position then thats whats required.
and I think in their current market its probably right.
my .002

Hi Alex

Shane, what's your view on China using some (a very small amount, granted) of its reserves to invest in things other than T-bills (such as Blackstone)? Do you think this signals the start of lowered demand for t-bills, resulting in higher interest rates for the longer maturities?

It seems to me that they are trying to secure access to resources and hard assets. Because of the need to prop up the US economy by recycling the money which enables US consumers to continue buying...I don't think they will abdicate from holding TBonds. As I see it the Chinese buy our resources, turn it into goods to sell to the US. The Chinese then buy TBonds which recycles the money back into the US. This money is then lent out and the cycle continues. The excess money in circulation causes asset price inflation.If the Chinese stop/dramatically reduce their buying of TBonds, then this could have a real implication for asset prices and Bonds/interest rates in the US.

Cheers

Shane

Shane what's your view on the end of bull markets?

I have seen it printed that most bull markets do actually roll over rather than crash and you should wait three months after you suspect this has happened, as corrections in a bull market tend to be sharper and faster than a general bear market. Got most of that from Ken Fisher.

Personally I'm yet to encounter any mechanical idea that times a top at all well, despite knowing a few really decent ones that identify excellent times to be buying.

We still haven't seen any exuberance in terms of pure % moves on the ASX, not to say they will arrive, just that if we are to have a bubble party then it's been a very sad one so far.

Andrew

I have seen it printed that most bull markets do actually roll over rather than crash and you should wait three months after you suspect this has happened, as corrections in a bull market tend to be sharper and faster than a general bear market. Got most of that from Ken Fisher.

Sadly the bear market can only be confirmed after the event. However being aware of the macro fundamentals and market behaviours at turning points is useful especially for risk management. The current XAO is certainly able to retest 5800 and still be in a bull market. A decline below the last major correction of 4750 would signify a real problem. The pattern of bear markets, I believe, is related to the rate of change of the market being looked at. If you look at larger capitalised, more established markets such as SP500 or the DJIA, then broadening tops tend to occur unless there has been a fast run up as there was in 2000. Even then these markets showed a rolling top rather than a calamitous sudden drop. Markets such as the NASDAQ and RUSSELL in 2000, had had such a great run up that the drop was rapid and calamitous as everyone ran for the exit.

Thomas Bulkowski has done the most recent work on patterns in stock markets. Here is a link to bear market patterns.

http://www.yrtrader.com/manuals/257BULK.pdf

We still haven't seen any exuberance in terms of pure % moves on the ASX, not to say they will arrive, just that if we are to have a bubble party then it's been a very sad one so far.

I don't think the ASX is going to be the index taking away the punch bowl at this party. Aus is more like the caterers at someone else's party. We are providing the goods (resources) and making a handsome profit from it. The overindulging is happening with the hosts (China) and their guests (investors).

IMHO people underestimate the degree of correlation between markets especially at times of high liquidity. The money looks for a return and so all asset classes become correlated to some degree on the way up. This is greatly magnified as everybody rushes for the door. It is difficult to sell if no-one wants to buy. If you aren't leveraged then it is not a major issue if you believe that you can ride out the market. Of course, if it is a multiyear (or decade as in 1960's-1970's ) bear market, then the opportunity cost of capital may be an issue. I have posted the change in correlations before but here they are again for those who may be interested.

I am not saying that we are about to have a major bear market imminently. Whilst it is always possible given geo-political considerations, I like most people hope that it doesn't evolve that way. That doesn't mean a significant correction isn't on the horizon. Looking at the major indices and macro-economic fundamentals may suggest where the bubble has been and where one of the catalysts may be.


Hope this helps.

Cheers

Shane

plusnq said:

I am not saying that we are about to have a major bear market imminently. Whilst it is always possible given geo-political considerations, I like most people hope that it doesn't evolve that way. That doesn't mean a significant correction isn't on the horizon. Looking at the major indices and macro-economic fundamentals may suggest where the bubble has been and where one of the catalysts may be.

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Shane what are you trying to say,it's very easy to work out the
"cost of debt" for any company it's simply the interest a bank
charges for the privilege of using it's/shareholders/ money and if
the company's captial is costing more than the returns then all
you have is a company that is destroying the shareholders longterm/shorterm vlaue,and i watch several that are in that
boat as we speak, there are a few companies out there that
are generating a greater return on their capital that what it
is costing them and these are creating shorterm shareholder
value..good luck willair..
When the ASX drops 75 point this morning, who is it going to
worry,it will not worry me 1%, because i have longterm plan
some will need a wake up call, but that's what margin lending
is all about and risk management..
good luck willair..

Hi Will

It is not my goal in life to convince you to my way of thinking and I apologise if I have offended you in some way. Like yourself, I have a wealth creation and protection plan and I monitor it closely. It happens to be a lot more broad than just monitoring individual company risk.

There are many risks to consider in any trading or investment strategy. these may include;

Inflation risk: where your purchasing power is eroded by rising prices.

Interest rate risk: obvious to most here as a cost of doing business. Also reduces attrractiveness of shares that pay dividends if the yields are greater for cash deposits (cash cycle).

Economic risk: decreased company earnings due to decreased economic activity.

Geopolitical and sociopolitical risk:The risk where governments may change tax status of investments (agribusiness in Oz) or even default on loans (Russia). Nationalisation of assets (?oil, Venezuela/Russia).

Currency or exchange rate risk: a declining currency can markedly reduce returns on overseas investments. Also a declining home currency erodes purchasing power for goods manufactured overseas.

Market risk: specific to market eg is the market rise sustainable (NASDAQ 2000,
? Shanghai Composite 2007)?

Sector risk: is this the right sector to be invested in in this stage of the business cycle?

Individual share or company specific risk: which you alluded to.

Liquidity risk: can I get out of this and at what price if everybody wants to sell at the same time? Am I the market? How many bid levels will I move to get out of my position?

Reinvestment risk: What yield is available in the economy for my acceptable risk level? How long do I wish to lock up these funds for?


I wish you well in your endeavours.

Cheers

Shane

plusnq said:

Interest rate risk: obvious to most here as a cost of doing business. Also reduces attrractiveness of shares that pay dividends if the yields are greater for cash deposits (cash cycle).
Liquidity risk: can I get out of this and at what price if everybody wants to sell at the same time? Am I the market? How many bid levels will I move to get out of my position?

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That's all the downside covered,no need to apologise to me in any way
it's just another day even with every arrow is the red,but i said the same
to myself when the ASX hit the 4500 mark ,do I cut and run or go with flow
,the same 5500,6000,this is no different ..good luck willair..

willair said:

it's just another day even with every arrow is the red,but i said the same
to myself when the ASX hit the 4500 mark ,do I cut and run or go with flow
,the same 5500,6000,this is no different ..good luck willair..

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Some green arrows in all the red.
BHP amongst others has come up green so far.