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More Hedge Fund Woes

By: Frank Armstrong

By: Frank Armstrong, CFP, AIFA

Hedge funds are in the news again. The near melt down of two Bear Sterns funds sent ripples through the world’s financial markets. We are detached observers to the entire mess because we never participate in hedge funds, but the sorry situation provides some valuable lessons for investors. Here’s the Cliff Notes on the how the mischief unfolded.

The underlying asset was subprime debt – Junk by another name. By now everyone is aware that part of the housing bubble was generated by providing people that never should have gotten credit with loans that had the potential of wiping them out if everything didn’t go just perfectly. The mortgage industry went into a frenzy of lending with products designed to enable folks to purchase homes with no money down, lie their way to financing, not verify their income or assets, and/or extend credit to people with bad credit histories. If you think that sounds a little dubious, you are right.

More than $800 billion worth of bonds is backed by subprime mortgages, according to Credit Suisse Group in Zurich.

Many Sub prime mortgages are a “toxic financial product”. Teaser loans, no money down, interest only, or variable loans can come back to bite with a vengeance. Terms of the loans were often not understood by borrowers, and/or blatantly misrepresented by lenders. There is plenty of suffering out there in middle America as a result.

These chickens eventually came home to roost causing grief as thousands of homeowners default when payments rose to levels they could not budget. A vicious mixture of huge oversupply of houses in many markets coupled with a large number of homeowners in acute distress propelled housing prices into virtual freefall.

A total of 11 percent of the loan collateral for all subprime mortgage bonds had payments at least 90 days late, were in foreclosure or had the underlying property seized, according to a June 1 report by Friedman, Billings, Ramsey Group Inc., a securities firm in Arlington, Virginia. In May 2005, that amount was 5.4 percent.

Of course, the people that originated the loans didn’t want to keep them on their books. They sell them to financial institutions that in turn bundle billions of dollars of loans into a pool, then sell different parts of the pool to different buyers. The financial instrument, a derivative product, is called a Collateralized Debt Obligation (CDO). The different parts are called tranches, and each has a different character. The tranches with the lowest risk pay the lowest coupon, while the tranches with the highest risk of default pay substantially more.

There are two problems with this picture which set the stage for some serious mis-pricing. First, otherwise rational people made insane predictions about the default rate. Second, the market was so thin that it was almost impossible to get appropriate prices for the CDOs. Prices for these assets are not recorded and disseminated like other bond products are. So, traders had to rely on market makers to tell them what to pay. This almost sounds like the bad old days when Drexel Burnham had the junk bond market to itself and unilaterally set prices. Strangely asleep at the switch, the various credit reporting services (Moody’s and Standard and Poor’s) kept credit ratings high long past the time it was apparent to the world that the CDOs were having some serious problems.

The hedge funds waded right into this swamp. They perceived that the prices were wrong and took big bets on it. Some made a lot of money on their wagers. Unfortunately other funds were dead wrong and the prices moved against them. That’s the way it goes when you speculate.

Not content with just holding the paper long or short, some funds bet on the spread between the tranches. They leveraged up their positions by selling one side short and using the proceeds to buy the other side long. This is a common hedge fund strategy. It always works until the unexpected happens. And then, Katie bar the door. In an atmosphere where nobody knew the default rate on the underlying mortgages, and nobody knew the prices of the CDOs bad things were likely to happen to some of the players.

Apparently, Bear Stearns’ two hedge funds inadvertently became famous by taking really huge bets on the spread, and the rest is history. Bear Stearns is well known for canny risk management, but in this case the traders got way out of control. Bear Stearns stepped up to the plate to bail out one of the funds by infusing their own capital, in part to prevent creditor Merrill Lynch from seizing and selling assets at fire sale prices.

Bear Stearns is hardly alone. They are only the best known of the hedge funds suffering from the CDO problem. Across the country and around the world, funds are closing down and/or freezing redemptions. Unlucky investors are likely to get more bad news in the coming days.

The whole sordid story has lessons for investors. It’s highly unlikely that one of a thousand investors had any real understanding of the risks built into the fund. Certainly the managers didn’t! And, of course, the salesmen simply relied on what management told them to sell.

At a macro level, Alan Greenspan argued that hedge funds serve a useful purpose by encouraging risk taking and making markets more efficient. That may be. But, for our investors hedge funds are a product with no transparency, no oversight, and no meaningful disclosure. You might as well buy a pig in a poke. Don’t even get me started on the obscene fees to participate in this lottery.

Professional selection through funds of funds didn’t help the investors of a Scottish fund that held both Bear Stearns funds and Amaranth. All that professional help did successfully add a layer of fees, aggravating an already dismal experience.

Leverage leads to both eye popping returns and devastating risks. Apparently, no one can tell whether the lady or the tiger is behind the door. After all, if Long Term Capital, Bear Stearns, and Amaranth can all blow up hedge funds, just who do you think can be relied on to deliver consistent results?

Hedge funds: Just say, NO!