Trouble in Hedgefundistan: “Its gonna get a lot worse”

Trouble in Hedgefundistan: “Its gonna get a lot worse”

Jul 22, 2007 - 03:04 PM

By: Mike Whitney

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Two columns of black smoke can be seen rising over Wall Street and disappearing into the ice-blue New York sky.

Terrorism?

Notquite. The plumes of smoke are all that's left of two major hedge fundswhich blew up just weeks ago leaving nothing behind but a fewsmoldering embers and a mound of black soot.


The compiledassets of the Bear Sterns High-Grade Structured Credit StrategiesFund—nearly $20 billion—have vanished into the miasma of cyber-spacewhere they will soon be joined by $1.4 trillion of other, equallyworthless, Collateralized Debt Obligations (CDO).

If you lookcarefully, you can almost see the mangled and bloodied bodies of theCDOs, the CSDs, the RMBS and the other shaky debt-instruments beingpulled from the wreckage and tossed unceremoniously on the bonfire.

Isthis how it all ends? The first whiff of trouble in the housing marketand then—in a flash--all the funds in “Hedgistan” begin teeteringtowards earth?

“No Value”-“No Bids”

According toBloomberg News, Bear Sterns announced last week that there's “littlevalue left” in one of its funds and “no value left” in the other.

Nothing, nada, zippo.

The news was like a bucket of cold water dumped on the stock market leaving slack-jawed traders shuddering in trepidation.

What does it all mean?

Doesthat mean that the entire hedge fund empire—which is built on afoundation of dodgy loans and quicksand---may be headed for the crapper?

Noone really knows. But a pall has settled-in over downtown Manhattanwhere gloomy-looking men in pinstriped suits are waiting for the othershoe to drop.

Y'see, the hedge fund industry is based on thebizarre notion that one does not have to produce anything of value tomake boatloads of money. You don't even need assets any more---just arisky loan that can be transformed into an investment grade securitythrough the magic of “securitization” a sprinkling of Wall Street snakeoil.

Abrah Kadabra---presto-chango!

It's like taking shards of bottle-glass and selling it as the Hope Diamond. Who's gonna notice?

The only catch is that--now that these toxic CDOs are going to auction--there are no bids. That's a bad thing.

“Nobids” means that $1.4 trillion of shaky investments have no discernablemarket-value. The CDOs were graded “mark to model” which translatesinto “mark to fantasy”. It means that the investment bankers and hedgefund managers got together over Martinis one night and pulled a numberout of a hat.

Now no one wants to buy them. They're worthless.

The skydiving hedge funds just pulled the CDO rip-chord and nothing came out but confetti.

Aaaaaaaahhhh!

Andthat's just half the story. There's trillions of dollars in derivativesriding on these shaky CDOs. That's enough to bring down the wholemarket in a heap once interest rates rise or liquidity dries up. Nowit's just a matter of “when” now, not “if”.

This illustrates an important point, though. It shows what it takes to be a good hedge fund manager:

Takea shabby sub-prime mortgage; chop it into “investment”, “mezzanine” and“equity” tranches. Bundle it with other equally suspect mortgage backedsecurities (MBS). Decide (arbitrarily) what the CDOs are worth Tellyour banker. Leverage at a ratio of 10 o 1. Take 2% “off the top” plussalary for your efforts. Buy a summer home in the Hampton's and a Lexusfor the wife. Wait for the crash. Then repeat.

Congratulations; you are now a successful hedge fund manager!

Ohyeah; and don't forget to prepare a few soothing words for theinvestors who just lost their entire life savings and will now bespending their evenings squatting beneath a nearby freeway off-ramp.

“We're so very sorry, Mrs. Jones. Can we get you some cardboard-bedding to keep off the rain?”

Theproblems that are appearing in the stock and bond markets all startedat the Federal Reserve when Fed-Chief Alan Greenspan opened thesluice-gates in 2003 and lowered interest rates to 1%. (Way below therate of inflation) Since then, trillions of dollars have flooded intothe markets creating multiple equity bubbles in real estate, stocks andcredit.

Serial bubble-maker Greenspan is to finance-capitalism what Wrigley is to chewing gum. The greatest flim-flam man of all time.

TheFed has tried to conceal the massive increase to the money supply, butthe evidence is everywhere. (Many analysts now calculate that inflationis running at roughly 13%) Food and energy have skyrocketed. Housingprices have soared. Everything has gone up except the cheapo importswhich the Fed uses to manipulate the inflation stats.

Thegigantic housing bubble is mostly Greenspan's doing. After printing-upmountains of cash and creating artificial demand through low interestrates; he promoted his product-line with the typical huckstersales-pitch. “Maestro” advised us that the extension of credit toall-God's creatures, worthy or not, is a good thing.

Here's a clip of Alan praising subprime lending in a speech on April 8, 2005:

"Withthese advances in technology, lenders have taken advantage ofcredit-scoring models and other techniques for efficiently extendingcredit to a broader spectrum of consumers. . . . As we reflect on theevolution of consumer credit in the United States, we must concludethat innovation and structural change in the financial servicesindustry have been critical in providing expanded access to credit forthe vast majority of consumers, including those of limited means. . . .This fact underscores the importance of our roles as policymakers,researchers, bankers and consumer advocates in fostering constructiveinnovation that is both responsive to market demand and beneficial toconsumers."

Yes, of course, with all these “advances intechnology” and new-fangled “credit-scoring models” why would we needto verify a loan-applicant's income or require that he scrape togethera measly $5,000 for a $450,000 mortgage?

That's all so 20th Century!

Nowthat foreclosures are mushrooming at an unprecedented pace, the Fed istrying to distance itself from the problem by blaming the banks fortheir shoddy underwriting practices. But the guilt lies with theCentral Bank. Its all part of their whacko plan to crush the dollar andcreate a police state.

It may sound trite, but “inflation istheft”. Unfortunately, inflation is also part of the ruling class'strategy to rob the poor, fuel the stock market with cheap credit, andmove jobs overseas. It is the autocrat's method of “socialengineering”---shifting wealth from one class to another by simplyprinting more money and pumping it through the system via low interestrates. Remember, bankers know that people will ALWAYS borrow money iflending standards are relaxed and the money is cheap enough. At 1%, theFed was basically losing money on every transaction, but persisted withtheir plan anyway.

Anyone who cares to go back and traceinterest rates moves for the last 7 years will see that the Fed isreally a political organization that decides monetary policy entirelyon the basis an elite agenda that supports endless war, outsourcing ofAmerican jobs, and domestic repression.

Are you surprised?

Now,a bad situation is about to get a whole lot worse. Consumer credit roselast month by a whopping 12.9%---credit card debt by 9.8%! Sincehousing prices have flattened out, homeowners can no longer borrow ontheir dwindling equity (Mortgage Equity Withdrawal; MEWs) which isforcing the maxed-out American consumer to use plastic even thoughrates are averaging from 18% to 27% monthly.

Automobile reposhave also hit historic highs. But the real damage is showing up in thesubprime market where the percentage of defaults continues to riseunabated.

In itself, a correction in real estate is not enoughto bring down the whole economy. Unfortunately, the contagion from thesubprime meltdown has spread to the stock market, the insuranceindustry, banking and pensions. Not even Secretary of the Treasury,Henry Paulson or Fed-master Ben Bernanke are claiming that the subprimeproblems are “contained” anymore. Just this week, the scholarly lookingBernanke said to Senators on the Hill that the housing market has“deteriorated significantly”.

It's about time. If anyone stillhas any doubts about the magnitude of fiasco, I recommend they lookover these eye-popping charts which tell the whole story. The housingblowdown will spread the carnage from “sea to shining sea”.http://www.itulip.com/forums/showthread.php?p=12232#post12232

Thefaltering housing market has drawn attention to an even more colossalcredit bubble that is limping towards earth as loan requirementstighten and liquidity dries up.

The prevailing fear on Wall Street is that we may be seeing the beginning of a global credit crunch.

Thedanger is not just the subprime loans or even the mortgage companiesthat made the loans, but the overall risk to the secondary market wherethese loans have been sold as CDOs to the tune of $1.8 trillion.

Inthis new deregulated environment, the banks don't have to rely onsavings anymore to make the loans. They simply originate the loans,take their commission, and sell the debt as CDOs. They're even allowedto sell the risk of default through credit default swaps (CDS) whichare a form of insurance that minimizes the banks exposure. These weirdinnovations have spawned riskier and riskier loans and increased thelikelihood of damage to the broader market.

The Toxic Cycle of Debt?

Economics correspondent, Stephen Long, explains it like this:

“Theproblem that arises from the subprime mortgage collapse is that itcreates a toxic cycle of debt. Banks originate loans or bundle up loansthat mortgage companies have made and sell the risk on to the hedgefunds. Then the hedge funds say, ‘Hey, we've got this product that hasan investment grade rating so we'll borrow against it from the banks.'(oftentimes leveraged at a ratio of 10 to 1) Now the hedge funds aretrying to buy the original loans to stop them from going intodefault.”(The hedge funds are forced to slow the rate of foreclosuresso they won't go bankrupt.)

So, what happens when these shaky bonds (CDOs) are “down-graded”?

Willthe hedge funds fall like dominos just like the subprimemortgage-lenders? Will we see liquidity evaporate in the broader markettriggering a plunge in the stocks and a massive sell-off in the bondmarket?

CDOs were conjured up with the idea that vast amounts ofmoney could be made on very meager assets through a complex expansionof leverage. They were promoted as “limiting risk” by spreading it to agreater number of investors and providing extra protection throughderivatives. Mortgage Backed Securities were sliced and diced into“more risky” and “less risky” tranches depending on investor appetite.Only now—to everyone's surprise---“collateralized debt obligations withstellar Triple-A ratings have been getting hit by the subprime market'swoes.” (Wall Street Journal, “Bernanke revises subprime outlook”) Ontop of that, the ABX derivative index “has started showing pronouncedweakness at the top of its ratings structure.” (ibid WSJ, 7-19-07)

Getit? In other words, even the VERY BEST of these multi-trillion dollarinvestments are beginning to falter. The contagion is spreading throughthe entire market. The CDOs are worthless. No one wants them. In fact,the whole new regime of exotic debt-instruments which emerged from2000-on, is barely hanging on by a thread. One minor downturn in thestock market and the hedge funds will go freefalling through open space.

Aspeech by Robert Rodriguez of First Pacific Advisors (CFA) gives us agood idea of the enormity of the money involved. In his “Absence ofFear” address in Chicago on June 28, 2007 he states:

“Since 2000hedge funds have more than doubled in number, while their assets havetripled. They too are using elevated levels of leverage, as are PE(Private Equity) firms and investors in highly leveraged fixed incomesecurities. These funds are heavy users of derivatives. The Globalderivatives market grew nearly 40% in 2006--the fastest pace in thelast nine years--to $415 trillion, per the Bank of InternationalSettlements. The amount of contracts based on bonds more than doubledto $29 trillion. The actual money at risk through credit derivativesincreased 93% to $470 billion, while that amount for the entirederivatives market was $9.7 trillion. The International Monetary Fund,in its April 2006 Global Financial Stability Report, estimated thatcredit-oriented hedge fund assets grew to more than $300 billion in2005, a six-fold increase in five years. When levered at 5-6x, thisrepresents $1.5 to $1.8 trillion deployed into the credit markets.Fitch, in their June 5, 2007 special report, “Hedge Funds: The CreditMarket's New Paradigm,” says that despite the upward trend in maximumallowable leverage, “notably, no prime broker reported raising marginrequirements in response to historically tight credit spreads andgrowing concerns about the general level of risk-complacency in thecredit markets.”

If Rodriguez's “eye-popping” numbers areaccurate and the market slumps a mere 5%, “the value of a hedge fund'sassets could lead to a forced sale of as much as 25% of its assets”. Ifthe market falls just 10%, the fund would get a 50% haircut!

Yikes! That just shows how over-exposed the industry really is.

Asthe requirements on mortgages gets tougher and the subprime marketcontinues to languish; bankers will naturally become more hesitant toloan zillions of dollars to hedge funds and private equity firms. Whencredit gets tighter, the hedge funds will begin to nosedive which willsend the stock market in a long-term swoon. That's what happens when amarket is this over-leveraged. It's unavoidable.

The markets arenow perfectly poised for a full-system breakdown. FDIC Chairman SheilaBair expects a CDO time bomb. She summed it up like this:

"Its going to get worse before it gets better. How much worse, I don't know."