How does Bear Stearns' hedge fund failed
The Bear Stearns Mess Will Correct ItselfBy Jim CramerRealMoney.com Columnist6/25/2007 2:36 PM EDTURL: http://www.thestreet.com/p/rmoney/jimcramerblog/10364686.htmlEditor's note: Jim Cramer presents this special series on the fallout from Bear Stearns' hedge fund woes while he is on vacation. Check back every day through July 3 for more of his contrarian view. He'll return to his regular blogging on July 5. Be sure to read Part 2, Part 3, Part 4 and Part 5. =============================================================================================Part 1. The Bear Stearns Mess Will Correct Itself=============================================================================================Is the Bear Stearns (BSC) bailout the beginning or the end of the subprime nightmare? First, let me just say that the "prudent" thing, once again, as always with the media, is to say that it's the beginning. There is no cost to saying that it's the beginning, except scaring people out of the financial asset stocks specifically and the stock market in general. That "cost" is never measured and is part and parcel of what I have been struggling mightily against -- and losing to -- for basically a generation now. I joined the fray only once, Oct. 8, 1998, and I still have the scars from when I did. (This is not to say I haven't been bearish at times on many stocks in the market or that I never shorted; I made a ton of money being short back when I ran my hedge fund. People still ask me all of the time for my shorts, particularly in the Answers section of Stockpickr.) I need you to know where I am coming from: a deep-seated belief that crises, even the worst ones, tend to get discounted in the market before people, particularly the media, get adjusted to them, which then causes regular, everyday investors to cash out after the crisis is deep into its recovery phase. Again, I would love to say this was the "tip of the iceberg," because if it was I could take great credit for getting you out and if it isn't, so what? Whoever got hurt for being cautious? There are no "trials" for those who get this wrong. It is with that preamble that I tell you what really happened here and why I believe that while it won't be over, it is self-correcting. First, you have to understand that there were two funds: the High-Grade Structured Credit Strategies Fund and the High-Grade Structured Credit Strategies Enhanced Leverage Fund -- let's call them Dumb and Dumber, for reasons I'll make patently clear. The former wasn't always such a mess. Both are run by the same manager, a guy named Ralph Cioffi, who was, until this debacle, a good manager, having compiled four years of good, steady numbers with no down quarters. He had no down quarters because he had a somewhat typical strategy of taking a couple of hundred million dollars and borrowing against it. You can borrow huge against that cash, much more than you can borrow against stock, which is why it seems so fanciful to stock-only funds and investors. Cioffi apparently borrowed up to 15 times, maybe even 20 times, what he had under management. You can immediately say, "Wow, that's risky." But what he was doing was a simple strategy. Cioffi's simple strategy was getting loans from brokers like Merrill (MER) and JPMorgan (JPM) at low rates -- similar to the overnight rates we call the fed funds rate -- and then buying mortgage-backed and corporate bonds and bonds backed up by pooled automobile loans. The spread between the highest-rated paper and the lower-rated mixture of paper is a couple of points. So, every time he did this trade he made more money because you didn't see much default risk in the big pools of mortgages and corporates that he had and he tended to buy the best, AAA, that you could pick up. If you are borrowing at say, 5%, and then buying the mixture for say, 6%, you can make a percentage point on the money. If you borrow 10 times, you are making a lot per percentage point. That was typically the strategy Cioffi employed. It was a winning strategy. In fact, people considered this strategy a no-brainer because of the logic and simplicity of it. You can see then how he had such a consistent record. How could he be assured that the mortgages, car loans and corporates were not going to default or go down in value so that he would have to put up more cash? Because the economy had been steady, the default rate on corporates low and the housing boom had raised the prices of pretty much all houses so if someone got in trouble, that someone could sell the house and the mortgage would be paid off. Car loans, when pooled together, have had a strong performance, too. Plus, we know from history that individuals will do anything not to lose their homes. They don't like their cars to be repossessed, either. So that sustained sense of security, plus the terrific, consistent returns, attracted investors always on the hunt for such nice, easy money. Enter the fund of funds. =============================================================================================Part 2. How Funds of Funds Hurt Bear's Hedge Funds=============================================================================================Enter the fund of funds. Or I should say, the funds of funds. These are pools of capital put together by shrewd individuals and banks that search out funds for their consistency. They love a fund like the one Ralph Cioffi was running for Bear Stearns (BSC) -- the High-Grade Structured Credit Strategies Fund -- because it creates no surprises. If it did, these funds would pull out and pull out fast. A bunch of these funds, including a powerful one from Barclays (BCS) , asked Cioffi to put a ton of money, thought to be $500 million, to work with his strategy. In the hunt for an even-bigger return, the funds urged him to set up a second fund (which became the High-Grade Structured Credit Strategies Enhanced Leverage Fund) that would buy paper -- shorthand for bonds of mortgages, autos and corporates -- that had lesser ratings, where the potential default was greater. Some of these were baskets of baskets of loans, called CDOs (collateralized debt obligations), that gave you diversification among a whole set of loans. (I am going to leave out how they work because what matters is that they are just a diversified set of loans of all kinds, with the diversification created to lower risk, just like diversification of stocks.) Cioffi took in the money in August 2006. Coincidentally, that was a market peak for these kinds of instruments. Think of Cioffi as a guy who bought Nasdaq stocks back in 2000 on margins that were greater than what you can do with stocks. That was the Dumb fund, as I like to call the High-Grade Structured Credit Strategies Fund. Now consider a Dumber fund that only bought dot-coms in 2000 -- that's the equivalent of the High-Grade Structured Credit Strategies Enhanced Leverage Fund. Say you get $500 million in each pool. You go to banks and brokers. You "repo" money to each of these banks, meaning that you take, say, $50 million to Merrill and get $500 million in return. So Dumb fund goes and does the equivalent of buying a Nasdaq 100 basket and, to continue the analogy, Dumber fund gets even more concentrated and buys stocks in TheStreet.com's Internet Index (DOT) basket. You could see how someone could say, "Look, the Nasdaq 100 has all kinds of stocks in it, and TheStreet.com DOT has all kinds of dot-coms in it." If you did either strategy from 1998 on, you looked like a genius. Ralph Cioffi looked like a genius to some of these investors. Almost immediately, things went south with both of Cioffi's baskets. What you may not realize when you borrow these sums, as the Dumb and Dumber funds did, is that the lenders are not idiots. They may have been portrayed as idiots through most of the coverage of the resulting mess at Bear Stearns, because they seemed to have been completely blindsided, but in a few weeks' time we will learn they weren't. Right now, though, I will look like a Pollyanna to the rest of the media about this issue for believing that they saw this coming. Tough. I like truth. The lenders saw the collapse coming because they saw the scandals. They saw what happened with the now-bankrupt New Century Financial and they watched Accredited Home Lenders (LEND) collapse and they saw what was happening at Fremont General (FMT) . They watched the pieces of paper that Dumb and Dumber had bought lose value. The credit departments that monitor this stuff are tough as nails. They get paid if their banks get paid back. They don't care about commissions and fees -- and Dumb and Dumber generated a lot of fees. No, these departments only care about defaults. As soon as the lenders saw the baskets start going south, they demanded more collateral than just the $50 million they each had. As they did, Cioffi sold off stronger assets -- the AAA paper in the Dumb fund and whatever was trading well in the Dumber fund -- to meet these margin calls. Right now, what Cioffi is accused of doing -- and again, it's hard to know what he told investors and what he didn't -- is telling the investors in these funds -- hot money, as they are called -- that all was well. Remember, they wanted consistency, and I am sure Cioffi and his managers didn't want to let people down. But they were doing just that. The performance of both funds was abysmal, because they had bought most of the portfolios they held at the high, and even though many bonds held up in value for Dumb Fund, that was not the case for Dumber. Either way, Cioffi didn't value his funds right. (If I had run this kind of money back at my old hedge fund, I would have valued the bonds at where they sold them and had an outsider vet the prices. But that's not how these funds were run.) I could see how he wouldn't, because some of these bonds didn't trade. As long as you didn't have to sell them it didn't matter where you valued them. The more dishonest managers who engage in this practice just either do the equivalent of sticking their fingers in the air or use prices roughly equivalent to what was actually paid. We stock people find this hard to believe because the prices of our assets are posted publicly every day. If Cisco (CSCO) is valued at $80 in the papers in 2000, it is hard to believe it is worth less than $80. Bonds aren't like that, particularly these pools of bonds that don't trade all that often. So it's like making Cisco $80 to the buyer but $60 to the seller. If you don't have to sell, you can offer at $80. If you do have to sell, you have to hit the $60 bid. Again, the media and stock players find this hard to believe. But if you have ever had to sell hard-to-understand-and-trade bonds, as I have, it is possible to value them highly, beyond reason, and make your investors feel good even when they shouldn't. Even when they should have reason to worry. Did Cioffi lie? I don't know. Wishful thinking? More likely. Bonds do come back. Now it gets more complicated and murky. =============================================================================================Part 3. The Pincers That Squeezed Bear's Hedge Funds=============================================================================================Bear Stearns (BSC) hedge fund manager Ralph Cioffi did not totally mislead his investors. Both funds -- the High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leverage Fund, or as I've called them in this series, Dumb and Dumber, were down. But they were understated. Fund of funds money is impatient. I have seen this money pull out after one bad quarter. I believe some of this money immediately pulled out, which necessitates selling. Dumber Fund then had to be more candid, honest or realistic about how badly it was doing. Dumb fund, too. Consider this is one of those situations where the lenders and the investors are reading the papers. They know something is wrong. Now you get the pincer moves. Just as the investors are pulling out, the margin clerks at the lenders are circling, asking for more money. Dumb and Dumber did exactly the thing all desperate managers must do: They sell the good to fund the bad. So typical. There were enough good assets in Dumb fund to make redemptions and put up more capital. I don't think there was enough in Dumber fund. (Remember, I am being a tad harsh in comparing the bonds to the Nazz and the dot-coms, for exaggeration. In this case, you could argue that some of the paper in Dumb fund was like AT&T (T) or Verizon (VZ) , good paper that didn't go down that you could sell. Remember, it was a diversified fund and the corporates were readily saleable. Dumber fund was totally bad stuff though, so there wasn't much of a chance of that working.) Let's cut to the chase. Every day that Cioffi came to work was another day where Dumb and Dumber's portfolios went down. At first they compounded the problem by buying more. That's another tactic of the desperate: The market's wrong, I am right. I am sure Cioffi was taught by the same good people I was. But I have seen really seasoned managers go down this same road and it always goes bad. He should have been frantically liquidating all paper and just trying to get back whatever he could. But professionals hate losses, and again, they don't like to disappoint. These traits are ingrained in all of us. They only hurt us when things go bad. Why did the stuff keep going down in value? Did things get much worse during this January-to-May period that encompassed the debacle? Why? The media's theory is that there has been another leg down in the mortgage market and the CDO market and that it is being shut down. That there is a cascade effect going on that could threaten every bit of paper that is not only subprime but only "barely prime." Again, that's compelling. It fits the media's theory: Everything's going to heck in a handbasket, get out now. Masked prudence. I look at it as being more like yelling "Fire!" in a crowded theater -- something that could be put out, results in a stampede and many die because of it. Now, of course we know that there are real fires, like that one in the Rhode Island nightclub, where a "fire yell" wouldn't matter. But more people get hurt in public places when someone yells "Fire!" than when people try to stay calm. Orderly exits save lives -- just ask your local firefighter. I don't mean to make something that isn't a life-and-death matter sound like one, but the analogy holds in this market and the heroes are those who keep people calm, not those doing the equivalent of spraying lighter fluid on the flames with their panicky yells. The media's theory that everything went to heck all at once in the mortgage market is just plain wrong, but I have to go through the whole debacle's history to get your there. =============================================================================================Part 4. How Bear Stearns' Subprime Bets Really Cracked=============================================================================================The media's theory that everything went to heck all at once in the mortgage market is just plain wrong, but I have to go through the whole debacle's history to get you there. First, though, some facts. There's a vintage of mortgage paper -- subprime, bad-credit paper -- that has had a very high default rate. That's the part that was crafted just when the crest in housing occurred and when Dumb and Dumber -- as I call the two Bear Stearns (BSC) hedge funds involved in this mess, High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leverage Fund -- levered up. The default rate on this paper ranges anywhere from 5%-6% for the better stuff, but lower-rated paper can see as much as a 10%-12% default rate for the real junk, depending on the issuer and the geography. That 10%-12% was and remains real junk because it was largely no-money-down paper where people could afford to walk away from homes and many speculators bought homes to flip. That went on extensively in 2006. But the problem is the word "many." Again, the media want you to believe that all mortgages throughout this period, beginning with the boom in 2001, are blowing up left and right. The reality is that only the paper circa 2006 is blowing up left and right. There are some blowups with 2005 paper, but not many because lending didn't get real sloppy until there were so many players in the game that they had to lower standards to make money. That was 2006. The media would have you believe that the default rate is 100% on this subprime paper that was written throughout the boom. The default rate is probably at worst, on a mixture of good and bad paper, 5%-6%. And there were very few funds that were like Dumber, which took mostly bad mortgage paper (remember, even Dumber had the good sense to mix the bad mortgage paper with low-rated corporates and autos), and fewer still that levered as aggressively as Dumber. On good paper, the prime and various degrees of A-rated paper, the default rate is the same historic 2%-3% at worst because the employment rate has remained steady and that, not the speculators' game, is making these mortgages very attractive as pools even now. You see them bought all the time; more than $2 billion of decent paper, even of the so-called toxic subprime variety, traded at 97 cents on the dollar recently when Accredited Home Lending sold its portfolio. And that was considered one of the worst, right up there with New Century, Fremont General (FMT) and the rest of the rogues' gallery. Keep that 97-cents-on-the-dollar number in mind; it holds the key to the story because it represents the current market, having just traded. It is also important because the seller was distressed so it wasn't like a good owner selling to another good owner. (Can't figure out bonds? They bought the stock at $100 and despite all the worry, they sold it at $97, even as the media would have you believe they sold it at $80. It's all in the public documents, for those too lazy to check, including many reporters.) Back to the plot: Now Dumb and Dumber are getting more frantic. =============================================================================================Part 5. Liquidity, Not Credit, Crunched Bear's Funds=============================================================================================Back to the plot: Now Dumb and Dumber -- as I call the two Bear Stearns (BSC) hedge funds involved in this mess, High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leverage Fund -- are getting more frantic, having sold the good to fund the bad as the paper doesn't rally but the redemptions from the funds of funds keep coming. Dumb has unloaded a lot of good paper to unwind leverage and free up collateral to pay other lenders and try to pay redemptions. But the redemptions continue, because the fund-of-funds guys have sold Dumb and Dumber to their investors as consistent and top-notch, so now the f-o-f gangs look like idiots and their reputations are getting killed. Adding to the pain, the totally hard-nosed credit guys at the lenders are freaking out and demanding ever more capital. You have to understand that the margin guys all convey to the sales guys that this stuff has to be dumped. At first, there are buyers who take it down at discounts. But given its strangeness, there can only be so many buyers. Worse, once a buyer is hit with this stuff and the price goes lower because Dumb and Dumber are still dumping, there's no place to put it. So they either stop bidding or offer the paper at a loss themselves. The paper becomes more toxic even as the defaults don't get worse. There's not even enough time passing for them to get worse -- even though once again the media says that's what's happening. This dichotomy is why I said Friday that the issue isn't the creditworthiness of the bonds and CDOs but the lack of liquidity in the market and the forced selling. That's what is knocking down the value -- not accelerated defaults. So now there's all of this 2006 paper floating around, and nobody wants it. Adding to the problem is that by this point, smart hedge funds, knowing that Dumb and Dumber are in trouble, are shorting the stuffing out of the paper, betting that when the funds collapse, they can cover on dimes to the dollar. Again, imagine shorting a stock at $60 and then being able to cover at $10. Great trade. How do these hedge funds know this? Because people talk; brokers get hedge funds to do the trades, and everyone but the investors in Dumb and Dumber do well. I always got these calls. And in 1998 I got my comeuppance, chronicled candidly in Confessions of a Street Addict. Meanwhile, the outlook is so grim at the funds that the manager of Dumb and Dumber, Cioffi, appeals directly to the lenders. First to the salespeople, then to the heads of the departments and ultimately to the tops of the firms. Here, the case gets really difficult for Dumb and Dumber because of some history. Cioffi works for Bear Stearns. Bear didn't do its part in the Long Term Capital bailout, walking away from the table as others ponied up. Now it was time across the Street for Bear to take the medicine, and Merrill and JPMorgan were particularly unforgiving, although others cut deals. By this point, things had gotten so bad that the managers at Bear, who are fabulous at this stuff and have seen everything and are schooled in distressed trading, had to start intervening. They don't want Dumb and Dumber to go under -- not, as the media would tell you, because they want to "save" the subprime market. Oh please; if it was so bad, no one firm could save it or even dream of saving it. They want to preserve their reputation as a firm, which matters to them. This is the "black-eye" theory that some are propounding, vs. the "desperate sinking swimmer" theory that the media embrace. The only way to defuse the situation is to calmly look at the portfolios, see what they have, and figure out whether you are throwing good money after bad, whether there is an opportunity to salvage something or whether there is a chance to make a real killing so it's worth it to make a big bet. A look through the Dumb portfolio produced a lot of good -- so much good that Bear recognized that if it put its own money in, paid off the largest of the outstanding loans and just waited things out, it could have a nice gain. Remember, it was the Dumb fund itself that was pressuring most of the merchandise -- not the underlying pieces of paper in the fund. Liquidity, not credit. But a perusal of Dumber fund did not yield such hope. That fund had sold whatever good it had and was simply a casualty. The investors in Dumb will get only a small share of the fund's comeback because the new Bear money will come in and take a large piece of the Dumb investors' pie. It looks like the people in Dumber will be totally wiped out.