CDO Hedge Funds = Enron ?

by: Barry Ritholtz

Wednesday night's discussion of the Bear Stearn's (NYSE:BSC) Hedge Fund melt down was remarkably sanguine; I guess to those who look at the blow up of a small hedge fund -- it was only $684 million in equity, albeit leveraged up 10-to-1 to $6.8 billion. Hey, sometimes, losses happen.

And Wall Street has been terrific about managing risk, haven't they? I mean, they did a great job with the dot coms, and they are doing a terrific job with housing, right? There may be 49 Trillion dollars worth of derivatives -- thats trillion with a "T" -- so what if 1 or 2% goes belly up?  It's well contained.

Um, not exactly.

There are several issues here that deserve closer scrutiny. Here's how I connect the dots:

1. Side Pockets: A way to move toxic holdings "Off Balance Sheet," to a netherland, hidden from investors and perhaps regulators. This lack of transparency does not exactly comply with truth-in-reporting to your investors or FASB accounting standards.

Sound familiar? It should: It's remarkably similar to Enron Off Balance Sheet Special Partnerships. The WSJ's Scott Patterson went into the details last week:

Even if Bear's pain spreads through the market, other hedge-fund investors might not feel it, at least right away. Sometimes, hedge funds move big pieces of their holdings into separate accounts known as side pockets to keep declining assets from hurting a main fund's performance record -- and managers' wallets. They can also block investors from cashing out.

2. Mark-to-Model: The similarities to Kenny boy's outfit don't end there:   What do we do with illiquid holdings where the fund is both the buyer and seller, and the parent company is the buyer of last resort? Unlike most mutual and hedge funds, who mark-to-market based upon the closing price of their assets, holders of these CDOs get to indulge their "creative" side. Instead of writing the great American novel, they derive a model that optimistically prices these illiquid assets.

Why optimistic? Because the theoretical returns to investors and actual fees to management are based on the pricing of these (non-priced) assets!  Keep those Enron parallels coming!

Indeed, the reason Bear was originally willing to pony up $3.2 billion dollars was what would happen if there was an actual public auction price: The entire complex would have to reprice all of their holdings. Buy bye investor returns, buy bye fees!

3. Crimping Copious Consumer Lending: What does all this esoteric derivatives and murky hedge fund operations have to do with me, Al Franken the ordinary investor?

First off are lending standards: They have tightened -- in some instances, dramatically. That means any debt fueled consumer purchases -- most especially, homes -- have a reduced pool of buyers. That will pressure prices further, reduce MEW, leading to decreasing consumer spending. The spigot that has been open wide for so long is now reducing its flow.

4. Crimping Copious Corporate Liquidity: Mr. Market has enjoyed a delightful wind at his back, funded  by corporate buybacks, Leveraged buyouts, M&A activity. The issue rates front page coverage in Thursday morning's WSJ: Market's Jitters Stir Some Fears For Buyout Boom.

Remember, this is all courtesy of lots of Fed induced liquidity, and a willingness of lenders to provide lots of cash to high risk borrowers at low rates with easy terms. In Tuesday's FT, Lombard Street Research's chief economist Charles Dumas noted what could happen as this dries up:

“With this mortgage-backed crisis we could simultaneously see market-price liquidity implode just as banks are forced to shrink their books by capital losses.”

“Banks’ capital is about to be slashed, and with it excess liquidity in the global system...Suppose the CDOs held by banks were valued at “market” rather than “model” levels (a fancy new euphemism for  illusionary historic book values). Their capital would turn out to be lower. Preservation of capital  ratios against loans would require fewer loans: liquidity would have imploded...  better to let the Bear flounder than reveal just what a low value the Street puts on even the A-rated paper.  A bunch of hedge funds may have problems, but that is the tip of the iceberg for “Titanic” Wall Street."

Mr.Duma may be overstating the case somewhat -- he's more Bearish than I -- but he raises very significant issues that have very real risks -- the same risks most of the bullish crowd seems to be overlooking.


How might this play out? Well, Mortgages at banks with past due payments are at the highest level since 1994, according to first-quarter data compiled by the Federal Deposit Insurance Corp. Mortgage defaults are accelerating, not getting better.

Oh, and a whole slew of Sub-prime ARM Mortgage Resets are scheduled to hit in the 2nd half of 2007.

To say the least, this is going to get increasingly interesting . . .


Recent Woes Cast Light on Hedge Funds' Murkiness
Scott Patterson
WSJ, June 21, 2007; Page C1

Is Cheap Debt Drying Up?
Breaking Views
WSJ, June 27, 2007; Page C14

Market's Jitters Stir Some Fears For Buyout Boom
Takeover-Related Debt Gets Chilly Reception;  Hearing 'Wake-Up Call'
WSJ, June 28, 2007; Page A1

Market insight: Liquidity under threat
Charles Dumas
Financial Times, June 26 2007 17:47 ¦ Last updated: June 26 2007 17:47