"When spreads go to zero, default is assured," opined IRA co-founder and CEO Dennis Santiago during a meeting with some like-minded financial analysts late last week. The occasion which gave rise to his remark: a discussion about integrating market and regulatory data sets to support safety and soundness analytics of US banks.
Around about that same moment, in New York some of our former colleagues at Bear Stearns (BSC) were ending a tough week navigating the illiquid, no-visibility world of hedge funds and collateralized debt obligations. You've read the details in the newspaper reports. Here's our take:
First, kudos to the Bear boyz for owning up to the obvious before the rest of the Street. We've been writing about the valuation issues facing the opaque OTC market for CDOs and similar designer securities for some time -- and with little gratification.
Now finally a hedge fund sponsored by BSC acknowledges same, but what about the dozens -- many dozens -- of other hedge funds and prime brokers out there with similar asset valuation and collateral margin issues festering behind the facade of mark-to-broker? The silence from some of the larger players in CDOs and similar assets -- not to mention their prime brokers and auditors-- is deafening.
Second, as and when the rest of the holders of CDOs and other illiquid assets make similar disclosures, a whole segment of the hedge fund sector -- and the secondary market for derivative securities like CDOs -- will crater. Why? Leverage. When collateral values fall, absent new capital, leverage ratios must follow.
We are especially amused to read press accounts of how CDO interest rate spreads are widening whole ratings break points in a single day, yet the agency ratings for these issues remain relatively unchanged. Could it be that the major rating agencies are thinking about withdrawing ratings for these issues entirely? If you cannot value an asset, can it be rated?
The lack of a publicly quoted market for CDOs and like assets is exacerbating the liquidity problems for these assets beyond the underlying economics, for example, in sub-prime real estate. Read: There's an opportunity here, somewhere, for the extreme risk oriented vulture. But don't be in a hurry to bid just yet. What the enterprising vulture can buy today can be bought cheaper tomorrow.
As the news accounts demonstrate, you don't just sell an asset like a CDO -- you actually have to organize special negotiated auctions, much like selling a private company or real estate. Since the dealer who sold you the paper won't make an outright bid, hedge funds are forced to hire investment bankers to run a formal sales process.
Yeah, that's right; a hedge fund actually needs to hire another firm of banksters to sell a block of CDOs or similar assets! And then pay them a fee! Perhaps this is part of the reason why Merrill Lynch (MER) and other creditors of the BSC hedge fund last week backed away from unilateral attempts to liquidate collateral.
Third, while the financial media is focused on the fate of various hedge funds, the lion's share of the risk resides with the dealers (and the ratings agencies which helped to price these deals). The use of leverage by hedge funds to enhance returns has the effect of placing ever increasing risk on the balance sheets of the prime brokers, especially for illiquid assets. As the WSJ notes: "More than anything else, this borrowing represents a triumph of greed over fear."
When you boil all the risks down to their essence, its all about reputation, as shown with the decision by BSC to bail out their wayward progeny. But there is a limit to the amount of capital which BSC or any prime broker can deploy to prop up the sagging market for CDOs. Look for the Fed to get involved in the CDO mess sooner rather than later, but hopefully before a major dealer is taken down. Just imagine what happens to the dollar and to the US financial markets if the Fed begins to accept this toxic waste as collateral on emergency discount window loans.
Along with BSC and MER, names to add to the CDO watch list include Lehman Brothers (LEH), Morgan Stanley (MS), Goldman Sachs (GS) and Barclays Bank (BCS). All have significant exposure to the hedge fund community, both in terms of counterparty risk exposure and forward revenue and earnings. But the entire dealer community is at risk because of the magnitude of the unrealized losses held by hedge funds and their lenders in the CDO sector.
Before the process of unraveling Wall Street's latest fiasco is complete, we suspect that a number of hedge funds will be forced to liquidate as their prime brokers hit the bid -- any bid -- for collateral. Just recall the work by the Corrigan Group a couple of years back, which noted that the difference between a market disturbance and a systemic risk event is that in the latter case, market participants act irrationally because of fear they won't get paid.
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