Staying Sanguine About the Bear Stearns Losses

DealBook today sets up a mini cage match between me and Janet Tavakoli:

Mr. Salmon said Bear’s final tally is much better than Wall Street had expected, but others would disagree. “How did you go from reporting very high returns to suddenly now saying the collateral is worth nothing?” Janet Tavakoli, president of Tavakoli Structured Finance, asked The New York Times in an article published Wednesday.

(Update: Tavakoli says in the comments that she was misquoted by Gretchen Morgenson, and that in fact she agrees with me.)

The fact is that these are leveraged funds, and the collateral in them is very much not worth nothing. In fact, the collateral in them is worth so much that all the lenders to the funds, including Bear Stearns itself, might well get paid back in full.

The key thing to realize here is that the assets of the funds were much larger than the total amount of money put into the fund by investors. The investors took the equity tranche, if you will: the difference between two large numbers. On the one hand there was the fund's assets, which were largely comprised of CDO investments, and on the other hand there was the fund's liabilities, which were largely comprised of repo lines with prime brokerages.

The high returns of the fund were essentially the fruit of a leveraged carry trade. The funds borrowed money from their prime brokers at a lower interest rate than the coupons on the CDO tranches they invested in. The difference between the two was profit. But if the market value of those CDO tranches fell, then the assets of the fund could drop perilously close to its liabilities – which is exactly what happened.

What if by "the collateral" Tavakoli meant not the net assets of the fund, but rather the collateral in the CDOs which the funds bought? Again, it's not worth nothing: the more levered of the two Bear Stearns funds invested mainly in AA-rated securities, and so far no AA-rated paper has even come close to being wiped out, as opposed to merely falling in value.

But the real answer to Tavakoli's question does not come down to nitpicking about what she means by "collateral". Rather, it's a simple question of how hedge funds value illiquid assets. And the fact is that for most of these funds' lives, the value of their CDO tranches didn't really change. These weren't buy-low, sell-high hedge funds which were looking for capital gains from investing in undervalued securities. Rather, they were leveraged coupon-clipping hedge funds which made substantially all of their returns in the cashflows from their bonds.

Given that the CDOs weren't trading on the market, one can understand why any fall in the value of those CDOs might have been missed by the fund manager, Ralph Cioffi. After all, it took the best part of a month for Bear Stearns to finally put a value on those investments once it was forced to do so by margin calls.

In other words, the high returns reported by the hedge funds only told half the story. They showed how much money the funds' investments were making – but they didn't show the degree to which the value of those investments was falling. When Bear finally got around to calculating that value, it turned out that the investors in the funds ended up with nothing. Which is bad news for those investors, and also bad news for Bear Stearns, which is revealed to have rather less rigorous risk controls than it would have us think. It also, most likely, presages similar revelations at other fixed-income hedge funds, many of which also took leveraged bets on high-rated CDO tranches.

At the same time, of course, other hedge fund managers, such as John Paulson, seem to be making money hand over fist. Some hedge funds will always blow up – it's in the very nature of hedge funds for that to happen occasionally, no matter what Veryan Allen might think. But the big worry in the market right now is not that hedge funds which got it wrong will blow up. That's just part of how markets work. The worry is that a series of hedge-fund implosions will spill over into prime brokerages and thence into credit markets more generally. And if the brokers who lent money to the Bear funds are getting all their money back in full, then the danger of that happening is greatly reduced.

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