Presentation to CFA association, New York

A recent example of the flawed nature of this market came to my attention when my associate, Julian Mann, showed me a very garden variety LIBOR sub-prime floating rate security. A major pricing service valued this bond at par, while on March 19, 2007, one of the major rating agencies rated this bond A3. To affirm the accuracy of this bond's pricing, we went to two brokerage firms that traffic in this type of security and requested what their bid might be, if we owned this security. One responded with a $7 bid. In other words, a 7% of par bid, a difference of 93% to the pricing service. The other firm declined to bid, but they did indicate that, if they were to, their bid would have probably been around this level. Julian has found several other similar examples, so this one does not represent the proverbial “needle in the haystack.”

We believe that many of these models are flawed and give a spurious representation of accuracy. Given the deterioration in underwriting standards, models predicated on prior experience have little value when compared to the data of the last two or three years. In essence, one is assuming a normal distribution curve of data for modeling purposes, while in reality you have data that comes from a highly skewed distribution. We are beginning to see the negative effects of flawed modeling by the growing number of downgrades in the sub-prime sector. This trend is also starting to develop in the Alt-A sector as well. We believe these trends will continue to unfold over the next two or three years and should lead to a retrenchment in the securitization/origination industry. If our assessment is reasonably correct, mortgage credit availability will likely contract and, therefore, exacerbate the housing contraction and its effects upon the general economy. We disagree with the opinion expressed by our esteemed Federal Reserve Chairman Bernanke, when he said in his speech of May 17, 2007 at Chicago's 43rd annual conference on Bank Structures and Competition, “We believe the effect of the troubles in the sub-prime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the sub-prime market to the rest of the economy or to the financial system.” We will see if this optimistic assessment proves to be the correct one.

We are of the opinion that the distancing of the borrower from the lender has contributed to the development of lax underwriting standards. Each participant, in the securitization/origination process, takes their ounce of payment, but no one truly worries about the underlying credit quality since the loan will be sold. Furthermore, most participants are compensated on volume and not quality of loan originated. In our opinion, “a rolling loan gathers no loss.” Possibly, with so many sub-prime originators failing because of loan put-backs to them, some degree of underwriting discipline will return to the market; however, with so many types of loan originators operating outside of the regulatory system with minimal capital, it is far better to originate a loan, capture the fee, and then get out of Dodge, should the business go bad. One can always return another day.

Finally, the securitization market and the multiplicity of products that have been created have never been truly tested in a major credit contraction like that of 1990-94. This is because most of today's securitization products did not exist back then. Another risk is how have they been used in various types of leveraged investment strategies? Have the creators of these products structured their operations to be able to handle a contracting market? It remains to be seen how this all works together. One may gain some insight to the potential risk by reviewing the collapse of the manufactured-housing securitization market. After seven years, it is still a fraction of its former size with all the former major originators gone.

Another example of risk knowing no boundaries, on June 1, the Government of Pakistan issued a $750 million 6.875% of 6/1/2017 dollar denominated bond priced at par and rated B1/B+ at barely 200 basis points above the ten-year Treasury bond yield. The following week in the Los Angeles Times, the headline read, “Musharraf's grip falters in Pakistan.” The second headline, “Dismay over U.S. support of general.” I guess the market believes the extra 200 basis points of yield spread is sufficient compensation for risk. I think not.

This weakening in credit quality trend also applies to the corporate bond market. High-yield bond spreads are at record lows, with the CCC component of the Merrill Lynch high-yield index at 18%, more than double the proportion ten years ago. 7 High-yield spreads have declined from nearly 1100 basis points over the Treasury yield in 2002, to barely 240 basis points recently. We believe this narrowing of credit spread is being driven by the near-record low default rates. For this trend to continue, a near “perfect” credit environment must continue. We see virtually no margin of safety for this sector. This narrow credit spread environment is the key driver that is propelling Private Equity and their bids for companies. As Dan Fuss, manager of the top-performing $10.7 billion Loomis Sayles Bond Fund, recently said, “I haven't felt this nervous about a market ever.” 8

PRIVATE EQUITY
The Private Equity (PE) industry is flourishing. PE has seen its capital raising rise more than ten-fold between 1990 and 2000, only to witness a temporary pullback in 2002, and then more than double between 2000 and 2006. PE is no different than any other hot investment trend, in that its peak capital raising and capital deployment occurred in 2000, the stock market peak, only to see this process collapse in 2002, the stock market trough. Capital deployment fell from $270 billion in 2000 to $49 billion in 2002, per the Leuthold Group. I call this process “buy higher” and then “don't buy lower.” Now we've seen PE fundraising rise to new all-time highs and along with that, acquisitions as well. Leuthold estimates that in 2006 $469 billion in cash acquisitions were announced and/or completed. While this was occurring, valuations have skyrocketed, according to JP Morgan's data. 9 Between 2001 and 2006, the average EV/EBITDA multiple paid rose 41%, from 6.1x to 8.6x. Leverage increased 54%, with the Average Total Debt/EBITDA multiple rising from 4.6x to 7.1x.

We are of the opinion that PE is pushing the boundaries of prudence and that this trend is elevating valuations in the equity market. It would not surprise us that there will be many other Chrysler situations in three to five years. By that I mean, Daimler-Benz A.G. paid approximately $36 billion for the Chrysler Corporation in 1998, only to sell 80.1% of its ownership for $7.4 billion in 2006. Given that this is other people's money, why worry.

HEDGE FUNDS
Since 2000 hedge funds have more than doubled in number, while their assets have tripled. They too are using elevated levels of leverage, as are PE firms and investors in highly leveraged fixed income securities. These funds are heavy users of derivatives. The Global derivatives market grew nearly 40% in 2006--the fastest pace in the last nine years--to $415 trillion, per the Bank of International Settlements. The amount of contracts based on bonds more than doubled to $29 trillion. The actual money at risk through credit derivatives increased 93% to $470 billion, while that amount for the entire derivatives market was $9.7 trillion. 10The International Monetary Fund, in its April 2006 Global Financial Stability Report, estimated that credit-oriented hedge fund assets grew to more than $300 billion in 2005, a six-fold increase in five years. When levered at 5-6x, this represents $1.5 to $1.8 trillion deployed into the credit markets. Fitch, in their June 5, 2007 special report, “Hedge Funds: The Credit Market's New Paradigm,” says that despite the upward trend in maximum allowable leverage, “notably, no prime broker reported raising margin requirements in response to historically tight credit spreads and growing concerns about the general level of risk-complacency in the credit markets.” The report provides a forced unwind example where an initial 5% price decline in the value of a hedge fund's assets could lead to a forced sale of as much as 25% of its assets, assuming leverage of 4.0x (20% margin). They conclude that liquidity risk is among the more important issues facing credit investors. In an era of constrained returns and narrow yield spreads, increased leverage is the solution since volatility is low; therefore, a higher level of leverage may be utilized. We question this logic.

EQUITY MARKET
Enhanced risk taking is widespread here as well. Equity mutual funds are now at or near their all-time record low cash percentage holding of 3.6%. According to the Leuthold Group's data, investors are directing their cash flows to among the riskiest areas of the equity universe—foreign focus equity funds. $80 billion has flowed into these funds through May compared to $11.8 billion for large-cap domestic equity funds and a net outflow of $4.2 billion for small-cap equity funds. This is the second year in a row that the foreign sector has overwhelmed the flows into domestic equity funds. We are of the opinion that investors are chasing the enhanced returns in the foreign sector but do not realize the extent of the risks they may be taking. We see little value in the domestic equity market since we view valuations as being elevated because, in our opinion, consensus profit expectations are assuming unsustainably high operating margins. There appears to be minimal valuation differentiation across most market cap sectors. For example, my value screen just hit a new low in terms of the number of qualifiers. Prior to the recent equity market decline, only 33 companies, with market caps between $150 million and $3 billion, were identified out of nearly 10,000 in the Compustat universe. The previous low was 46 this past February, and before that, it was 47 for both January 2004 and March 1998. When the market cap upper limit was expanded to $150 billion, only ten additional companies qualified. In times past, I would generally get 250 to 400 companies in just the smaller market cap range alone.

Amid Financial Excess, a Revival of Austrian Economics

Does the U.S. risk repeating the mistakes that led to the Great Depression? The Bank for International Settlements’ annual report, released Sunday, suggests that it does, and offers a remedy steeped in the doctrine of Austrian economics.

In the 1930s adherents of the “Austrian school,” named for its Austrian-born proponents Ludwig von Mises, Joseph Schumpeter and Friedrich Hayek, argued the Great Depression represented the unavoidable remediation of misallocated credit and overinvestment in the 1920s. The Austrian school largely failed to become orthodoxy as first Keynesian demand management appeared to end the Depression and later monetarism blamed the Depression on inadequate attention to the money supply.

Austrian economics, however, has enjoyed a minor revival in the last decade, most prominently at the Basel, Switzerland-based BIS, which has few formal banking duties but is an important talking shop (it is sometimes called the “central bankers’ central bank.”) The BIS’s leading “Austrian” is a Canadian, William White, the head of the bank’s monetary and economic department and sometimes-rumored successor to retiring Bank of Canada governor David Dodge. In a 2006 paper Mr. White wrote that under Austrian theory, “credit creation need not lead to overt inflation. Rather…. the financial system … create[s] credit which encourages investments that, in the end, fail to prove profitable.” This leads to an “an eventual crisis whose magnitude would reflect the size of the real imbalances that preceded it [because] the capital goods produced in the upswing are not fungible, but they are durable. Mistakes then take a long time to work off.” He argued that in recent decades, “financial liberalisation has increased the likelihood of boom-bust cycles of the Austrian sort.”

Although the concluding chapter of the BIS’s latest annual report, released Sunday, never mentions the Austrian school, it is suffused with its influence. “Virtually no one foresaw the Great Depression of the 1930s, or the crises which affected Japan and Southeast Asia in the early and late 1990s, respectively,” it begins. “In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a ‘new era’ had arrived.”

It notes that “the prices of virtually all assets have been trending upwards, almost without interruption, since the middle of 2003.” While fundamental economic improvements are at the root, “the market reaction to good news might have become irrationally exuberant. There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking… [S]uch endogenous market processes … can, indeed must, eventually go into reverse if the fundamentals have been overpriced.”

Apart from financial imbalances, the report argues the world economy also displays dangerous misallocations of capital. In its “recent rates of credit expansion, asset price increases and massive investments in heavy industry, the Chinese economy also seems to be demonstrating very similar, disquieting symptoms” to Japan in the 1980s. “In the United States, it is the recent massive investment in housing that has been unwelcome from an external adjustment perspective. Housing is the ultimate non-tradable, non-fungible and long-lived good.” In other words, the U.S. could be stuck with a lot of houses that are hard to sell to each other and impossible to sell to foreigners, and won’t need replacement for a long time.

What does the BIS say central bankers should do? Essentially, relax their single-minded focus on price stability, and tighten monetary policy when “a number of indicators — not just asset prices but also credit growth and spending patterns — are simultaneously behaving in a manner that indicates increasing exposures.” In other words, when easy credit is fueling excesses, raise interest rates to end the party, even if inflation is quiescent.

In practical terms, few central banks are ready yet to heed the Austrian prescription. Federal Reserve Chairman Ben Bernanke spent a lot of his life arguing just those sorts of prescriptions helped bring about, and deepen, the Great Depression. (See, for example, his 2002 speech, “Asset-Price ‘Bubbles’ and Monetary Policy.” Under him, the Fed remains focused on inflation. The European Central Bank has recently reasserted the importance of money and credit growth in its deliberations, but its policy for practical purposes also remains focused on inflation. The Bank of Japan comes closest to sharing the BIS view and has routinely cited the risk overinvestment as a reason to raise rates, but it has recently stopped tightening as inflation remains near zero.

As Mr. White has acknowledged, the Fed can rightly argue its practice of leaving bubbles alone and cutting rates to mitigate their bursting appears to have worked well. The post-stock bubble rate cuts may have in turn created a housing bubble whose consequences haven’t fully played out. But the strength of economic growth since 2002 appears to have placed the burden of proof on advocates of an alternative policy.

This isn’t to say Fed officials are unsympathetic to some of the BIS’s diagnoses. Some, in particular New York Fed president Tim Geithner, regularly warn that risk-taking is at an extreme and a reversal could trigger a self-reinforcing spiral of price declines and asset sales. Yet, having thought it over, they’ve concluded anything the Fed does with interest rates to address this risk would likely make matters worse. –Greg Ip

Has the global bubble Popped

Is this the 'Big One'? Is the Bear Stearns blow-up the moment when America’s subprime debacle spills over into the global credit markets and pops the greatest bubble of all time?

Or have China, India, and Russia changed the game? Has their inclusion in the traded world economy - the “great doubling” of the global consumer base, in the words of Professor Richard Freeman – stretched the economic cycle by an extra couple of years?

Well, the coal-face analysts I talk to at Morgan Stanley, Goldman Sachs, Deutsche Bank, Barclays Capital, et al, all think there is enough liquidity to keep the global boom going well into 2008 - with Europe, Japan, and the emerging BRICs doing the heavy lifting as America takes a breather.

Most expect a nasty squall now, or soon, one that will knock another 7-8pc off stock markets, perhaps pushing America’s S&P500 down a hundred points to its 200-day moving average - currently at around 1432.

Every bull market needs mini-purges on the way. Technically, Wall Street and the Euro-bourses look wicked, with double tops and momentum indicators tipping into the graveyard (RSI, ROC, Stochastics, and MACD).

So no, the 'pros' are not yet calling the big one. But then they never do, until it happens. Such is the curse of consensus, and slavery to linear economic models. Crashes are famously non-linear.

We have clues. Alchemy’s boss Jon Moulton told the House of Commons this week that the private equity boom was “somewhere near its top.” Anthony Bolton, Britain’s Warren Buffet, told a forum in Monaco that the vast CDO and CLO debt boom was based on false models and could “collapse”.

We learn that investors in the Bear Stearns Enhanced Leveraged Fund are getting offers of just 5 cent on the dollar for their stakes. A wipe-out, in other words.

The Bear Stearns rot goes much deeper of course. When Merrill Lynch forced a fire-sale of assets, it revealed that even A-grade tranches of these CDO mortgage debt securities were worth just 85pc of face value, and the B-grades nearer zilch.

The creditors orchestrated a quick cover up, but the CDO cat is already out of bag. We now know that some $2 trillion of subprime and 'Alt A' mortgage debt is falsely priced on the books of banks and funds worldwide. Worse is surely to come. Bank of America warns that $500bn of adjustable mortgage debt in the US will be reset upwards in the second half of this year by an average 2 percentage points, and a further $700bn next year.

For now, bears are all watching the yield on that 10-year US Treasury bond – the benchmark price of world money, the Christmas Tree upon which all the other baubles hang: property booms, the emerging market bubbles, leveraged buy-outs, hedge funds and private equity, those $410 trillion in derivatives contracts (seven times global GDP) and that $2.5 trillion of debt packaged as “structured finance”.

The yield surged 65 basis points from early May to mid June to nearly 5.25pc on inflation scares, the fastest rise since 1994. Interestingly, the 94 bond shock did not in itself cause a US recession. But then the US was a very different country. There was no housing bubble, for starters.

However, it did set off the chain of events that led to Mexico’s Tequila crisis and the China bust a year later. Notice the time delay. My guess is that the latest credit crunch will set off a slow-fuse crisis in Eastern Europe, now the epicentre of speculative excess. Watch Hungary and Latvia, both current account disaster cases.

For now, the 10-year yield has since slipped back to 5.04pc. Don’t be fooled. Part of that is a fear reaction as spreads widened between quality and junk. There most certainly is a credit crunch at the low end – or a “gale force wind” in the words of SocGen’s debt guru, Suki Mann.

Just $3bn of the $20bn junk bonds planned for issue last week were actually sold. A long list of leverage buy-outs and dodgy floats have been pulled, or cancelled. Alliance Boots will have to pay 35 basis points more for the £9bn of debt required for its own jumbo buy-out by KKR.

(Strange, is it not, that victims of these bandit raids should have to pay for their own funeral pyres. Why is KKR not be raising its own debt, on its own books, or have we all lost sight of the greater morality here?.. But I digress.)

Roughly $300bn of leveraged buy-outs waiting in the pipeline will face a frosty reception, and perhaps a volley of rotten eggs. Without the takeover spree to juice the stock markets, the indexes will falter and then fall back.

Never take my rotten advice on the markets, but it might be good time to cash in a few stock gains, and rotate a little wealth into banal interest-bearing accounts. The cycle is already one year beyond its normal life. The balance of risk and reward it turning ever less friendly. Ambrose Evans-Pritchard in The Telegraph

Building Homes in Florida --- a nightmare

Building in Cape Coral a Homebuilders Perspective

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Where do I begin with this mess?
We are homebuilders in the cape, and cannot believe what is going on out there. The general public and Florida lawmakers need to be aware of this situation.
If you drive around the cape and see alot of unfinished homes, have you ever wondered how that transpired? Well, let me tell you!
Situation #1 Customer comes into the builders office and wants to sign up for a home. Customer signs on the dotted line, gets there loan.....sometimes the bank is on the NOC/sometimes not! The price of the home is divided into 5 draws. Builder gets a deposit draw does work, then gets another draw.
Builders are having subs do work, getting draws, and then not paying subs.
Subs file liens, title co does not do title updates, builder gets other subs to finish trimouts etc. Builder gets another draw. Now the builder is 75% done with the home. Builder has profited (example 350k home w/out lot price in there)
$280k builder maybe paid for some earlier subs work, say concrete and site work 40k
builder now has $240k in his pocket. Bank isn't aware, homeowner has gotten
a few nto, but builder says its standard proceedure, that bill was paid etc.
Now bank has a title update! Bank says no more draws....there are liens out there. Customer wonders why there is not activity on there home, now that
there interest payments are getting larger based upon amount borrowed.Bank does not relay no draws to builder to homeowner. Homeowner has never built before and isn't sure of building time frame.
Builder then decides to exit. The property has 140k of liens to subs,
some subs didn't file nto/per builder request? and the property is 70k away from being completed. Now a new builder tries to complete it.
plus the liens have to be contested , paid, or neg. The new builder goes out to bid.
New builder checks property and the soffit panels are missing for scrap metal
$500, The a/c copper lines have been cut $500, a couple cabinets are gone
$300 and the pocket sliders have been ripped out taken into a bedroom and the glass broken out and the frames and used for scrap metal. with a rock, (that the vandals just left on the floor, with the broken glass) a bathrom door is missing $50.
Why aren't the police checking for "new metal slider frames: at scrap yards?
There are areas with 200 properties that are going through this right now!
The builder comes in with a price of say 85k to finish.
Bank has 70k draw money left, new builders bill is 85k to handle the mess, and warranty work that has been done by numerous subs he didn't know, and
several subs doing electrical, in some cases three companies completing one house's wiring.
So at the end of the day, the homeowner has a lot he bought for 100k,
had a builder build a 350k home on it. So instead of the homeowner having a 450k dream home, this is what he has........

a lot for 100k
a home 75% complete
a home with 140k liens on title
a new builder who will finish for 85k
draw money left in loan 70k
amount buyer must come up with to finish home 15k
liens contested, some stay,some go away
to leave a balance of 90k

Now builder has helped client get everything on track, homeowner borrowing against his personal credit lines to pay liens and come up with the shortfall
of what is needed to complete construction.
Now bank says"the borrower has gone over the aloted time for construction,
now we have to protect ourselves, and at our discretion, we will need a new appraisal and will requalify borrower for the loan. If the home does not appraise for the loan amount, we will need to put that borrower in default".
That came from a bank that has written loads of loans in cape coral.
The market has taken a nose dive, the homeowners lot has gone down say half of its value,.....mr banker, I can tell you now, that it will not appraise for what it did a year ago!
So what does this homeowner do?
He has a home that he double paid for on some subs work.
Essentially he has a home that has cost him 100k lot
350k const 90k liens 15k to finish over draws left=$555k home and lot
that will appraise in todays market at about $370k
So he is upside down $185k, instead of the 80k in todays market.

So the cape has hundreds of these homes scattered around from other builders doing the same thing, leaving the homeowners in a bad situation.
Where is the previous builder? Well he is still building! By the way, he built
a mini mansion for himself and didn't pay subs on that either......but his home got a CO, where as the (9) homeowners we are working with didn't get their CO, just problems. Plus he has the cash from the draws.
This needs to stop!!!!
This is the atmosphere in the cape-
Hundreds of half finished houses, hundreds of empty new houses just sitting vacant, 19k homes for sale oin lee county. Eight hundred forclosures last month.
When I drive around the cape north of veterans, and see all this, like the lady I saw struggling to put out the last of her belongings , she couldn't take with her.....(she was probably losing her home) it gives you an earie feeling that
I have never experienced in my life before.
Ps, another builder who did this has started a new company in the cape, and a bank just loaned him over a million to build his personal home!
After checking more closely on this one, he changed his first name on his license to the state, but forgot, and put the first name he used on his old license on the NOC of
his new mansion being built.
This builder left his homebuyers in forclosure, didn't finish homes, we could not even help them!
They only had home loans for the under 200k range.
What is this ............people are getting two loans and one closing to avoid the pmi insurance. That insurance is so if the homeowner defauts there is something for the bank to fall back on to resell the property.
Ps, even the million dollar loan has this. Who is allowing this behavior.
I like cape coral, but all of this is wearing on us, and it leaves us wondering
what is coming down the road. What happens when the lenders go under?
Helping these people move forward is somewhat rewarding, with alot of
problems at every turn most loans take 2-3 months each to get on track. My emaillog is the thickness of a phonebook!
It is very frustrating when the lender gives you the title co name, and they are out of business, and then you go through three more to finally get the
one who is still in business, and they are handling the work from 3 out of business locations so it takes weeks to get anywhere.
We called a homeowner last week to give them a heads up about ther home
with liens and that they might want to look into it. We told them they are so far under we cannot help them, they stated that it is under control.
Some builders advertise a cheap price and rob peter to pay paul.
As long as new deals are signed they can go on for a very long time, until
no new deals are signed, then someone is left holding the ball.
We can have a sign telling homeowners that we can build there home for
100k, but after the builder starts nearing the end of the job and the house costs
150k to build, as long as the builder signs new deals and subs are floated
payment it won't catch up until new deals are not signed.
Each deal I have worked, the identical home has ranged in price(construction price only) same areas of town, same options,and time frames 20-30k.
What does this tell you? Someone was building for cash flow only.
Maybe with a home builder in high places, this will all change.
P.S. These homeowner are too distraught with what has happened to them they never file anything against the builders.
Some I have worked with are on their 2nd or 3rd builder on one house!!!

WARY INVESTORS PEEK OVER THE HEDGE

By RODDY BOYD
July 2, 2007 -- Shell-shocked mortgage bond traders who just closed the books on a surpassingly ugly June are eyeing the calendar warily, waiting for the next two weeks to bring the first word of just how much damage hedge funds sustained as a result of the subprime mortgage mess.

With a series of bad bets on subprime bonds and arcane structured securities triggering the near-collapse of two Bear Stearns hedge funds, wide swaths of the $6 trillion mortgage-backed bond market have sold off sharply. In turn, it is believed that many investors - especially hedge funds, which can borrow over a dozen times their capital base - have seen their already lackluster performance shellacked.

If the performance of subprime investors is as bad as expected, institutional hedge fund investors and the investment banks that loan funds money and clear their trades will be faced with investors' concerns over capital withdrawal, matched by the banks' need for better collateral and reduced exposure.

With a fear of lawsuits for breach of duty and a lack of faith in the quality of the loans backing the subprime mortgages, there could be little incentive to ride out the storm.

In 1994 and again in 1998, this cycle of fund redemptions and reduced leverage resulted in something akin to a panic in the mortgage market, triggering the closing of hedge funds and brutal losses for Wall Street firms.

Already there are some unsettling indications that the global retreat from risk is spreading and Cheyne Capital's Queen Walk fund, both were hit with significant losses as a result of exposure to the mortgage bond market. Late last week, two British mortgage funds, Cambridge Place's $900 million Caliber Global Investment fund and Cheyne Capital's Queen's Walk fund, announced plans to close.

The trading on Friday gave little indication that things will get any better in the near-term. The widely watched ABX index, a key gauge of the health of the asset-backed and subprime mortgage markets, began what one market player called "a collapse." One index, called the ABX 06-2 Single-A, saw its value drop four points Friday; as recently as two weeks ago, a move of one or two points was considered unusual.

Another looming crisis is the potential for widespread downgrades by rating agencies of arcane, illiquid securities called collateralized debt obligations - essentially bonds created from pieces of other bonds. With about $200 billion worth of CDOs backed by the bonds and loans of mortgage issuers - many of which have suffered bankruptcy or near-collapse - the market has avoided disaster only because of a loophole in valuation.

However, if the rating agencies begin downgrading CDOs, these securities could be re-valued, potentially sending their market prices down as much as 50 percent.

When hedge funds implode

By Axel Merk

The US trade deficit with the rest of the world leapfrogged in recent days. Aside from goods and services, the United States is now importing "consensus-based crisis management" from Japan.

Out of fear that a cleanup of bad loans would trigger widespread defaults, Japanese banks got themselves deeper and deeper into trouble by hushing up the problems. We are talking about the crisis at Bear Sterns' subprime hedge fund. The crisis shows that major adjustments on how the market prices risks are overdue; this may have negative implications for stocks, bonds, and commodities, as well as the US dollar.

Bear Sterns is a leading provider of services to hedge funds; it is also one of the largest originators of subprime-backed collateralized debt obligations. CDOs are what their name implies: a security backed by collateral. CDOs are created when mortgages with various risk profiles are grouped into different tranches or segments. Among others, Bear Sterns would create a CDO in a bundle according to a client's specifications. Indeed, Bear Sterns would work with a rating agency, such as Moody's, to obtain the desired rating (a practice likely to face more scrutiny as some allege that Moody's no longer acts as an independent rating agency, but as a syndicator in the offering).

The explosive demand in this sector has attracted ever more creative structures. Investors should have grown concerned when dealmakers started suggesting that one can create a higher-grade security by grouping together a couple of lower-grade securities; it is rare that 1 + 1 = 3. As these instruments have grown more complex, the clients buying these instruments often do not have a full understanding of what they buy.

How do you make a best-seller better? You introduce leverage. Not only can leverage be introduced in the credit derivatives that define some of these securities, but brokers eager to attract hedge-fund business may also accept CDOs as collateral to lend money. The hedge fund now attracting so much attention is Bear Sterns' High Grade Structured Credit Strategies Enhanced Leverage Fund, launched only 10 months ago. It shall be noted that Bear Sterns did not put much of its own money into the fund, but supplied many of the CDOs. A total of US$600 million in invested capital was boosted with borrowings of about $6 billion.

The collateral provided by the fund had the highest ratings by Moody's. However, a high rating does not ensure that the CDOs are liquid, ie, that they can be sold off on short notice. This became painfully clear as bets of the fund were creating heavy losses and some lenders asked for more collateral for the loans extended. In the industry this is called a margin call. Bear Sterns told other lenders, including Merrill Lynch, JPMorgan and Citigroup, that the fund was unable to provide more collateral. On a side note, it is rather grotesque that Merrill, JPMorgan and Citigroup are among the larger investors in a fund managed by Bear Sterns. The company put little of its own money into the fund.

In the brokerage industry, when a margin call is not met (when the borrower cannot provide sufficient collateral), the broker may seize the collateral and liquidate open positions. While a forced sale of the collateral may be painful for the borrower, it protects the system as a whole. Such forced sales happen all the time in the futures market, where positions are "marked to market" every day to evaluate the profitability and risk of open positions.

But the CDO market is not a regulated futures market; there is no daily market price that would allow one to assess the value of the collateral. The primary methods used to value CDOs are called "mark to market" and "mark to model". In the more conservative "mark to market" approach, independent parties are asked to value the securities; as the name implies, the "mark to model" approach is more aggressive and uses a computed, theoretical value.

But because these instruments are sold in privately negotiated transactions, rather than a regulated and liquid market, neither valuation method is suitable in case of a forced liquidation. In the case of Bear Sterns' fund, Merrill Lynch sent bid sheets to numerous parties, soliciting prices for their holdings; as everyone knew that Merrill wanted to get rid of the securities at any price to cut its losses, it is fair to assume that the prices offered were significantly below the value assumed for the collateral.

As Merrill went public with its plan to auction off the collateral, others tried to rescue the fund. There was talk that Citigroup would inject $500 million and Bear Sterns might inject $1 billion. And the Blackstone Group was very interested in supplying much-needed capital. Blackstone's offer required the brokers to abstain from further margin calls for 12 months. Such restrictions may be common in the private-equity world that Blackstone is active in, but was not acceptable to Merrill.

As the rescue plan fell through, Merrill stated that it would go ahead with its auction yet again. In the meantime, JPMorgan was front-running Merrill by trying to unload collateral it held for the Bear Sterns fund. When all was said and done, it wasn't clear how much which broker was able to sell, but the sales were halted once again, and the parties seem to have agreed on an "orderly unwinding" of the positions.

This had the hallmark of the biggest financial crisis since the bailout of Long Term Capital Management. In 1998, the US Federal Reserve coordinated a bailout that led to the orderly unwinding of a fund that threatened the stability of the financial system. But this time is different: the instruments involved are so complex that journalists have had difficulty relaying the issues to the public, but the multiple calling and canceling of auctions by Merrill highlight the behind-the-scenes maneuvering to avoid fallout to the rest of the industry and beyond.

The risk to the financial system was not merely that some large brokerage firms may have been forced to write down a couple of hundred million dollars - they may still have to do that. But had the fire sale gone through, market values would have been available to the securities sold. This in turn would have forced other lenders to revalue the collateral they hold, and as the collateral is worth less, the brokers will lend less money. That would have triggered further margin calls, further forced liquidations.

When hedge funds implode, they tend to sell off more liquid assets first. At the end of the sale, the prices of the liquid assets are depressed, yet the fund may still be left holding illiquid securities. To illustrate this, take the example (this is not the Bear Sterns fund) of a hedge fund that may make bets on CDOs and, say, the price of oil. As such a fund needs to raise cash, it would close out the more liquid oil positions, causing a spike (or drop - depending on which way the unwinding works) in the price of oil. The resulting volatility in the markets would be most painful for leveraged investors in the oil market, although the crisis originated in the CDO market.

Too many leveraged investors have become complacent because of the low volatility enjoyed in recent years. Aside from the short-term volatility, the high leverage employed by many hedge funds would need to be reduced permanently. As speculators pare down their leverage, they sell off assets to raise cash.

The well-intended attempts to unwind the Bear Sterns fund in an orderly fashion are highly problematic. The fund's problems have clearly shown that the credit extended to the industry is too large. The bankers involved commit similar mistakes to those of bankers in Japan in the 1980s and 1990s, where clearly bad loans were kept afloat with artificial means; those involved had the best intentions, but caused more than a decade of pain to Japanese banks, corporations and consumers.

It may well be that the value obtained in a fire sale is less than that obtained in an orderly liquidation. But the lesson to take home from this is that CDOs must not be used as collateral for 10:1 leverage. In our assessment, the unreasonable leverages employed by many hedge funds have contributed to a global liquidity glut that has driven up all asset classes, from stocks to bonds to commodities and other hard assets. As lenders have ignored risk, volatility reached abnormally low levels in 2006. Markets need risk to price assets properly; it is urgently necessary that volatility come back into the markets, so that lenders make more reasonable decisions.

The Bear Sterns debacle highlights that the industry has gone too far, and that it is high time that credit be reined in. So far, the first good that has come out of all this is that the planned initial public offering (IPO) of Everquest Financial seems to have been aborted: Bear Sterns was the underwriter in Everquest, a firm that specializes in buying CDOs from hedge funds.

Another hope is that traditionally more conservative investors, such as pension funds, will reduce their exposure to overly leveraged hedge funds. If such investors are told that they should not "rock the boat" with a rushed decision, they may be well served to take their losses now rather than potentially even greater losses later.

Federal Reserve chairman Ben Bernanke is particularly proud that regulators have extensive experience on how to manage crises. The danger of superior crisis management is that you take the "danger" out of investing. Without risk, speculators have no restraint; in recent years, we have called this the "Greenspan put", named after the reputation of former Fed chairman Alan Greenspan to allow bubbles to be created, and then bail out those who suffer from the bursting of the bubble. The Fed is shooting itself in the foot with such an attitude, as the Fed loses control of the money supply in a world where risk is underpriced.

When European Central Bank president Jean-Claude Trichet was recently asked whether the latest interest-rate hike in the euro-zone meant credit was now tight, he mused that higher interest rates mean little when sources of credit are abundant. His comments came before the recent selloff in bond prices. But as bond prices sold off in recent weeks, lower grade bonds fell not significantly more than government bonds. A healthy market requires a greater risk premium for junk bonds. The collapse of an overly speculative fund must be allowed, so that investors have an incentive to demand higher yields for riskier investments.

In summary, we expect volatility to pick up in all markets. As volatility picks up, speculators may sell assets to raise cash. Given the gains experienced in just about every asset class, there may be few places to hide. As bond prices may be under further pressure, the cost of borrowing goes up; this in turn may have implications for American consumers whose spending habits are interest-rate-sensitive because of their high levels of debt. This is where the circle to the trade deficit is closing.

The US dollar is dependent on inflows from abroad, as Americans import more than they export. If higher borrowing costs cause consumers to spend less, foreigners may redeploy more of their investments to other, more robust areas in the world. While Treasuries tend to be the first safe haven in times of increased volatility, the dollar no longer is the safe haven it used to be. In our view, a diversified approach to something as mundane as cash is something investors may want to evaluate. Gold is one such diversification; a basket of hard currencies is another.

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Axel Merk is the portfolio manager of the Merk Hard Currency Fund.

Does It All Add Up?

Nope...

By Saskia Scholtes and Gillian Tett
Financial Times, London
Thursday, June 28, 2007

http://www.ft.com/cms/s/d5f91f6e-2513-11dc-bf47-000b5df10621.html

As head of the financial stability unit at the Banque de France, Imene Rahmouni-Rousseau travelled to America this month to look at the current turmoil in the US subprime mortgage world.

Although initially that had seemed an all-American saga, Rahmouni suspected that French and other European investors also held assets linked to subprime securities. So on behalf of her central bank she wanted to assess the risks.

What she discovered surprised her. There was little confidence about how to value the holdings. "Pricing data are difficult to obtain," she says.

It is a discovery being shared by numerous other policymakers and investors around the world as the fallout widens from a subprime lending boom, in which US banks provided vast amounts in home loans to financially stretched borrowers who put little money down and gave no proof of income. Among the casualties have been two hedge funds run by Bear Stearns, the Wall Street investment bank.

Until recently, when late payments and defaults on these mortgages spiked higher, the problem drew little attention. This was because, through the magic of so-called structured finance, risky assets such as subprime mortgages could be packaged into attractive investment products.

These elaborately constructed securities, called collateralised debt obligations (CDOs), are designed to yield juicy returns while also carrying high credit ratings. They have proved popular with hedge funds as well as with longer-term investors such as pension funds and insurance companies, many of which have bought billions of dollars of such securities in recent years, thus providing the liquidity that was then channelled into mortgage loans.

But heavy losses incurred at the two Bear Stearns hedge funds as a result of such financial haute couture have prompted fears that the CDO emperor may turn out to have no clothes. Such a revelation could threaten the value of investor portfolios around the globe -- not just in the mortgage sector but in the way many sorts of company fund themselves.

This is because unlike stocks listed on an exchange or US Treasury bonds, CDOs are rarely traded. Indeed, a distinct irony of the 21st-century financial world is that, while many bankers hail them as the epitome of modern capitalism, many of these newfangled instruments have never been priced through market trading.

Instead, products such as CDOs, which are designed to be held until they mature, have often been valued in investor portfolios or on the books of investment banks according to complex mathematical models and other non-market techniques. In addition, fund managers and bankers often have broad discretion as to what kind of model they use -- and thus what value is attached to their assets.

So when Wall Street creditors last week threatened fire sales of CDOs seized from the stricken Bear Stearns funds, thus creating a market price for them for the first time, they also threatened to create a wider shock for the system. Fire sales rarely realise anything close to the previously expected value of assets. But if these deals went ahead, they would provide a legitimate trading level that would challenge current portfolio valuations.

In the event, Bear Stearns' creditors sold only a fraction of the assets put up for auction. Market participants suggest that this was in part because bids fell far below expectations, with traders increasingly reluctant to take on CDOs tainted with subprime exposure. But the crisis at Bear's funds has left investors, brokers, and regulators asking an uncomfortable question: Can the pricing models that have provided the foundations for this new financial edifice really be trusted? Or will valuations turn out to be over-optimistic and result in further investor losses?

"Investors are slightly more cautious, becoming more picky and asking more questions," says Michael Ridley, co-head of high-grade debt capital markets at JPMorgan. "They want us to lift the lid off the box a bit more."

To an extent, the valuation problem for CDOs reflects the fact that the frenetic pace of innovation seen in the financial industry this decade has outpaced the development of its infrastructure. It has often been the case that when new instruments emerge in the banking world, the market is initially quite illiquid, meaning that the level of trading is low. But the murky nature of new products has rarely had broad systemic implications, because they have typically occupied a small niche.

What makes the CDO sector unusual is that it has exploded at such a breakneck pace with bankers packaging bonds, loans, and other debts into ever more complex structures. Last year alone, about $1,000 billion (£500 billion, E745 billion) in cash and derivatives CDOs was issued in Europe and the US, according to data from the Bank for International Settlements. More than one-third was composed of asset-backed securities, often including low-grade mortgages.

As this explosion has occurred, some corners of this universe have already become relatively widely traded and transparent. Every day in the London and New York markets, for example, billions of dollars worth of deals are struck involving indices of derivatives on well-known corporate bonds -- making it easy to obtain prices.

However, many other such products are created by bankers directly with their clients and then simply left to sit on the books of an investor. Since such instruments typically last three to five years -- and the CDO boom is so recent -- many have not come to the end of their life. Nor have they been traded. Christopher Whalen of Institutional Risk Analytics, a consultancy, says: "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 subprime real estate."

To compensate, investment institutions and banks use a variety of techniques to assign a value to these instruments in their accounts. In some areas, third-party data groups exist that can offer price estimates. However, the pace of innovation is so intense that it is hard for these providers to keep up with all corners of the market. So in many cases, investors are turning to alternative techniques to create prices. One tactic used by hedge funds entails asking several brokers for price quotes and taking an average. Results vary -- not least because dealer banks may hold positions in these instruments themselves.

"It is very easy for hedge funds to shop around to find valuations that suit them best and then book their assets at that," says one banker who advises hedge funds. "Going back to the bank that sold you a CDO and asking for a price is rarely likely to produce an accurate picture."

Another approach is to estimate valuations based on the ratings the instruments receive from credit rating agencies. Yet this does not offer a fail-safe valuation method either. The rating agencies have been downgrading bonds backed by subprime mortgages in recent weeks but critics say they have been slow to act and face difficulties in analysing the market.

Christian Stracke, analyst at CreditSights, a research company, says: "With so little truly relevant historical data on the behaviour of subprime mortgages, and with such massive structural changes having occurred in the mortgage landscape in recent years, any time-series analysis approach is little more than a not-so-educated guess."

Moreover, while ratings attempt guidance on the chance of default, they offer no indication of how market prices could behave -- as the rating agencies stress. As the BIS noted in its annual report this week, ratings reflect expected credit losses rather than the "unusually high probability" of events that "could have large effects on market values."

That means that on the rare occasions that instruments are traded, a large gap can suddenly emerge between the market price and its book value. This week Queen's Walk Fund, a London hedge fund, admitted it had been forced to write down the value of its US subprime securities by almost 50 per cent in just a few months. That was because, when it was forced to sell them, the price achieved was far lower than the value created with the models the fund had previously used -- which had been supplemented with brokers' quotes.

But unless circumstances arise that force a market trade, valuations often remain at the investment managers' discretion. While managers say they strive to assign honest values, these are often difficult for an outside accountant to verify, since the techniques used are invariably highly complex.

Moreover, incentives do not always encourage fair valuations: for example, hedge fund managers are typically paid a percentage of the profits they book, giving them a vested interest in reporting a high asset valuation. At best, this means that the valuations of CDOs, for example, may often lag behind any swings in broader asset classes; at worst, this ambiguity may enable hedge fund managers or investment bankers to keep posting profits -- even when markets fall.

But Amitabh Arora, head of interest rate strategies at Lehman Brothers, points to a further potential impact from the Bear Stearns upheaval. "The bigger risk now is that it calls into question CDOs as a financing vehicle in the corporate credit market. I think in the next six to 12 months we will see a significant reassessment of CDOs as a financial vehicle not just in the subprime world but the corporate world too."

Adil Abdulali, a risk manager at Protege Partners, a fund of funds, recently studied the performance of hedge funds and discovered clear statistical indications that they tend to stage-manage their earnings when they trade illiquid instruments. "Conservatively, 30 per cent of funds trading illiquid securities smooth their returns," says Mr. Abdulali.

Some bankers and policymakers argue that this is simply a teething problem that will fade as structured finance becomes more mature. History suggests that most opaque, illiquid markets eventually become more transparent when they grow large enough -- and behind the scenes, the Bear Stearns hedge fund problems are prompting bankers and investment managers to re-examine their valuation techniques. "We are getting a lot of calls from worried people," says one third-party data provider.

However, history also shows that large-scale structural dislocations -- such as a serious mispricing of assets -- are rarely corrected in an orderly manner. Thus the big risk now is that if thousands of banks and investment groups suddenly have to slash the value of the securities they hold, the wave of accounting losses might at best leave investors wary of purchasing all manner of complex financial instruments. At worst, it could trigger more distressed sales and a broader repricing of financial assets, not just in the subprime sector but in other illiquid markets too.

"If every CDO was forced to mark to market their subprime holdings, it would be. ... Well, I can't think of a strong enough word to describe what it would be," confesses a US policymaker.

Bear Stearns and MBS Hedge Funds: What are the real risks today?

Safe Haven | Bear Stearns and MBS Hedge Funds: What are the real risks today?: "'...What people don't fully appreciate is the extent to which our financial system has geared up over the last twenty years to finance the worldwide residential housing boom...'

MOST SIGNIFICANT MARKET EVENTS cause an immediate and substantial price reaction, which makes it hard to profit from them. But sometimes there's a sort of slumber, when the market gazes sleepily about itself not quite sure what to do.

We may be experiencing one of them now.

This week a major American investment bank called Bear Stearns was reported as having some serious trouble with a couple of hedge funds. It is difficult to be clear exactly what is going on, because this story involves lots of people and banks who have a vested interest in not being very open. I have been trying to find out the details."

CDO's claim US broker Brookstreet

To Our Valued Brookstreet Members,
Disaster, the firm may be forced to close...

Today, the pricing system used by National Financial has reduced values in all Collateralized Mortgage Obligations. Many of those accounts were on margin and have suffered horrendous markdowns and unrealized as well as realized losses.

National Financial and the regulators expect Brookstreet to pay for realized liquidated losses and take a capital charge for unrealized mark to market losses.

This firm has done a valiant if not Herculean job of managing the liquidations and capital charges to the firm's net worth and net capital. We had reduced the margin balance significantly; we had liquidated and reduced exposure by 80%.

That still left a $70,000,000 margin balance against around 85,000,000 of value. Unfortunately the pricing service used by NF revalued many CMO positions downward last night. We went from a positive net capital of 2.4 million, down from 11 million at the end of May, a negative net capital of 2.1 million. It would take a capital infusion of at least $5,000,000 to keep the company in compliance with no guarantee that additional markdowns will not be forth coming.

I cannot in good conscience request that anyone put money in the firm, I think $10,000,000 would be a minimum without consideration of the horrific customer complaints to follow.

I have told many of you that you are always in danger of not being paid on your last check when working for any broker dealer, which is why I have always paid twice per week and maintained huge net cash positions, generally in the realm of 15,000,000 on average. I will try to get enough money from our account at NFS to complete our upcoming payrolls.

Since I have been writing this letter I have received three hurried inquiries about re capitalizing the company. I will negotiate an arrangement that guarantees that everyone gets paid, to the best of my abilities. Please stay at Brookstreet at least until Friday so I may do my best for each of you.

Unfortunately we are on "SELL ONLY."

I believe I will be able to reconstitute another opportunity for everyone that will result is a minimum of change and disruption. There will be disruption.
Please give a day or so for us to come up with the best strategy. This has happened to us in one day, amazing. All of our family net worth is in the firm, please give me time to present a new plan."