Bear Stearns & 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.

It starts with the humble mortgage. Lots of people in the United States who have no money - they are called sub-prime borrowers - borrowed 100% of the value of a house right at the top of a housing market which has since fallen sharply.

The lenders, however, did not have to worry very much about the risk of default, because they rolled these mortgages into packages called Mortgage-Backed Securities, which they then sold. They got to be off-risk within a few weeks, because by then these MBS belonged to other financial organizations.

But it is not always easy to sell a package of these Mortgage-Backed Securities (MBS). The process of selling such a device demands that the credit quality is assessed - and because the underlying lender is marketing to sub-prime borrowers, the package of debt in the MBS is heavily composed of mortgages quite likely to go into default. So a credit ratings agency will give it a low credit score.

This makes it difficult to sell, which is where a bunch of smart investment bankers join in.

The investment bankers slice the MBS into several chunks or "tranches". These are known as Collateralized Debt Obligations, or CDOs for short. The idea is to create some higher risk assets and some much safer ones, slicing up the MBS into what are called equity, mezzanine and investment-grade bonds.

The equity takes the higher risk, and so it earns the higher return if things go well. But if things start to go wrong, the equity is lost first...and then the mezzanine. However, even if there's quite a high rate of failure in the higher risk end, the investment-grade bonds still get fully paid out. This persuades the credit ratings agencies to give them a respectable stamp of approval, thereby creating out of low-quality mortgages a respectable amount of highly-rated bonds.

In this way the bankers might, for example, convert a large package of MBS into perhaps 70% investment grade bonds, 15% mezzanine, and 15% equity. The original mortgage lender is in a hurry to get the whole MBS off its book, remember, selling the MBS into the financial markets. That way he replenishes his cash and can go out marketing more mortgages to more sub-prime borrowers.

The investment bank is well motivated to slice up the MBS, and it had better be good at selling all this debt on. It won't want to keep much - if any - of the newly created CDO tranches, since the bank earns its money primarily by distributing the MBS, rather than by taking risks with the chance of subprime mortgage borrowers not making their repayments on time.

It is relatively easy to sell the high-grade investment bonds. Stamped with an investment-grade rating, these bonds are sold off to mostly respectable investment institutions. But the mezzanine, and particularly the equity, are less easy to dispose of.

In effect the 30% of the mortgages in the original MBS which were deemed on a statistical basis to be likely to fail, are concentrated into what investment insiders call "Toxic Waste". How can these bonds be sold off?

Enter the hedge fund. Somehow, and possibly even using some its own money, a bank sets up a hedge fund whose objective is to trade in the high-risk CDO equity and mezzanine instruments. Let's say the bank puts up the first $10 million. The hedge fund then buys the equity tranche of the CDO from the bank.

With a bit of luck, and this is what happened over recent years, the housing market goes up. Now the equity is floating higher in the water, because there's a cushion of higher house prices preventing those original sub-prime borrowers from defaulting. This rather obscure equity instrument, which is not traded anywhere and is not liquid, appears to be worth more than it was at issue. It gets marked up in value, and much faster than the underlying houses, because all the price volatility is concentrated in this thin slice of CDO equity.

The hedge fund is now a performer! And that means it will be rewarded by further investment from outside. So what started as a vehicle with a little investment bank money can grow the funds it manages under its own steam - and that can make its managers very rich.

Next, and this is what hedge funds are all about, it will leverage its risk, too. The hedge fund goes out to a lending bank, holding its high-performing but illiquid toxic waste in its hand, and it asks to borrow money using the waste as collateral. The bank has access, whether directly or indirectly, to cheap money from Japan - where interest rates remain at just 0.5% - and so it has the prospect of lending for spectacular profits.

Now the MBS wheel is fully in motion. The hedge fund loses no time in marking up the value of its equity CDOs on the basis of rising house prices. There is an overwhelming pressure to do so, since the hedge fund's managers are rewarded based on performance - a figure which is far too easy to manipulate if your investments are illiquid and hard to value in the absence of an open market price.

The toxic waste gets marked up without the waste itself getting tested on an open market.

The lending bank sees the equity floating higher and higher in the water, and lends more and more cash against it to the hedge fund. Naturally - as with all collateral - it claims the right to sell if the underlying debt gets into trouble, but it certainly doesn't look like a real danger at this stage. The money lent by the bank against the equity goes back to the hedge fund, which buys more CDO equity from the investment bank, which buys more MBS from the mortgage lender, which provides more money to sub-prime borrowers, who then buy more houses, pushing prices higher again.

This appears to be the background to the Bear Stearns hedge fund problem today. Recently, US house prices have turned sharply down, so now the lending banks have asked for their money back and the hedge funds haven't got it. So the collateral needs to be sold. No problem, surely. It's in the books at a few billion dollars after all.

But with its concentration of risk, the equity slice has been hemorrhaging value. No-one is bidding. But that's not the full extent of the problem. There are so many similar hedge fund loans backed by questionable and illiquid securities at marked-up prices - untested by dealing on the open market - that the lending banks have stopped trying to sell for fear it will accelerate and exacerbate the problem into a full-grown systemic disaster, forcing every similar hedge fund out there to own up, catastrophically, to significant overvaluations in their CDO equity portfolios, too.

There is currently no market for this toxic waste. Everyone is taking a breather. All this came to light Thursday - and amazingly the US stock market went up. But it really could turn very nasty. Everyone with a hedge fund holding in any similar market is powerfully motivated to sell 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. Banks used to have to work quite hard finding profitable businesses to put their money into. But for twenty years now, those banks which concentrated on financing housing have left everyone else in their wake.

I was chatting to a senior financier recently from AIG - the biggest insurance company in the world. Even his business has come to be all about finding and assessing risk in housing finance. Everyone is up to their nostrils in this market.

What might happen? I expect the recent rises in bond rates are related to this developing problem. People better informed than me are starting to gather in cash, rather than lend it out. This could accelerate. The banking sector - whose profits have surfed this business and turned the banks into the pillars of the stock market indices - are going to be hit with some monster bad debts. Barclays bank has already owned up, but the debts it's admitting to are mushrooming, with early reports of $300m being replaced with ones later in the week suggesting more than $1 billion of losses. That hits the stock market with a double whammy - of falling bank stock prices and higher rates for everyone.

The quick deal might be to short Wall Street, which seemed to be wholly in a state of irrational denial as this story hit this week. If you do that today, and things start looking bad next week, consider sending some money to BullionVault to buy gold, too. Few places are better able to ride out the credit squeeze which could result than physical gold bullion owned outright - with no risk of default - in your name alone.

But on the other hand do not underestimate the skill of people including Ben Bernanke at the US Federal Reserve in underpinning the financial system at a time like this. They seem so often to get away with it. It would be interesting to know if Dr.Bernanke has chosen to cancel his social engagements this weekend.