Timing in a hedge fund bust

Escrito el 6 Julio 2007 por Juan Toro en Financial Markets

The seed of the sub-prime mortgage debacle is the fact that more than 6 millions individuals in the US borrowed 100 % of the value of a house when the real state sector was peaking. Moreover these borrowers had a bad history (or just no history at all) on credit borrowing. These borrowers represent a cohort of borrowers that later had a high rate of foreclosure as soon as housing prices started to fall. This was just the countdown of the process, but how did thing proceeded?

Lenders holding the hot potato repackaged the mortgages into MBS (mortagage backed securities or bonds backed by the pool of mortgages) . This MBS are difficult to allocate among investors as the members of the pools (on average ) have a low credit rating. Here is when the concepts of the collaterized debt obligation (CDO) come into play. The CDO is a reshuffling of the credit features of the mortgages within a set of MBS that is engineered by investment banks. Investment banks would take the MBS and would slide them into tranches according to the credit/risk of members in each slice. The end result is that a MBS can be broken down into different pieces/slices/tranches of debt, each with a different credit risk. These operations make different CDOs out of a group of MBS. Generally, through a CDO, a MBS is repackaged in the form of 80 % investment grade bonds, 10 % mezzanine (middle risk) bonds and 10 % equity (high risk). Now each part of the slice can be marketed to different investors according to their risk needs. Obviously the more problematic tranche to allocate is the equity slice. Here is where another player comes in the stage, a hedge fund.

The investment bank that has created the CDO can well decide to start a hedge fund to try to allocate the equity slice of the CDO that generated. The bank will put part of its own money on the hedge fund and will call for further external funds.
The fund will buy the equity slice (the riskiest part of the CDO) from the bank (truly the bank is buying it from itself). If the housing market goes up, the equity slice will perform pretty well as most of the risk of the original MBS is concentrated in this tranche. This early well performance of the fund (in the case of a rise in housing prices) will trigger a new process where leverage is called upon. The hedge fund will call
his prime broker (that might also be the same bank that initiated the hedge fund though not necessarily) and requests higher leverage given that his collateral is worth more. So long as housing prices do well (the end and true collateral in these operation) everything goes well. The hedge fund has more valuable assets (the CDOs they own) and can request a higher leverage against these assets. With fresh flows the hedge fund will get more CDOs from the investment bank and the investment banks will get new MBS deals from the initial lenders.

But things start getting ugly if housing prices go down (and the true
collateral decreases in values). This decline in value originates a spiral of
risk reassessments. Lenders revise their valuation with borrowers (and some of them cannot attend payments). The MBS see its pool of mortgages devalued. The CDOs that are backed against the MBS also sees its creditworthiness diminished. The prime broker that was providing fresh funds to the hedge funds might want to amend their agreement with the hedge fund that has seen a decrease in value of their CDO holdings. The same way the equity slice is very volatile in an upwards market; it is also the worst hit in a declining market.

In a nutshell, this is one way (not the only one) that can explain the bust
of a hedge fund investing in CDOs (sub prime mortgage related). May be this is how it happened in Bearn Stearns. But as in any investment decision, timing matters. If you invested into this business when the housing prices were on the rise, for some time you could have made quite a bit of money. But if you got into it when the
housing prices peaked, things could have turned ugly as it did with Bearn and Stearns. This firm went from having no share in the subprime/CDOs business at the end of 2004 to become the 13th player in terms of liabilities within this business by September of 2005 (see table below from


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