Bear Tracks & CDOs

Bear tracks are all over the place. No, I am not talking about the stock market I am talking about Bear Stearns and CDOs. It's time for some history as the Bear Stearns tracks go back a long time.

2005-08-05
Bear Stearns Shakes the CDO Honey Pot

All of Wall Street may come to rue the day Bear Stearns sold $16 million in collateralized debt obligations to Hudson United Bank. The sale prompted a complaint to New York Attorney General Eliot Spitzer from Hudson United, which believes Bear Stearns gave it bad prices on the sophisticated bonds. Now Spitzer's office is contemplating taking a broader look at the market for these fast-growing derivative investments.

Hudson United complained to Spitzer after trying to sell the CDOs and allegedly finding they were worth much less than Bear Stearns claimed, people familiar with the investigation say.

Bear Stearns also disclosed last month that the Securities and Exchange Commission's Miami office is much further long in a separate investigation involving a similar dispute over the pricing of $64 million in CDOs. In the SEC investigation, which began more than a year ago, regulators have notified Bear Stearns they are contemplating filing civil charges against the firm.

[Mish comments: those lawsuits are the tip of the tip of the iceberg. It is interesting to note that after a couple years Bear Stearns has gone on a massive attempt to unload more toxic waste on unsuspecting buyers as the following will prove]

2007-05-11
Bear Stearns Funds Own 67 Percent Stake in Everquest
Funds run by Bear Stearns Cos. own two- thirds of Everquest Financial Ltd., a firm that invests in debt backed by subprime mortgages and buyout loans that's planning an initial public offering of as much as $100 million.

The IPO, announced May 9, may help the funds transfer risk to other investors. The funds buy some of the riskiest portions of collateralized debt obligations, which package loans, bonds and derivatives into new securities. Assets in CDOs may have lost as much as $25 billion of value as mortgage delinquencies rose this year, Lehman Brothers Holdings Inc. said last month.

The potential for conflicts of interest that would hurt investors buying such an IPO are "mind boggling" because buyers would need to rely on securities firms to assign prices to assets that have no ratings, don't trade often and are difficult to value, said Janet Tavakoli, president of Tavakoli Structured Finance Inc., a Chicago-based consulting firm.

[Mish comments: Mind boggling indeed ... to the point of fraud potential. There will be congressional investigations into this before its all over]

2007-05-11
Bear Stearns' Subprime IPO

Everquest Financial is going public with risky mortgage bets purchased from its underwriter’s hedge funds.

Never underestimate the ability of a Wall Street investment firm to find a new way to pawn off risky assets onto retail investors. The latest example? The initial public offering for Everquest Financial.

Everquest is a fledgling financial-services company that has been buying up equity interests in risky bonds backed by subprime mortgages from hedge funds managed by Bear Stearns (BSC)—one of Wall Street's biggest underwriters of mortgage-backed securities and other exotic mortgage-related bonds. The deal appears to be an unprecedented attempt by a Wall Street house to dump its mortgage bets.

[Mish comments: What do these CDO buyers think they know that Bear Stearns doesn't? ]

2007-06-01
Banks Sell 'Toxic Waste' CDOs to Calpers, Texas Teachers Fund

Bear Stearns Cos., the fifth-largest U.S. securities firm, is hawking the riskiest portions of collateralized debt obligations to public pension funds.

At a sales presentation of the bank's CDOs to 50 public pension fund managers in a Las Vegas hotel ballroom, Jean Fleischhacker, Bear Stearns senior managing director, tells fund managers they can get a 20 percent annual return from the bottom level of a CDO.

"It has a very high cash yield to it," Fleischhacker says at the March convention. "I think a lot of people are confused about what this product is and how it works."

Worldwide sales of CDOs -- which are packages of securities backed by bonds, mortgages and other loans -- have soared since 2003, reaching $503 billion last year, a fivefold increase in three years. Bankers call the bottom sections of a CDO, the ones most vulnerable to losses from bad debt, the equity tranches.

They also refer to them as toxic waste because as more borrowers default on loans, these investments would be the first to take losses. The investments could be wiped out.

Fleischhacker, 45, says she doesn't associate toxic waste with the equity tranches she's selling. Pension funds in the U.S. have bought these CDO portions in efforts to boost returns.

Many pension funds, facing growing numbers of retirees, are still reeling from investments that went sour after technology stocks peaked in March 2000. Fund managers buy equity tranches, which are also called "first loss" portions, even though those investments are never given a credit rating by Fitch Group Inc., Moody's Investors Service or Standard & Poor's.

[Mish comments: For a discussion of rating companies and their role in this mess, see Monte Carlo Simulation of CDOs (Part 1) and Monte Carlo Simulation of CDOs (Part 2)]

The California Public Employees' Retirement System, the nation's largest public pension fund, has invested $140 million in such unrated CDO portions, according to data Calpers provided in response to a public records request. Citigroup Inc., the largest U.S. bank, sold the tranches to Calpers.

"I have trouble understanding public pension funds' delving into equity tranches, unless they know something the market doesn't know," says Edward Altman, director of the Fixed Income and Credit Markets program at New York University's Salomon Center for the Study of Financial Institutions.

"That's obviously a very risky play," he says. "If there's a meltdown, which I expect, it will hit those tranches first."

Calpers spokesman Clark McKinley declined to comment.

Because CDO contents are secretive, fund managers can't easily track the value of the components that go into these bundles."

As the $503 billion-a-year CDO market thrives, CDO marketers like Bear Stearns and Citigroup find buyers for the portions known as toxic waste, the equity tranches.

`Lipstick on a Pig'

Chriss Street, treasurer of Orange County, California, the fifth-most-populous county in the U.S., says no public fund should invest in equity tranches. He says fund managers are ignoring their fiduciary responsibilities by placing even 1 percent of pension assets into the riskiest portion of a CDO.

"It's grossly inappropriate to take this level of risk," he says. "Fund managers wanted the high yield, so Wall Street sold it to them. The beauty of Wall Street is they put lipstick on a pig."

Seven percent of all the equity tranches sold in the U.S. in the past decade were purchased by pension funds, endowments and religious organizations, Fleischhacker says.

That hasn't stopped pension funds from taking high risks with the retirement plans of teachers, firefighters and police.

[Mish comments: Bear Stearns is saying one thing: Buy CDOs and get get a 20 percent annual return, while doing another: unloading every CDO it can. If Bear Stearns really thought those CDOs were good for a 20% annual return would they be dumping them?]

2007-06-12
Bear Stearns Fund Hurt by Subprime Loans

Hard hit by turmoil in the market for risky mortgages, a big Bear Stearns Cos. hedge fund has fallen 23% from the start of the year through late April, according to people familiar with the matter.

The performance was disclosed late last week in a letter to investors from executives at the Wall Street firm's asset-management division, these people say. The fund, called the High-Grade Structured Credit Strategies Enhanced Leverage Fund, is widely exposed to subprime mortgages, ... [the rest is subscription only]

2007-06-12
Welcome to the Hotel California

Most by now are familiar with the following dynamic:

• Bears buy Credit Default Swaps on the debt of various companies – mainly financials – with reckless abandon using hyper-leveraged instruments.
• The corporate bond market underwrites the CDS purchases.
• The CDS get crushed by ever tightening corporate spreads forcing the bears to cover their leveraged bets.
• The underwriters have just collected free money to lend at very tight spreads (no need to worry about risk spreads since the lenders are playing with house money) which in turn fuels LBOs, M&A and buybacks. Stock prices go up, bears must cover their equity bets, and Hoofy throws a big party.

While I have been forced to respect this scenario for the last many months (or else I’d be doing something else by now), there are a couple of articles in this morning's Wall Street Journal which explain why I have refused to defer to it.

First is the piece discussing that the losses at a Bear Stearns mortgage-related structured product were in fact much bigger than initially disclosed, because the initial loss estimate relied on mispriced mark-to-market holdings.

Second, is the commentary on how companies that have no business still being in business have been rescued by cheap, risk-seeking money.

The two stories are one and the same in mind. That is, risk spreads in corporate bonds have collapsed not because the lenders see an ever ending plateau of prosperity in corporate America, but because, IMHO, bears’ bets on the demise of many companies have been crushed by squeezes triggered by the mispricing of the derivatives tied to the debt.

IIn essence, the underwriters of the CDS bearish bets have come to see the premiums collected from the CDS buyers, much as option sellers these days view the premiums they collect: free, and risk-free money, with the critical difference being that the option markets price their instrument in a relatively market driven environment, while the CDS market – not being an open, tradable market – mostly relies on the very same underwriters to “arbitrarily” mark-to-market the value of their own assets.

One does not have to be a genius to guess who is going to be the winner in that trade. .......

Flood of Loans

Thanks Fil. The second WSJ article that Fil was referring to in Hotel California is For Troubled Firms, A Flood of Big Loans

Bally Total Fitness Holding Corp., a Chicago health-club operator, is deep in debt and has periodically been considered a candidate for bankruptcy.

That didn't prevent Bally from borrowing $284 million last October. A unit of J.P. Morgan Chase & Co. arranged the loan, with investment banks and a hedge fund participating.

"I'll never forget being in a board meeting and saying to our investment bankers: 'How on God's earth was this so easy?' says Steven Rogers, a finance professor at Northwestern University who was then a Bally director. "They said: 'There's a lot of money out there.'"

To be more precise "There's a lot of credit out there with little real capital to back it up". The distinction is very important and will become obvious when a chain of defaults unearths the fact that no one is capitalized well enough to cover the guarantees. [See Monte Carlo Simulation of CDOs (Part 2)]

Companies that are all but dead have been given round after round of financing to stave off bankruptcy. In addition, there has been a sea of endless credit (nearly all of it toxic waste) used for no other purpose than to buy back shares. That too has been fueling the stock market.

Two Things To Remember

1. The debt does not go away when the party ends
2. Many corporations are going to have a very hard time servicing that debt

At some point there is going to be a complete revulsion of credit. With that in mind it will be interesting to see if the market chokes on the Blackstone IPO or not. The expected IPO date is the week of 2007-06-25. IPO terms: Blackstone sets terms for 2007's largest U.S. IPO.

Blackstone Group LP plans to raise as much as $4.75 billion in what would be the year's largest U.S. initial public offering, a day after agreeing to sell a $3 billion stake to China.

In its prospectus, Blackstone said it plans to offer 133.3 million common units at $29 to $31 each, for proceeds of $3.87 billion to $4.13 billion. Another 20 million units may be sold to meet demand, boosting the IPO as high as $4.75 billion. That's 19 percent more than the $4 billion Blackstone originally estimated.

Blackstone transactions this year include a $23 billion takeover of Sam Zell's Equity Office Properties Trust, and a $6.76 billion purchase of Alliance Data Systems Corp.

Blackstone plans to list its units on the New York Stock Exchange under the symbol "BX." Citigroup Global Markets Inc. and Morgan Stanley are the lead underwriters. Credit Suisse, Deutsche Bank Securities Inc., Lehman and Merrill Lynch & Co. are joint book-runners.

Interestingly enough REITS have struggled ever since that takeover. What did Blackstone know that Sam Zell did not? Answer: nothing, but Blackstone had OPM funding (other people's money) and were willing to waste it.

What do pension plans know that Bear Stearns doesn't? The answer, unfortunately is the similar: nothing, but they have OPM funding and are willing to place bets without having a clue as to what they are buying or how it is priced.

Credit Suisse, Deutsche Bank Securities Inc., Lehman and Merrill Lynch & Co. are joint book-runners for the Blackstone IPO. You have to like the title "joint book-runners". It sounds like a mob controlled numbers racket. The big difference is that in the numbers racket, everyone knows up front what % the house take is, and the game itself isn't rigged.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/