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Thursday, July 05, 2007 11:29 AM


The Redemption Trap & Merrill Lynch Cover-Up


The UK Telegraph is writing about a the near collapse at Bear Stearns and the subsequent cover-up by Merrill Lynch.

When creditors led by Merrill Lynch forced a fire-sale of assets, they inadvertently revealed that up to $2 trillion of debt linked to the crumbling US sub-prime and "Alt A" property market was falsely priced on books.

Even A-rated securities fetched just 85pc of face value. B-grades fell off a cliff. The banks halted the sale before "price discovery" set off a wider chain-reaction. "It was a cover-up," says Charles Dumas, global strategist at Lombard Street Research. He believes the banks alone have $750bn in exposure. They may have to call in loans.

Not even the Bank for International Settlements (BIS) has a handle on the "opaque" instruments taking over world finance. "Who now holds these risks, and can they manage them adequately? The honest answer is that we do not know," it said.

Wobbles are turning to fear. Just $3bn of the $20bn junk bonds planned for issue last week were actually sold. Lenders are refusing "covenant-lite" deals for leveraged buy-outs, especially those with "toggles" that allow debtors to pay bills with fresh bonds. Carlyle, Arcelor, MISC, and US Food Services are all shelving plans to raise money. This is how a credit crunch starts.

"This is the big one: all investment portfolios will be shredded to ribbons," said Albert Edwards, from Dresdner Kleinwort.
Bear Stearns Buyers Strike

The Financial Times is talking about fire sale bids for Bear Stearns debt.
Investors in the worse-hit of two stricken Bear Stearns hedge funds are offering to sell their holdings for as little as 11 cents on the dollar but still finding no buyers, according to unfilled trades on Hedgebay, a secondary market for funds.

Vulture funds and others have been quick to bid for holdings in the two funds, but the best bid for Bear Stearns High-Grade Structured Credit Strategies Enhanced Leveraged Fund, the more geared of the two, is just 5 cents on the dollar.

Private sales of stakes are the only way investors can exit the two Bear funds, after the bank suspended redemptions in May amid a wave of withdrawals.

"There are buyers but they can't agree on price," said Jared Herman, co-founder of Bahamas-based Hedgebay.

The less-geared Bear Stearns High-Grade Structured Credit Strategies Fund, which the bank has rescued with a $1.6bn loan, is being offered at about 70 cents on the dollar. The fund is only attracting bidders at about 30 cents, according to people who use the system.

Market participants estimate the CDOs the Bear funds held would sell for at least 10 per cent less than the values calculated by lenders. "Where things transact is still many points below where dealers have been marking them," said one manager of CDOs and hedge funds. "That is the big ugly secret of this market."
Marked Down

No takers at 11 cents on the dollar should put a new perspective on the meaning of marked to market. The best bid was 30 cents on the dollar for assets held by the High-Grade Structured Credit Strategies Fund and a mere 5 cents on the dollar for the High-Grade Structured Credit Strategies Enhanced Leveraged Fund.

Wow. 5 cents on the dollar. That's quite an enhancement for something supposed to be High-Grade. Given that redemptions are suspended there is no escape for many investors caught in the jaws of this Bear Stearns Trap.

The Redemption Trap

It's not just Bear Stearns that has stopped redemptions. Consider United Capital Asset Management Suspension of Redemptions.
July 3 /PRNewswire/ -- The structured-finance marketplace was very volatile during June as news broke early in the month of significant losses in a large ABS/MBS hedge fund. June saw a dramatic widening of credit spreads across asset-backed securities ("ABS"), mortgage- backed securities ("MBS") and collateralized debt obligations ("CDOs"). Because of the current negative sentiment, other risks have been heightened in the past month such as liquidity risk, redemption risk, and the pricing risk resulting in margin calls issued to the entire structured-finance sector.

Over the past 10 days we have received an unusually high number of redemption requests, including a request from our largest investor that accounts for nearly one-quarter of our assets under management. As has been announced in the press, United Capital Asset Management ("UCAM") has temporarily suspended redemptions for the Horizon Fund L.P., Horizon ABS Fund L.P., Horizon ABS Fund Ltd. and Horizon ABS Master Fund Ltd. ("Horizon"). We wish to emphasize that UCAM and Horizon are not liquidating and intend to continue in operation.

Observing these serious market conditions highlighted above, we reduced many cash bond and all synthetic positions in June. We have greatly lowered the Horizon's leverage. We sold a large amount of cash securities into the market without issuing bid lists or conducting auctions.

Horizon lost money in closing down its positions in the ABX. We view the synthetic markets as highly volatile and, at this time, have stopped trading them entirely.

Horizon has taken the step to suspend redemption requests in order to protect the interests of our investors while we continue to analyze the risks highlighted above, and we expect to resume processing these redemptions as soon as it is prudent, which we hope will be in the very near term.
I see that it took a disaster for Horizon to realize synthetic markets are highly volatile and stop trading them. Did they not know this before?

Furthermore, Horizon may be making the exact same mistake Bear Stearns made. Bear Stearns suspended redemptions way back in February. The assets are now worth 5 cents on the dollar. It's highly likely that investors would have gotten more than 5 cents on the dollar back then.

I talked about this in Bear Tracks & CDOs and A Bear's Bath. Here is a snip from the latter.
The situation is so bleak that Bear Stearns' asset management group is suspending redemptions at the onetime $642 million fund—meaning investors have no choice but to sit on their losses. And that's got some hopping mad.

An investor in Europe, who didn't want to be identified, says he's been trying to get his money out of the hedge fund since February.

He's particularly incensed that on a June 8 conference call the fund's managers set up to discuss performance, Bear Stearns officials refused to field investors' questions. "They specifically said they weren't taking any questions," says the investor. "They didn't want to say anything."

A Bear Stearns spokesman declined to comment.
Part of the excuse given by Horizon for suspending redemptions was that the largest investor accounts for nearly one-quarter of our assets under management and that investor wants out.

Isn't it gross mismanagement for an entire fund to be at the mercy of a single investor? Horizon doesn't want to liquidate but it may have to unless it wants to lock in that investor until this credit crisis blows over which could be something like forever at least in the eyes of someone who wants out and wants out now.

See Who's Holding The Bag? for comments from Buffett about derivatives, but my favorite has to be "the derivatives business is like hell easy to enter and almost impossible to exit".

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

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