Hedge Fund Crisis Building: 'The Truth Is Pretty Ugly,' Insider Says
June 21 (LPAC) "This is going to be a rough Summer," commented an active market trader in Collateralized Debt Obligations (CDO) to EIR June 21 about the cascading effect of the collapse of two Bear Stearns investment bank hedge funds.
The two hedge funds made bets in housing-related, especially subprime housing-related paper. Bear Stearns' first fund, the High-Grade Structured Credit Strategies Enhanced Leverage Fund (HGSCSELF), has $638 million in investor capital and borrowed $6 billion from some of the world's biggest banks. It leveraged that borrowed money into $16 billion in bets on the mortgage market; its sister fund, the HGSCSELF II, has $925 million in investor capital, and made $13.7 billion in bets. The $29.7 billion gambling bets went wrong, the hedge funds lost billions of dollars, and they are going under.
The danger is that the Bear Stearns' funds invested their monies into CDOs, an insanely risky instrument, which mixes into itself 50 to 100 other instruments, predominantly Mortgage-Backed Securities (MBS), and other asset-backed securities. The CDOs have tranches or levels. The upper tranches are sometimes AAA-rated MBS, which have a greater rate of paying off to investors; the lower tranches are BBB-rated MBS or below, which have a poor rate of paying off.
This trader noted that as the subprime housing market explodes, and U.S. interest rates rise, the lower tranches are massively failing. This makes it difficult to market the CDO as a whole.
The trader warned that "the spread between what the CDOs sold for when they were new [called the offered price], and what the CDOs could sell for now on the market [called the market price] is widening. The spreads will get even wider." In return for the $6 billion in loans, Bear Stearns' HGSCSELF hedge fund gave CDOs to the lending banks as collateral. Lehman Brothers, a small lender, seized the collateral, and sold it on the market June 19 but received only 50 cents on the dollar, reported www.housingwire.com. A big lender Merrill Lynch is threatening to auction $825 million of Bear Stearns CDOs that it holds, on the market.
This could expose that the CDOs which banks and hedge funds carry on their books at "offered price,'' are really worth 50-70% less. This would cause a massive, instantaneous asset devaluation and crisis, spreading from the $1 trillion CDO market into other markets.
"As of now, there is soul-searching going on on the Street. Very senior level executives at financial firms are calling their trading desks, and saying, 'Tell me what the securities you have are really worth,'" the New York-based trader said. He stated, "I don't know if the Treasury or Federal Reserve have stepped into the market. But I would think that Paulson or Bernanke are calling big banks and saying, 'How does it look?'"
As we reported earlier today, Securities and Exchange chairman Christopher Cox acknowledged the SEC is, indeed, monitoring the hedge-fund collapses for a potential "systemic event''; in plainer terms, a crash. Treasury Secretary Paulson, on the other hand, told Congress June 20 that the Treasury in unconcerned.