Friday, June 22, 2007

Problems in the Credit Markets with Bear Stearns (update #1) and What Happens Next Time?

The following summarizes the events of the last week concerning the Bear Stearns hedge funds Bloomberg #2, Bloomberg update 4, and WSJ:

Bear Stearns has two hedge funds holding collateralized debt obligations (CDOs) backed in part by sub-prime mortgages: High-Grade Structured Credit Strategies Fund and the High-Grade Structured Credit Strategies Enhanced Leverage Fund. The former fund has lost 10% and the latter 20% since the first of the year. Also the latter fund is more leveraged than the first.

These CDOs are seldom traded in an open market so the true value of the bonds is not known. For the most part they are carried on the books of the hedge funds at par value.

Last week it began to emerge in the press that the Bear Stearns hedge funds had losses since the first of the year and as a result were in violation of some of their loan covenants. Specifically, t
he funds received ``high levels'' of margin calls from creditors in the past few weeks and had trouble selling enough assets to keep running, Bear Stearns said in the statement.

Creditors extended $9 billion to the funds which made bets of more than $11 billion. . . . Lenders include Merrill, Lehman, JPMorgan Chase & Co., Goldman Sachs Group Inc., Citigroup,Cantor Fitzgerald LP, Bank of America Corp., Barclays Plc, and Deutsche Bank AG.

Bear Stearns tried to arrange a sale of some of the CDOs to bring the loans back into compliance with the loan agreements.

Due to difficulties in selling the CDOs, Merrill Lynch, seized about $850 MM in CDOs from the hedge funds and planned to sell them to repay the loan.

On Wednesday Merrill Lynch auctioned the CDOs. The result of the auction led to the sale of less than half of the CDOs at discounts ranging from 5% - 15%.

Cantor Fitzgerald, JPMorgan, and Lehman seized collateral along with Merrill Lynch. Cantor Fitzgerald auctioned off some of the assets. JP Morgan cancelled plans to auction off their assets. Lehman “had no comment”.

The ultimate issue in seizing the assets and selling them on the open market is:

A sale would give banks, brokerages and investors the one thing they want to avoid: a real price on the bonds in the fund that could serve as a benchmark. The securities are known as collateralized debt obligations, which exceed $1 trillion and comprise the fastest-growing part of the bond market.

Because there is little trading in the securities, prices may not reflect the highest rate of mortgage delinquencies in 13 years. An auction that confirms concerns that CDOs are overvalued may spark a chain reaction of writedowns that causes billions of dollars in losses for everyone from hedge funds to pension funds to foreign banks. Bear Stearns, the second-biggest mortgage bond underwriter, also is the biggest broker to hedge funds.

To combat this possibility:

Bear Stearns Cos. plans to establish a $3.2 billion line of credit for the High-Grade Structured Credit Strategies Fund to stop creditors from seizing assets of one of its money-losing hedge funds in the biggest fund bailout since 1998, . . . . The firm told lenders to the High-Grade Structured Credit Strategies Fund yesterday (June 22) that it would assume their loans . . . .

The question that comes to mind is that even though a credit crisis may have been averted this time. What happens next time when the hedge fund in question does not have the wherewithal to assume the loans of the lenders?

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