It was the best of times, it was the worst of times. It was the age of wisdom, it was the age of foolishness.

The saga of the Bear Stearns High-Grade Structured Credit Funds invites many uninspired literary references, but as history repeats itself, many of them offer valuable insight. In the case of fund manager Ralph Cioffi's illiquidity driven downfall, the facile LTCM analogy is nonetheless apt. Even if it is a bit farfetched to compare the Russian government defaulting on their GKO bonds to the US poor having to give up their homes in the current subprime melt-down, the flight-to-quality is overbearingly similar as well as the bailout situation. Furthermore, the ensuing revaluation of assets will most probably lead to excellent distressed opportunities (one telling example of this is the deals hedge fund group SAC Capital Advisors was able to close during the aftermath of the earlier collapse).

Major differences include the likely containment of risk and the increased resiliency of the financial markets, all indicating genuine progress. Below we will try to recapitulate what really happened including a background on the developments in the US subprime residential markets. We will wrap up with some predictions regarding the fallout's effect on structured credit investing going forward. We would also like to point out that we were not investors in the funds: everything in the text below builds on publicly available information and we make no claims regarding the accuracy of the data.

In 2003, long time bond-salesman Ralph Cioffi, who had been a prop trader for Bear Stearns for six months, was lured over from the Bear Stearns' proprietary trading desk to start his own hedge fund. Seemingly conservative, he christened the fund the Bear Stearns High-Grade Structured Credit Strategies Fund. True to its name, the fund invested in bonds and securities backed in part by subprime mortgages and churned out returns of about 1 to 1.5% a month, with no drawdowns. In 2006, investor demand and the rock-steady performance of the fund led Bear Stearns Asset Management to launch a sister fund with slightly more leverage.

In August of last year, the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage fund raised $642 million. At their peak, the two funds controlled over $20 billion of assets in fairly illiquid instruments and Ralph was in effect one of the biggest buyers of subprime backed CDOs. As is often the case with low-yielding fixed income, this size was achieved through substantial leverage, ranging from 10 to 25 times. According to investors, 60% of the portfolio of the original fund was invested in residential mortgages and the rest in commercial loans. Overall, 90% consisted of securities with AA or AAA ratings. Prima facie, that does not look exceedingly toxic, and complacency ruled until February of this year, when credit markets started to reassess the likelihood of future defaults and losses in the US subprime debt market. A market-wide repricing of the highest rated (AAA through A) tranches of subprime CDO deals followed, which created large mark-to-market losses. February saw the first losses of the more leveraged fund, and on 15 May it declared a loss of 6.5% for April. On June 7, the investment firm told investors that the fund's actual April loss was 19% (which would imply a loss of 23% for the year). This significant restatement has led the SEC to investigate both funds.

Vicious cycle

So how could the steady returns turn into fat-tail double-digit losses? As the astute reader has already deduced, leverage magnified the initial mark-to-market losses. These revaluation losses led the investment banks to make margin calls on the loans they had extended to Ralph's funds. Illiquidity made it hard to pay, so some of the banks stopped negotiating with Bear Stearns and assumed control over part of the collateral (in the form of CDOs). Merrill Lynch held the biggest auction, which some observers called a firesale (and others a revenge for Bear Stearns not wanting to bailout LTCM 9 years earlier). The sale had to be called off after buyers took just $200 million of the $850 million on offer, with banks not prepared to bid over 85% of face value for the offered CDOs (which were all rated A or better). Naturally, the markets were severely interrupted, as these prices (if truly indicative and persistent) would necessitate a revaluation of substantial amounts of CDO securities. This in turn led to even more margin calls and the Bear Stearns funds entered a vicious cycle.

Valuation

This leads us to a fundamental question: how do you put a value on illiquid securities such as these CDOs? The answer, which might sound dangerous given the opacity and the amounts involved (total CDO issuance is above $1 trillion), is mark-to-model. Building models requires one to make assumptions about the future, something which will almost surely be based on past behaviour and values that may have very little to do with the present. One example is how the remarkably loose credit standards in subprime lending during the last two years have never been experienced before. So what about mark-to-market?Even when there is careful mark-to-market pricing, there is no guarantee that portfolio valuation will reflect the actual price paid at execution (mark-to-market does not make much sense if there is no active market). As was the case with the Merrill auction, there can be a considerable difference between prudent mark-to-market price and execution price. In fact, a non-negligible part of the funds' returns was related to the liquidity premium.

Rating agencies

Double-digit drawdowns from investing in high-grade securities might seem paradoxical, so what is the rating agencies' take on these developments? Already in March, the major agencies declared that there were going to be massive downgrades in the CDO market, but so far very little has been done. As a managing director at Moody's Investors Services put it, "[…] we don't change our ratings on speculation about what's going to happen". In other words, the rating agencies are waiting for tangible statistics regarding defaults and foreclosures. The most imminent problem with downgrades is that many investors, especially institutional ones, cannot hold securities below a certain grade, with forced selling and downward pressures on prices as a consequence, which could drive even more investors into the aforementioned cycle.

Hedging

Something which exacerbated the misfortunes of Cioffi was the supposed hedging using the ABX indices. In theory, shorting the ABX should provide a hedge against long exposure to subprime. In practice, the ABX indices have tended to be rather distanced from their fundamentals and many of the major swings have been driven by technical factors like short covering and the heterogeneous investor base (one problematic example is the large share of non-specialist macro funds which makes it hard to get a good overview of the flows) etc. Another peculiar dynamic that is overshadowing fundamentals is that we are dealing with a one-way market where most of the hedge funds are buying or selling at the same time.
 

Subprime meltdown

How did we reach this state of subprime meltdown (as the favourite epithet seems to be)? Lax interest rate levels tend to drive asset bubbles, and the first years of the new millennium saw real estate markets sky-rocket. As the Federal Reserve tightened monetary policy to stave off inflation, the housing markets started to cool considerably, with home-price appreciation slowing and in some instances turning negative (see Fig.2).

In order for the mortgage brokers to continue squeezing out handsome returns, they decided to cut lending standards, with no-document-income loans and loan-to-value ratios at and above 100% (a form of the principal-agent problem due to asymmetric incentives). The mortgages themselves were often sucked up into CDOs, which were sought-after because of their attractive yields and the demand caused by excess global liquidity. The aforementioned lack of lending standards has led to the current state of rising defaults and increasing delinquency rates, which was one of the main triggers of the high volatility in February. The nature of mortgages will make the process play out over a period of years rather than months, even if we have seen a lot of instability already this year (one pundit quite wittily called this a train crash in slow-motion).

The next phase of this train crash will be the coming resets of outstanding Adjustable Rate Mortgages, which constitute a majority of the subprime mortgages issued from 2004 to 2006. Bank of America estimates that approximately $500 billion of ARM are scheduled to reset in 2007 followed by $700 billion in 2008. Resets could affect the CDO market if enough borrowers cannot afford the new rates. This will further impair collateral and potentially force leveraged investors into the vicious cycle described above.

Contagion

Perhaps the most interesting issue at hand is whether there will be spillover to other markets. The connection to the corporate side is through sentiment and increased risk aversion, which might curtail the flow of leveraged loans to buyout funds. As investors turn to treasuries, the impact on the high yield market would be rather direct, causing high-yield spreads to widen. This sequence of events could eventually put a stop to the easy credit feeding the LBO and M&A frenzy, which in turn has been an important driver of the global equity markets.

Recent Morgan Stanley research provides an additional perspective on leveraged loans by pointing out that "notwithstanding the gradual deterioration in high yield balance sheets, the fundamentals of the loan markets are far removed from the dire straits of subprime ABS" and they do not expect to see any ratings downgrades-driven selling by CLO investors.

As a consequence of the current flight-to-quality experienced in recent weeks, several large bond deals have been pulled. A mere $3 billion of $20 billion junk bonds planned for issue the last week of June found a willing buyer. At the same time default rates outside of subprime mortgages have stayed low this year, with high-yield default rates in 2006 at their lowest since 1981, according to Edward Altman of New York University and of Z-Score fame. With healthy corporate profits (although corporate debt is increasing) and an abundance of liquidity, it is too early to speak of real contagion. What we are experiencing at the moment is most likely a case of transitory repricing of risk and a return to more prudent credit standards – paradise lost and regained?

Distressed opportunities

The structured ABS market will probably remain in price discovery mode until there is more transparency on who sits on what risks etc. This should provide fertile grounds for distressed investing, in the same vein as LTCM-SAC and Amaranth-Citadel. Already hedge funds are picking up and reworking bad subprime loans in accordance with the guiding principle that there is no such thing as a bad loan, just a bad price. To further exploit these developments, some of the funds are also asking bond rating services about the process of bundling the 'repaired' loans into securities. As always, one has to do one's homework before entering this market. An illustrative example of a potential obstacle is that lawmakers in several states are considering more than 70 bills to protect homeowners.

The end?

Turning back to the Bear Stearns funds, one might want to know if there will be a happy ending to this story. In a move to satisfy the market's expectations of change, the hitherto quite successful Richard Marin (as head of their asset management unit he doubled assets under management to $60 billion and grew revenue by 138 percent over the last 4 years) has been replaced.

Furthermore, Bear Stearns has decided to bail out the bigger of the two funds through secured loans of $1.6 billion. The pundits are debating whether this is a benign outcome or not. Although there was no upfront agreement to bail it out, investors would probably have lost faith in the investment bank had it not acted the way it did. The negative side is that it does not bode well for the independence of hedge funds, which is an important topic in itself, particularly as it determines whether the funds should be treated as off-balance sheet or not.

The more leveraged of the two funds will be left to its own devices, but as of the latest estimate, it has $1.2 billion in repurchase agreements on its books, much less than the $7 billion reported last week, which makes a forced liquidation less likely than before. In short, Bear Stearns will have no difficulties absorbing the losses financially; what is at stake is its name in the mortgage industry and even more generally. As Charles Dickens would surely have put it: ABS investing is fixed income with a twist. The lesson could be 'bewareinvesting into highly leveraged illiquid securities' or 'a 40-month track record without losses does not mean you can skip due diligence', but it is rather: people know both these things, and yet similar blow-ups will happen again.

Erik Larsson is Head of Research at AlphaSwiss Group