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Nye Lavalle
Summer Storm in CDOs Shakes up Global Markets
Hedge funds with highly leveraged bets in CDOs and sub-prime mortgages created a storm that could push the U.S. economy into recession.
By Ivy Schmerken
September 20, 2007
Summer typically is a time for hedge fund managers to vacation in the Hamptons or someplace more exotic, but this year the season was disrupted by a storm in the credit markets. Fueled by collateralized debt obligations (CDOs) and the shorting of sub-prime mortgages by hedge funds, the summer credit storm left a lot of carnage to clean up in July and August (see Credit Crisis in Sub-Prime Mortgages Affects Hedge Funds Trading in Other Asset Classes. At press time, for example, Bank of America was injecting $2 billion into Countrywide Financial to help the nation's top mortgage lender obtain short-term financing and possibly prevent the slumping housing market from pushing the U.S. economy into a recession.

While hedge fund meltdowns always are unexpected, this one seems acutely unnecessary since defaults with sub-prime mortgages were predicted as early as a year and a half ago. The question is, Where was the risk management at Bear Stearns Asset Management and other funds that made big bets on sub-prime mortgages?

When two of Bear Stearns' hedge funds blew up in June, it sent shock waves through the financial community. After all, Bear Stearns is one of the most sophisticated risk management firms when it comes to fixed-income trading and analysis of mortgage-backed securities. "You've got a firm that has tremendous experience in fixed income, lots of very smart quants writing algorithms to price these securities and hedge funds that invest in some of the most sophisticated fixed-income securities today," notes a risk management expert who spoke on the condition of anonymity. Further, Bear Stearns has its own in-house risk engine, Bear MeasureRisk, which it acquired three years ago.

But at least one hedge fund expert says risk models weren't the problem in this case. "Effective risk management first has to start with common sense and then see what the numbers say," says Virginia Parker, founder of Parker Global Strategies, a fund-of-funds manager in Stamford, Conn. "But always start out with a reality check."

The current turmoil, according to Parker, resulted from a lack of common sense. First, many of the sub-prime loans were given to homeowners without verification of income, she notes. Second, there were problems with the fundamentals behind the structures of the CDOs -- which were rated AAA but were filled with the shaky sub-prime mortgages. "Essentially this was a house of cards," says Parker.

Although the CDOs are created through financial engineering they are traded as over-the-counter transactions. They lack price transparency and are illiquid under normal conditions. So once all the hedge funds and dealers decided to get rid of them, the supply of CDOs far outweighed the demand. And once Bear had to sell assets to raise cash to meet demands for more collateral, that created fears around the Street that every hedge fund and dealer had to mark down their positions. When markets turn dire, it can be hard to value the securities and get out at a fair price.

But Robert Hegarty, managing director in charge of TowerGroup's securities and investments and insurance practices, doesn't think it was the lack of transparency between the sub-prime market and the CDOs that foiled the funds. "I doubt it was a lack of information," he says. "It's just being too leveraged and concentrated in a single security," Hegarty contends. "You mix a fast moving market with a little bit of ignorance and a little bit of arrogance and you wind up with a situation like this." Hegarty notes similarities between trading on leverage and gambling.

While blow-ups occur on the trading desk every so often -- think Long Term Capital Management, another quant firm using leverage in fixed-income -- the danger of the current collapse is that it rattled global markets. Wall Street sprinkled so much stardust on CDOs that everyone seems to own sub-prime mortgages, including pension funds and other institutions with long-term liabilities.

So perhaps investors whose assets were wiped out should scrutinize hedge funds for more information on their strategies, and prime brokers should think twice before allowing funds to deploy heavy leverage. In the meantime, let's hope that the Federal Reserve calms down the markets and that hedge funds get some common sense when it comes to rolling the dice on risky instruments.
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