The Wall Street Journal yesterday had two front page items on the failed bailout plan for two hedge funds at Bear Sterns, which were involved in subprime housing loans.
Bloomberg also had a major item highlighting the fact that Merrill Lynch had "decided to seize and sell $800 million of [the Bear Stearns's hedge fund] bonds held as collateral."
Apparently other major investment banks are off-loading more of the Bear Stearns hedge fund bonds. These include: JP Morgan and Deutsche Bank ($700 million).
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The headline of the Financial Times was of a related subject, "Blackstone brings IPO launch day forward."
Another FT front page item is headlined, "UBS chief warning over risky lending."
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This should remind our readers that the problems of Bear Stearns are not the first to be felt. Only weeks ago, UBS announced the liquidation of two of its hedge funds run by Dillon Reed.
So what is going on?
Our readers and those of our sister publication, Financial Intelligence Report (FIR) know that we have long pointed to the fact that the housing bust has far further to go. Indeed, we feel it is only just beginning and that it is the primary reason behind the Fed's fear of raising interest rates both to stop inflation evolving into stagflation and to defend the U.S. dollar and so retain its most politically useful role as a reserve currency.
Readers of the May 2007 issue of FIR, will remember that we ran a lead item, titled "The Great Housing Crash of 2008." In that article we discussed in some detail the involvement of hedge funds.
Indeed, we expressed "great concern" in a specific reference to the U.S. mortgage market losses of a hedge fund run by Mr. John Costas for UBS AG.
We included the telling comments of Florian Esterer, joint money manager at Swisscanto Asset Management, who was reported by the Financial Times as saying, "Once UBS agrees on a strategy they normally stick to it. There must have been a huge problem."
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We also reported on an illuminating Financial Times article that spelled out the incredible leverage that hedge funds can negotiate and that they can leverage still further by investing in derivatives, which are themselves highly leveraged.
Let us remind our readers of the example we used.
A "Collateralized Debt Obligation," or CDO, is a leveraged derivative often based upon real estate, sometimes of a subprime nature.
A "Credits Derivative Product Company," or CDPC, is a company that can leverage its capital up to 30 times to invest in leveraged items such as CDOs. Talk about leverage? You ain't heard nothing yet!
Now, a hedge fund, funded by shareholders driven by high return and itself highly leveraged, invests in CDPCs.
The total leverage available in such an investment is a staggering 54 times.
Now that is real leverage. Compare this 5,300 percent to a mortgage of 80 percent!
It means that a hedge fund with $100 million of equity capital can buy CDPCs that have invested in CDOs with the underlying real estate valued at a staggering $5.4 billion! Now, that is leverage!
It is all great while the value of the underlying assets rises or even stays level, throwing off the interest payments on some $5,400,000,000.00 worth of debt at high, subprime rates. Some investors fight the doors down to get at such returns.
But what if the value of the underlying real estate were to fall, even just a little?
Given our example of leverage of 54 times, a fall of just two percent would wipe out the entire equity capital of the hedge fund.
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Now, we can see what Florian Esterer meant when he said the problem at UBS' "Costas" hedge fund, "…must have been huge."
As our readers know, the hedge fund industry is largely unregulated.
We still believe that financial greed has led to an abuse of freedom by certain hedge funds, many of whom are the exact opposite of "hedged." Indeed they are highly "exposed!"
We feel that there are a considerable number of "exposed" private equity funds and that they could prove to be the trigger to a financial panic of massive proportions, if interest rates were to rise.
In this respect, we note that, despite the mainline media comment to the contrary, there has been a very marked reduction in overseas demand for our Treasury debt.
A sustained fall-off in overseas demand for our government debt, could force our Fed to raise interest rates, just when it most afraid to do so.
A rise in interest rates at this time could hurt all our financial markets and magnify the real estate bust. Some highly leveraged and exposed, so-called hedge funds could be in for trouble — big trouble.
Here, we refer again to the announcement by Blackstone that it is to bring forward the launch of its IPO. There are a number of other hedge funds looking to "cash in," including the prestigious Carlyle Group.
Do these bright founders of hedge funds see something that general investors are not seeing?
Finally, in our column of yesterday we commented on a most prescient article in the Financial Times concerning what we term the "stealth risk" being added, ever so quietly, to certain debt instruments by the dilution of the conventional restrictive covenant of those debt instruments.
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We highlighted how the hedge fund industry is forcing these changes by means of so-called "cov-lite" (containing greatly diluted covenants requiring for instance, performance monitoring ratios) and "cov-loose" (allowing for "balloon" repayments) debt agreements.
It is hard sometimes to see exactly what the shrewd managers of hedge funds have in mind.
Today, it could be the new political cries, in both the U.S. and in the E.U., for the dead hand of "state regulation."
But then again, it could be that these clever fund managers are selling into what they see as a "sucker's rally."
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