Sunday, June 24, 2007

When Models Misbehave

By GRETCHEN MORGENSON
Fair Game
The New York Times
June 24, 2007

ALTHOUGH Bear Stearns announced on Friday that it would shore up one of its two faltering hedge funds that are heavily exposed to the subprime mortgage mess, the move did little to instill confidence in an already fearful market.

Even after Samuel L. Molinaro Jr., Bear Stearns’s chief financial officer, said in a conference call that his firm would lend the fund up to $3.2 billion to conduct an orderly liquidation, questions continue to swirl around the implosion of the funds, how they could have lost so much value in such a short time and why the firm’s risk management professionals seem to have been AWOL in recent months as subprime mortgage loans plummeted in value.

It is an uncomfortable spotlight for Bear Stearns to stand in. It is, after all, one of Wall Street’s major players in the mortgage securities market. In addition, the funds that have blown up were once gems in the firm’s asset management business. At the end of 2006, Bear Stearns’s asset management unit oversaw $29 billion in so-called structured credit assets — derivatives related to fixed-income securities.

Although Bear Stearns would not discuss how much money has been lost by its funds, an investor in one of them said that the securities in both were valued at $16 billion. The investor said that the fund Bear Stearns plans to bail out — the High Grade Structured Credit fund — was set up three years ago and produced steady monthly returns of roughly 1 percent to 1.5 percent until March, when it produced its first loss.

The second fund, born 10 months ago, is called the Bear Stearns High Grade Structured Credit Enhanced Leveraged fund. It was a sort of steroid-laced version of its sister fund because it used considerably more leverage. Bear Stearns has decided to abandon that fund for dead.

There are a couple of lessons in this. They are not new ones, but because the unraveling of the funds seems to have taken investors by surprise, they merit repeating.

First, marking illiquid securities to a model that makes certain assumptions about their future behavior is not the same thing as marking to an honest-to-goodness market of buyers and sellers. Assumptions about the future are inherently based on past behaviors and values that may well have absolutely nothing to do with the present — the laxity in subprime lending in 2006 and 2007, for example, has never been seen before.

In worst-case scenarios, such models may reflect the fantasy that a firm’s principals prefer, not the reality of a security’s likely value. And yet, investors and financial firms everywhere are relying heavily on these models and building their balance sheets accordingly — a very dangerous game, especially when it comes to complex pools of securities backed by assets like home loans.

What does this mean in cold, hard cash? On a conference call with clients on Thursday, a Credit Suisse analyst estimated that the markdowns would likely be in the billions of dollars.

That brings us to our second lesson, which is another blinding glimpse of the obvious emerging from this debacle: the rating agencies, which investors rely on to be prescient cops on the beat, are stunningly behind on downgrading mortgage-backed securities and the pools that own them. Do the math: Bear Stearns is paying $3.2 billion to shore up a fund that once had $10 billion in value, according to one investor. That’s 32 cents on the dollar.

THE portfolio wasn’t just made up of toxic stuff, either. While 60 percent of the fund was invested in residential mortgages, 40 percent was in commercial loans. Moreover, 90 percent of the fund consisted of securities with AA or AAA ratings, according to the investor.

Officials at ratings agencies have said in the past that their ratings reflect their estimates of future performance, not market pricing. So the agencies are also marking to model. And that keeps people playing the fantasy game about values, especially in hard-to-analyze collateralized debt obligations that are essentially pools of other asset-backed securities. Some $1 trillion of C.D.O.’s have been issued. (Yep, C.D.O.’s were in the troubled Bear funds.)

“The C.D.O. sector is still extremely rich versus where the underlying collateral is trading,” said Albert Sohn of Credit Suisse on the conference call. “Either subprime has to get richer or C.D.O.’s have to get cheaper.”

Another bit of reality is setting in now that Bear Stearns has taken action: values of securities higher up in the capital structure of these asset pools will likely take a hit. The Bear funds unwound as quickly as they did partly because of a surprisingly close correlation between lower-rated slices of these pools and higher-rated ones, according to people who have seen the portfolio. The bad performance is bleeding upward.

Starting tomorrow, fresh data on mortgage delinquencies is due. Investors will be able to see how borrowers are responding to the big interest-rate increases that are just now kicking in on many loans.

While the market may have been somewhat relieved that Bear Stearns stepped in and stopped the bleeding in its fund, David Ader, a government bond strategist at Royal Bank of Scotland Greenwich Capital, said in a note to clients on Thursday that liquidation is not the end of the problem, but more like the start. “Our expectation is that other entities will find their C.D.O.’s (or whatever) priced differently from reality and so the process of price discovery will be ongoing,” he wrote. Volatility will result, as well as the possibility of an unraveling into what he described as “something bigger.”

Hold onto your hats — it looks as if it’s going to be an interesting summer.

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