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The Desperate Optimism of the Invested

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  • The Desperate Optimism of the Invested

    The Desperate Optimism of the Invested

    The latest revelation from the Zombie Financial Media is today's report that Bear Stearns Co. has informed investors in its two failed hedge funds they will receive little if any money back after "unprecedented declines" in the value of AAA rated securities used to bet on subprime mortgages.
    Bear Stearns Tells Fund Investors `No Value Left'
    July 18, 2007 (Bloomberg)

    Estimates show there is "effectively no value left" in the High-Grade Structured Credit Strategies Enhanced Leverage Fund and "very little value left" in the High-Grade Structured Credit Strategies Fund, Bear Stearns said in a two-page letter.

    Based on interviews with fund managers over the past few weeks, in an update to our January 22, 2006 report Most Hedge Funds Suck, commenting on press reports that the value of securities in these funds were getting marked down between 30% and 70%, we noted: "We have conducted several interviews of fund managers. 70 percent? 30 percent? No. There are no bids. None. As of yet, there is no price."

    They mystery is how Bear Sterns was surprised. Early January this year we interviewed Jim Finkel for our iTulip Select subscribers. Jim is CEO of one of the companies that creates these high grade–per the ratings agencies–ABS CDO packages for hedge funds and bond portfolios, Dynamic Credit LLC. We re-interviewed him in March, and he and others a couple of weeks ago.

    More than six months ago Jim told us what was going to happen to the ABS CDO market and to many funds like Bear Sterns'. Let's go down a few key items from the interview:

    Ratings downgrades

    Janszen: You mentioned last time we talked that the ratings agencies might play into the correction. You were expecting a wave of downgrading. Any surprises there?
    Finkel: No, not really. Markets re-price risk today, not ratings agencies. They have a lesser role in more transparent markets.

    Failure of Synthetic CDO indexes to hedge fund losses

    Janszen: How about those synthetic CDO indexes you were expecting to see come on the market. You told us mortgage derivatives indexes use optimistic model based valuations and they will not work if used by funds to hedge major re-pricing events. What effect have you seen?

    Finkel: Well (Jim looks at his wireless PDA) the synthetic TABX at the moment is 27% and cash CDO market is 14%. Which would you buy? The unexpected result of the TABX is this huge spread. Means dealers won't accumulate CDOs. The CDO cash bid is gone. AAA cash CDOs still get done, but the technicals are driving the CDO markets now since the introduction of synthetic CDO indexes, not fundamentals.

    Eventual correction in "higher grade" CDO tranches

    Janszen: Where are the opportunities?
    Finkel: The so-called "Super senior tranche" has not yet re-priced. Specifically, the Alt-A BBB has not yet corrected.

    Janszen: What are the weaknesses there?
    Finkel: Geographic concentration, the fact that the ratings agencies permitted thin subordination (even less than sub-prime), meaning that prices can erode even faster than sub-prime.

    Failure of risk models under extreme collateral price decline conditions

    Janszen: Ok, let's get to the heart of it. Last time we talked, you said a national housing price correction of more than 14% was a big deal. Let's break it down. Which grades of debt securities get hit as prices decline, X% per year and Y%? cumulative?
    Finkel: What is expected is a 11% cumulative loss over the average 5 year average term of a debt security.

    Janszen: And if housing prices fall more?
    Finkel: Typically, the BBB takes the brunt of a credit market correction. But if the decline in housing prices is greater than 14%–cumulatively, over a few years–we start to see the the "A" getting hit. At a cumulative loss of more than 22% or 24%, AA- (aa3) gets hit.

    Janszen: What does that mean?
    Finkel: No one really knows. That's unprecedented.

    The Bear Sterns funds blew up because they counted on the synthetic CDO indexes to operate efficiently as a hedge. Finkel said way back in January that these funds were going to lose their shirts that way. Following Finkel's advice may have saved Bear Sterns' investors a few billion.

    Here are a few other predictions in the mortgage markets he made which have not yet appeared in the markets:
    • Buy-back obligations will lead to more bankruptcies among lenders - Many more lender bankruptcies to come
    • Major risks lurking in speculative and second homes - We are starting to see this locally this summer on Cape Cod and other areas of the country where second homes dominate
    • Sound loans depend on market-priced housing values and accurate FICO scores, but both are gamed – Opening up yet another layer of default risk in the mortgage market, in addition to no-doc/low-doc loans
    • Financial engineering will create problems when mark-to-model becomes marked to market – Not only ABS CDOs but the CLOs (Collateralized Loan Obligations) which have fueled the buyout boom
    • If housing decline 15% to 20% nation-wide, the mortgage securities market will be in dangerous, uncharted territory - Given the prediction by Case/Shiller of a more than 20% home price decline nationally, there are many more mortgage securities re-pricings to come
    Both the housing market and the market for the securities backed by home loans have a long way to go before reaching bottom.

    The ABS mis-priced and mis-rated cat is out of the bag, but we see more "surprises" to come, as identified by triangulating on the opinions of the experts we interview in the context of our own view of how the financial and economy world really works. If Finkel's other predictions of events which have not yet occurred are as prescient as his others, there are major market events lurking in the prices of stocks in companies that have been levered up with debt over the past few years, and the banks that lent the money to finance the CLOs that banked the deals:
    • Between 45% and 60% of all bank loans are going into PE deals via the CLO market
    • Private equity bubble is even bigger than mortgage bubble, and more serious macro-economic fallout is more likely
    Are any of these upcoming "surprises" priced into the market? We doubt it.

    The moral of the story is that the availability of the kind of information iTulip Select readers received six months ago was surely available to all market participants had they sought it out. But information alone is not sufficient to create an efficient market.

    Much has been said of the madness of crowds in a market bubble. Our experience is that optimistic beliefs that develop within a community of bankers, fund managers, dealers, traders, consultants, and investors when vast sums of money are flowing during an asset bubble create systemic mis-pricing and poor evaluation of risk within a market. The availability of apparently free money flowing for years on end distorts the judgment of, not to mention the motive for accurate appraisals by, highly experienced professionals, a phenomenon we call The Desperate Optimism of the Invested. It is as likely to infect the professional holder of any non-diversified, un-hedged or ineffectively hedged long position in any asset in a sustained bubble market. It's not only the 24 year old no-money-down real estate mogul during the housing bubble or gold-bug with most of his or her net worth tied up in precious metals during an inflationary boom who is susceptible.

    Whether a pro or an amateur, maintaining a disinterested and impartial perspective on the contents of one's portfolio may not be as much fun as being a cheerleader for and true believer in a particular component of it, but the practice will save you a lot of money and heartache.

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    Last edited by FRED; 07-19-07, 01:53 AM. Reason: Error in "Most Hedge Funds Suck" article date: 2006 not 2007

  • #2
    Re: The Desperate Optimism of the Invested

    Take credit where due, the Hedge Funds Suck article on my computer is dated 12/22/06. Very good.
    Jim 69 y/o

    "...Texans...the lowest form of white man there is." Robert Duvall, as Al Sieber, in "Geronimo." (see "Location" for examples.)

    Dedicated to the idea that all people deserve a chance for a healthy productive life. B&M Gates Fdn.

    Good judgement comes from experience; experience comes from bad judgement. Unknown.


    • #3
      waiting for "the bottom is in" / "well contained" prognostications

      no credible ones recently - all the cheerleaders seem AWOL, or maybe are concerned that this kind of statement would severely diminish their credibility.

      Is this the kind of unanimous opinion that signals an upside breakout?

      Even if I could intellectually convince myself that it is some kind of bottom in some appropriate market segment, I would be too paralyzed with fear to place any bets with my own money.


      • #4
        Re: The Desperate Optimism of the Invested

        2 little articles from bloomberg today fit right in:

        Moody's Shut Out of Rating Commercial Mortgage Bonds (
        By Mark Pittman

        July 18 (Bloomberg) -- Moody's Investors Service has been excluded from rating 70 percent of new commercial mortgage-backed securities after toughening its guidelines.

        Moody's has been shut out of nine of the past 13 deals as underwriters sought better ratings from rival companies, Tad Philipp, a managing director at Moody's said today in a telephone interview. The securities had a face value of more than $25 billion.

        ``There's no doubt in my mind that it's because of the change'' said Philipp, who included a chapter titled ``Rating Shopping is Alive and Well'' in a report released today. ``Normally, we'd rate 75 percent of the issues, not 30 percent. I guess this is sort of like, no good deed goes unpunished.''

        JPMorgan's Dimon Sees `A Little Freeze' in Lending for LBOs

        By Caroline Salas
        July 18 (Bloomberg) -- JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said demand for leveraged buyout debt is drying up and banks may be left holding more loans that they can't sell.

        There is ``kind of a little freeze in the marketplace,'' Dimon said on a conference call with investors to discuss the New York-based bank's second-quarter earnings. ``If you see this continue you will see the Street taking on a lot of bridge loans and more aggressive repricing of those things.''

        JPMorgan, the third-largest U.S. bank, is among lenders that have been saddled with at least $11 billion of high-yield bonds and loans they haven't been able to readily sell, data compiled by Bear Stearns Cos. analysts show. Investors have balked at the increasing amounts of debt being taken on for LBOs.

        In most deals, investment banks promise to provide loans to the buyer. They then seek other lenders to take pieces of the loans and find buyers for bonds. When buyers vanish, the banks must either buy the bonds themselves or provide a bridge loan to the borrower, tying up capital that would otherwise be used to finance more deals. The banks typically parcel out portions of bridge loans to reduce their risk.


        • #5
          Moody's revenues

          Does anyone know what percentage of Moody's revenues over the past couple of years has come from rating various issues, and how much from other activities?

          And within the rating of issues, how that might have been split across the various types of issue?

          If all the have been doing is rating debt, then they must be in for some very thin times ahead even if people go back to trying to issue plain vanilla debt.


          • #6
            free mortgages?

            is there any conceivable way (before the government even steps in with gifts) that all this shuffling of paper between bankrupt entities could yield more than a few people a free house?

            If some bankruptcy or other causes the loss of some papers, for example?

            If you figure out a way to use this supposition, please drop me a line with the specifics.


            • #7
              Re: The Desperate Optimism of the Invested

              Spartacus, it is unlikely anyone will get a free house out of it. If they didn't pay their mortgage, it is also likely they didn't pay their taxes, or insurance, or a host of any other expenses that come with a house. So if the mortgage proper is lost, then there are likely to be miles long lines of lien-holders ready to take the house. Remember that even if the mortgage is lost, there are public records of every real estate transaction that takes place, and so there is someone out there who knows what home owners are delinquent on whatever they owe.

              A lot of the HBB'ers joke about squatting in houses, and that's about as close to "free" as you can get although squatting is illegal.

              You could maybe find a vacant house and offer the owner to live in it and keep up appearances (like a house-sitter), but as far as someone who "bought" a house and has a huge alligator mortgage, I can't see how they would be able to get their liabilities discharged to get a "free" house.


              • #8
                Re: free mortgages?

                Originally posted by Spartacus View Post
                is there any conceivable way (before the government even steps in with gifts) that all this shuffling of paper between bankrupt entities could yield more than a few people a free house?

                If some bankruptcy or other causes the loss of some papers, for example?

                If you figure out a way to use this supposition, please drop me a line with the specifics.
                unforturnately i can't find the link, but i read that several home "owners" have been able to retain title in spite of not paying their mortgages. their attorneys have been successful in resisting foreclosure because the holders of the debt are so complex - i.e. the note was sliced and diced into various tranches of various cdo's - that judges ruled that it was not clear who had the legal right to foreclose. whether these were just a few poorly written cdo documents or this might be endemic i could not determine.

                edit: check out
                key quote
                "I buy time, then get lenders to cut interest rates and fees," says Charney, who claims she's stopped dozens of foreclosures over ownership issues. Other lawyers are making similar moves in Maryland, New York, Massachusetts, Ohio, Kansas and Washington State--often forcing sloppy lenders to offer generous terms to avoid litigation.

                Talk about shooting yourself in the foot. These days just about every mortgage is flipped by a lender to another one or sliced up into pools of securitized packages that are sold on Wall Street. The financial engineering helped oil the housing boom by making credit more available. But stalled housing prices and rising defaults have revealed a mess: In the rush to flip paper, lots of the new lenders or pools don't have the proper paperwork to show they even hold the mortgage.

                There is a case in Kansas with no documents to show a bank owns the loan it says it does. In another, ownership of a loan was recorded on a single date in the name of two different lenders. In March last year Deutsche Bank filed to foreclose on a seven-bedroom home in Worcester, Mass. owned by Sima Shwartz. But it came out that Deutsche was assigned the loan in May or June--that is, after the foreclosure filing. A U.S. bankruptcy court judge in April slammed Deutsche for its "jumble of documents" and ruled the bank could not evict Shwartz.
                Last edited by jk; 07-22-07, 09:25 AM.


                • #9
                  Re: free mortgages? - coolness

                  In one of Nasser Saber's books he writes about the SEC, the US FED and the Treasury all filing amicus briefs in a case, and all making an obviously uneconomic point to grease the regulations for their own purposes - if the obvious economic standard had been applied, the precedent would have wiped out several banks, and the US Gov agencies all conspired to get a ruling they could live with.

                  I forget the case - a fruit grower trying to sell shares in his farm or some such.

                  I'm waiting to see the legal issues that fall out of this housing bust situation, and especially all the incredibly convoluted paper derived therefrom - the legal issues will be extremely convoluted, I bet - especially since no one wants this toxic sewage to see the light of day.

                  Originally posted by jk View Post
                  unforturnately i can't find the link, but i read that several home "owners" have been able to retain title in spite of not paying their mortgages. their attorneys have been successful in resisting foreclosure because the holders of the debt are so complex - i.e. the note was sliced and diced into various tranches of various cdo's - that judges ruled that it was not clear who had the legal right to foreclose. whether these were just a few poorly written cdo documents or this might be endemic i could not determine.

                  edit: check out
                  key quote
                  Last edited by Spartacus; 07-22-07, 03:11 PM.


                  • #10
                    Re: The Desperate Optimism of the Invested

                    Also a good article - Hold On to Your Seat: America and Its Debt Based Economy