The Desperate Optimism of the Invested

[EJ]

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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