The fall-out from Bear Stearns

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“The recent collapse of two hedge funds at Bear Stearns Asset Management raises two questions few people can answer”, writes Frank Partnoy, law professor at the University of San Diego. “How did they lose so much money so quickly? And where else are similar problems buried?”

“It is virtually impossible for investors to understand how much exposure an institution really has to the subprime markets”, argues Partnoy. Now that investors seem to understand this, the markets are swinging wildly. “Volatility is highest when people realise they cannot figure out what investments are worth”, he writes.

What lessons can hedge funds learn from the subprime problems? Mr Partnoy answers readers’ questions on subprime markets and the fall-out from Bear Stearns.

Having read your compelling arguments in both Fiasco and Infectious Greed, I would like to ask what you recommend investment banks, hedge funds and private equity firms do to avoid financial market epidemics like the current subprime crisis? One example of the complexity of the topic is a question such as: Is there a precise and specific link between the subprime crisis in the US and the LBO liquidity dry-up in Europe? If so, how is it possible to avoid it? Whose role is it to clear up their act? Investment banks, hedge funds, private equity houses?
Charles Thoma, Paris

Frank Partnoy: First, thanks for calling my arguments compelling - flattery will get you everywhere! Great questions: There are a couple of ways for sophisticated market participants to avoid these kinds of crises. One is to stay on the sidelines. Many investors have shunned CDOs or subprime investments. There are plenty of ways to make money in the markets without trying to juice yields through questionable investments that don’t merit high ratings.

Warren Buffett famously called credit derivatives financial weapons of mass destruction, has avoided those investments, and has done pretty well for him and his investors.

Another way to avoid the crises is to make the opposite bets. Several hedge funds, most notably Paulson, bet that subprime was going to collapse, and they made a fortune. I don’t see a direct connection to the LBO liquidity dry-up in Europe, except that financial crises often lead to a reduction in liquidity, which indirectly affects most markets.

As for clearing up their act, I think the most culpable culprits are the credit rating agencies, which gave high ratings to subprime CDOs and really precipitated the crisis. Regulators need to step in and clear up there, by breaking up the agencies’ oligopoly lock, requiring better disclosure, and eliminating rules that depend on credit ratings. Quite a few pension funds bought sub-prime CDOs primarily because of the rating.

Frank, In your book Infectious Greed you wrote about how complexity made it difficult to judge financial risk but you suggested that astute investors who read more could have spotted most of the financial collapses before they happened. Do you think that statement applies equally well now to those who invested in hedge funds and fund of fund hedge funds? If so what were the warning signals that could have alerted the average attentive private investor to what was happening in subprime and what the consequences might be?
David G Wallace, Glasgow

Frank Partnoy: Yes, I think so. There were two key clues investors could have spotted. First, the exponential growth of CDOs was no secret, and many institutions made general disclosures about their involvement in CDOs. Although it would have been impossible to know the specifics, an investor could have dodged companies with any involvement until they made more specific disclosures.

Second, the big collapse in subprime occurred in February of this year, and an investor could have bailed out of companies that said they had exposure to subprime earlier, before they marked to market their losses. Unfortunately, there wasn’t much transparency about CDOs and subprime, though - as I argued in that book, we really do need more transparency regarding derivatives for investors to make the kinds of judgments you suggest.

Given the uncertainty in quantifying the exposure of financial institutions to the subprime markets in particular or other derivatives in general, what would be your advice to investors?
SK Tan, Kuala Lumpur

Frank Partnoy: My advice is to read the most recent quarterly and annual report of the institutions. If you don’t understand what an institution says about its exposure, don’t buy.

I don’t want to give specific stock advice, but I think that generally investors are well served by purchasing assets that the markets are able to price, and that means buying shares of financial institutions that make pertinent disclosures. It’s worth noting that shares of financial institutions have been trading at low multiples for a while, and are even cheaper now.

Is it not just the case again of investors chasing yield (as per Long Term Capital Management’s collapse in late 90s) but once again not thinking about the exit strategy? (ie liquidity issues in crisis conditions once more neglected.) And how can boards and regulators allow the banks to hold instruments they cannot evaluate under stress? Is that not the purpose of the new accounting standards regarding mark to mark and value at risk?
Ross McInnes, Sydney Australia

Frank Partnoy: Ross, the new accounting standards are partly to blame for this mess. They permit investors to avoid mark to market when they say they are planning to hold the investments through maturity. That distinction led to quite a lot of gamesmanship regarding mark to market.

For example, how much of AIG’s subprime exposure is marked to market. In its most recent quarterly filing, it admitted to having subprime and CDOs in its cash and short term investments. How is that possible? Boards need to be more diligent about disclosure of these kinds of risks.

As to exit strategy, I’m not sure. What would a pension fund’s exit strategy be for a subprime CDO? I think they are buying yield and praying the investments pay off at par. A bigger problem is that the employees at the investors are pursuing their own exit strategy: outperform their competition by buying subprime CDOs, and then get a better job.

Do you really believe that these quant strategies got too crowded? I find it hard to believe that all these different black box strategies came up with similar results. And if the strategy really had got so crowded, wouldn’t the first movers have had stellar returns earlier in the year, which would have just been unwound in the last two months? Personally, I suspect that most of the managers were drunk on their own risk, chasing riskier assets with more leverage, without properly hedging, and were naked once the downturn came.
Tom Adshead, Moscow

Frank Partnoy: Tom, you probably are right, but there is one variable many people treated similarly: correlation. The correlation among assets is not very well understood, and was a factor in the Long-Term Capital collapse as well. Basic financial pricing is straightforward, but correlation gets tricky and if a trade works everyone does it.

Having said that, we don’t know all the details yet, so it very well might be the case that they were naked, not hedged. Recall that once we learned the truth about Long-Term Capital, it turned out they had plenty of naked short positions, in addition to the supposed arbitrage strategies.

There has been much said in other papers recently about ”moral hazard” and how the policies of Greenspan and Bernanke may have contributed to this mess. My philosophy, however, is that it is the Fed’s job to protect the economy from a hard landing. The Fed did its job to slowly deflate the equity bubble, and in that case it was the job of Congress to legislate against poor accounting and clap irons on those who did so maliciously. Similarly, in this case I feel the onus is on Congress to legislate against impractical and inconceivable lending practices because each bubble was created through the violation of the fundamental need for perfect information to insure markets work smoothly.

Bernie Ebbers and Ken Lay cooking the books does the same harm to market performance as a lender who makes loans without examining the applicant’s likelihood for repayment. This bubble went a step beyond when these loans were then anonymously rolled into bonds and securities. The cheap money from the Fed certainly encouraged the expansion of the asset market and higher home prices would be expected. What made it an unsustainable bubble, in my mind, is not the cheap money itself but the unsavoury lending practices which followed. What do you think?
Andrew Martin, Washington, DC

Frank Partnoy: Nice philosophy, Andrew. I think too many people tend to blame the Fed. So let’s be clear about what the Fed has done wrong. Its rate policy does not take into account the effect of rate changes on financial innovation. Just as the rate hikes in 1994 sent shock waves through the market because the Fed didn’t know the scope of interest rate swap bets, so did the rate cuts after 9/11 send perverse incentives to the home lending markets. That alone wouldn’t create a scandal. But the Fed didn’t understand or anticipate the increase in subprime.

The one element missing from your philosophy is the REASON for the increase in subprime, and the Fed missed this, too, although it wasn’t the Fed’s fault. The reason was the massive increase in CDOs. The fact that investors would pay more for the CDO tranches than the underlying subprime loans created incentives for lenders to make more subprime loans.

And the moral hazard resulted from lenders being able to offload their loans to the market. Citigroup and JP Morgan didn’t care whether Enron defaulted because they had hedge their risk using credit derivatives - that’s moral hazard, and the same thing happened with subprime lenders. You can’t blame them exclusively for the unsavoury lending practices. Or, you can blame them, but you should anticipate that this is what they would do, given that they could offload the risk of bad loans.

I am intrigued by the fact that there’s no liquidity in MBS market right now, so pricing is quite off. One would have to rely on textbook models to calculate values, but there would be a marked difference between these models and the actual price you can get from the market if one actually sells. So how does the market get fair value prices as opposed to theoretical values?
Marcel Cachia, Amsterdam

Frank Partnoy: Marcel, what you are seeing in MBS occurs during every major financial crises, when prices overshoot and no one can tell what assets really are worth. Eventually, the markets will settle down and prices will approximate fair value. But that is the nature of a market.

The law of one price says that in a competitive market equivalent assets will have the same price. But in a crisis, equivalent assets might not seem equivalent. Some people will make money now, just as they do in every crisis, by purchasing underprice assets when the markets overshoot. I don’t trade MBS now, but I’m quite sure traders are doing just this. Within a few months, the markets should be saner.

If subprime risk has spread globally and many institutions have not yet marked to market the value of some of their funds which hold CDOs, would it make sense for regulators to intervene now and force the institutions to accurately reflect the value of these funds? This would lead to one painful period of bloodletting but might be better than volatility continuing indefinitely as the market wonders who will be the next subprime casualty.
Laurence Daly, Cork, Ireland

Frank Partnoy: It’s a great suggestion, Laurence, although regulators should have done that from the beginning. Some will do it now. There is one tough question, though: what value should the funds record?

I think the best approach would be to have them get bids from three dealers and take the average, or something like that. Many of them will try to use mark-to-model, so the regulator will need to specify clearly what qualifies as a mark. Perhaps regulators could set up rules to do this next time around.

Do you think that the CDO market is a passing fashion and the events in subprime will spell the end for CDOs as we know them now?
Samuel Curwen, UK

Frank Partnoy: No, I don’t think so. CDOs have been around a long time, since the days of Drexel and Michael Milken. (Fred Carr did the first one more than two decades ago.) As long as the incentives to generate favourable credit ratings are there, CDOs will continue to exist. It might be a while before we see them resurface. I’d say look for another wave of CDOs beginning in 2012, and another scandal five years after that

Should we perhaps limit the leverage that hedge funds and investment banks can take on their balance sheets for the sake of more stable and less risky markets?
Marco Nordio, Sao Paulo

Frank Partnoy: Rules restricting leverage don’t work very well. Sophisticated market participants, especially hedge funds and investment banks, quickly figure out ways around them. Remember that Regulation T supposedly limits margin on equity investments to 50 per cent, and EVERYONE gets around that. People also are facile at using options and other derivatives to create leverage. So, although I like the thought behind the suggestion, I don’t think limiting leverage will work.

A better approach would be to require that these institutions make clearer disclosures about the amount of leverage they take on, and then to allow investors to sue them for damages after the fact if they make false disclosures.

Do you think the EU economy will gain a strong competitive advantage over the US economy as a result of the US subprime mortgage market crisis?
Viktor O. Ledenyov, Ukraine

Frank Partnoy: I don’t think so, Viktor. European funds bought subprime, too, and the same fundamentals affect all markets. Indeed, we already know that German funds were a major casualty in the subprime scandal. Also, hedge funds have investors from everyone, including a lot of money from the EU. I think that if one sector obtains a competitive advantage it will be because of how it responds to this crisis. Everyone is involved. (Don’t forget that although Long-Term Capital was perceived as a US scandal, many EU investors, including the Bank of Italy, were deeply involved.)

Frank Partnoy: Markets abhor the vacuum left by derivatives

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