Where's The Paper?

We are now a full week into the Bear Stearns mortgage debacle and, after big press coverage, a sizable pull back in the equity markets worldwide and a small unwind of the global carry trade, we still have little information concerning the CDO risk. And it's quite possible the markets will pretend that we really don't need to know much more.

We don't know actual pricing for a lot of the paper because no one wants to trade it, and we don't know who owns it, because no one wants to fess up. There are articles that suggest it's the hedge funds, some say it's the insurance companies and endowments, maybe some sovereign funds and maybe, god forbid, the commercial banks. But no one knows. Where's the paper?

Meanwhile, Moody's continues downgrading mortgage focused CDO's (basically corporations that hold the underlying mortgages - usually subprime - as assets and finance these assets with debt and equity; the debt is issued in tranches that get rated from AAA on down and the equity becomes the most toxic part of the capital structure) because the collateral itself has deteriorated. This means that at some point, assets will have to be shuffled - bought and sold by the CDO manager - finally setting prices for these things.

The quality of the paper is unlikely to improve in the near term. Subprime defaults continue to rise and as the CDO managers try to maintain credit ratings for their debt issues, who's going to step up and buy the low grade paper and the toxic equity as they drop like a stone? We also have a big ARM reset comming over the next few months that will affect the higher grades of mortgage paper, adding even more pressure.

There is a sizable chunk of CDO paper that will tank. A lot of capital will be wiped out. It might look like the savings and loan game all over again. We assume this isn't the case because derivatives have allowed a very broad distribution of this paper and the ability to hedge the paper's risk; but what do we really know? It sounds good, but it is quite possible that some big, well regarded institutions, in a desperate reach for yield, have built up large positions of unhedged CDO's. This is, after all, why the banks invented this product - AAA paper with a better yield. And we haven't even started talking about the overlevered, no-covenant, PIK paying LBO - I'm sorry, private equity - deals out there.

I know when my stocks are working against me, I have a tendency to avoid the truth and not look at my trading account. We all know what the elephant in the living room is all about. We'd like to think that the $10 million men running some of the world's largest financial institutions are above this kind of human behavior. I'm gonna guess they aren't. We have heard from the CEO's of UBS, BofA and CD&R; they are concerned. Concerned enough to start building up big distressed asset teams to buy all the crap they issued over the years. At a nice discount, of course.

The Black Hole

Here we stand in the middle of another US/Euro equity sell off, this one triggered by bond concerns related to the housing market, just like the last wobble. So, by now everyone knows that Bear Stearns has two hedge funds that speculate in CDO's, and both funds have made bad bets. One fund was leveraged as much as 20 to 1. The amazing thing is, in all the papers, blogs and research reports, no one can actually describe the trades made or the status of the funds.

Based on the Markit Index for CDO's, the perceived risk of owning low-rated subprime-mortgage bonds created in the second half of 2006 rose to a record as loan delinquencies and mortgage rates climbed. But this index depends on sales data to price risk; if certain paper isn't trading, then how can you price risk? It sounds like the entire bond market is hoping no one will actually transact any of the crap CDO's so no manager actually has to see the size of their losses. A nice big black hole.

How much do leveraged funds have of this crap paper and what is its real price? No one knows, and no one seems to want to know. What does seem to be clear is that the housing market is not improving, the recent surge in the 10 year is making the problem bigger and it's still early in the cockroach game. There seems to an inept old man waving a flashlight around this black hole of a room, so we only see a few of the critters. Wait until he finds the light switch.

Of course, we may not have found the final sucker in this game. As stated in the WSJ," "There's an opportunity out there to buy these loans at a discount," says Lou Morrell, vice president for investments and treasurer at Wake Forest University in Winston-Salem, N.C. The university's $1.2 billion endowment is in the process of placing about $25 million with a hedge fund to invest in subprime mortgages. Because these loans could sell for steep discounts, he says, "they will be popular with a lot of endowments out there." " Well gee golly gosh, Andy.

Meanwhile the equity markets, after a huge run since the Feb/Mar correction, are susceptable to any bad news. But is there a connection? What if a lot of hedge funds are carrying a leveraged CDO position that is falling apart? Redemptions start with treasuries and other liquid fixed income assets, but do we have enough contagion that the equity assets get hit?

Must be frustrating holding a bunch of oil service, E and C, mining, equipment and ag stocks, knowing the numbers in July are going to be fabulous, while the mooks reaching for yield in their leveraged, greed saturated funds look at you like a four year old pretending he didnt just take a crap on the living room rug. And then smear it on the wall. Thank you Eric Theodore Cartman.

It's Different This Time

My first step in the business world was in the early 90's with NCNB, the precurser to a host of bank names ending in B of A. When I joined the company they had just completed the purchase of First Republic Bank of Texas. They paid $1.5 billion, and then didn't, benefitting from a tax loophole that has since closed. First Republic had burned through its entire capital base and a lot more on dodgy real estate, dry oil wells and international loans, the same problems that brought Citi close to its end, trading for $1.50 a share in the cigar butt discount bin.

When the times get good, prudence and the rules that got you in position to make a bundle get thrown out the window - the first law of greed. Raw land, speculative real estate, no money down? No problem. Banana republic (not the stores) needs a soveriegn loan, no problem. Everyone's doing it, have to keep up with the peer group (a bad behaviour that starts around age 3), have to grow earnings.

After business school, I worked at Robertson Stephens, a fabulous brand with a first class crew. This time I was lucky enough to be in front of the bubble and make a little coin along the way. But after losing the leadership team that got the firm into an enviable position, and discovering an inability to do wrong, the firm found itself shut down by its parent company, Fleet Boston (again, after many name changes - life in financial services). In 2001, after uttering the infamous ad line, "Thanks old economy, we'll take it from here!", we found ourselves with triple the work force doing a third of the business, leaving a trail of liability-smelling bad behaviour.

Now, thankfully, I sit at my own desk watching the next mass grab for wealth spiral out of control. The same signs - rampant insider trading, new custodians of capital with different ideas of credit risk, and absolutely unknown risk concentrations. Whistling past the graveyard? I know, I've heard it all - explosive growth in risk abating derivatives, a shrinking pool of equity and vast growing pools of equity funds, a veritable central bank led fire sale for debt capital - its different this time. Maybe. Doubt it.