Wall Street Fears Bear Stearns Is Tip of an Iceberg [WSJ]
Near-Collapse of Funds Stokes Broader Concerns Over Murky Investments
By JUSTIN LAHART and AARON LUCCHETTI
June 25, 2007; Page A1
The near-meltdown of two hedge funds at investment bank Bear Stearns Cos. last week underscored -- and in some ways aggravated -- a growing fear on Wall Street: that hard-to-trade investments may suddenly turn south and set off a broader market downturn.
The Bear Stearns funds, whose investors include wealthy individuals, other hedge funds and some of the firm's own executives, are part of a recent boom in investment vehicles specializing in illiquid assets, such as exotic securities, highways and timber lands.
Unlike stocks or bonds listed on an exchange, such assets can't be readily bought or sold. That makes it hard to establish an accurate price for them. Fund managers have broad discretion in attaching a value to these assets, and often don't reveal many details of their trades.
Bear Stearns's High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leverage Fund ran into trouble when a downturn in parts of the housing market hurt the funds' bets on complex securities backed by subprime mortgages, or home loans to borrowers with troubled credit histories.
Such securities trade infrequently, which makes it hard to sell them quickly without incurring steep losses. The funds, especially the Enhanced Leverage Fund, used borrowed money, or leverage, to amplify returns. But leverage also amplifies losses when a fund's bets go sour.
Investors with plenty of cash on hand, thanks to years of low interest rates, have flocked to illiquid investments in search of outsize returns, often with the help of borrowed money. Some market experts worry that investing in illiquid assets, despite their inherent risks, has become almost mainstream.
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In 2006, U.S. institutions such as pension funds and endowments, had about $1 of every $10 invested in less easily traded assets -- such as hedge funds, real estate and private-equity funds -- up 27% from 2003, according to consulting firm Greenwich Associates.
Endowments and foundations, among the nation's richest investors, had about a quarter of their portfolios invested in less-liquid assets last year, Greenwich says. These deep-pocketed institutions can afford to wait a long time if they see big returns on the horizon. But many other investors, especially those backed by potentially nervous lenders, don't have that luxury.
"A lot of investors unfortunately are chasing returns rather than focusing on risk," says Leon Metzger, an industry veteran who teaches hedge-fund management courses at Yale, New York and Columbia universities.
Now, the problems at the Bear Stearns funds -- which prompted the firm to lend one of them up to $3.2 billion in a bid to rescue it -- show how hedge funds bent on short-term gains can go astray when holding assets that can't be easily valued. That has stoked worries on Wall Street that other funds with similar types of investments will suffer losses as fund managers reassess the value of those investments. Those concerns contributed to last week's 279.22-point, or 2.1%, drop in the Dow Jones Industrial Average to 13360.26.
Many hedge funds and other institutions are paid in part on performance, so it is often in their interest to price, or "mark," their assets aggressively, attaching the highest possible value to them. The higher the value, the more compensation the fund manager receives from the fund's investors.
Moreover, hedge funds typically don't keep investors abreast of the details of day-to-day trading. As a result, any losses the funds suffer may be significant by the time investors learn of them. That can be especially true for illiquid assets, which may not show much price movement for months and then dip sharply when confronted with the one-two punch of declining fundamentals and nervous investors.
The combination of illiquidity and leverage has long been a mainstay of financial crises. In 1994, hedge funds run by Askin Capital Management sustained huge losses on leveraged bets on infrequently traded mortgage-backed securities. The collapse of Long-Term Capital Management, which roiled markets around the world in 1998, was sparked by its inability to unwind leveraged bets.
Last fall, commodity hedge fund Amaranth Advisors LLC lost about $6 billion when it couldn't easily exit esoteric trades that went against it. (See article on page C1.) Earlier this year, Bank of Montreal lost more than 600 million Canadian dollars (US$560 million) with a bad bet on natural-gas volatility.
Many investors have grown more comfortable with illiquid investments, based in part on the view that even highly illiquid assets have become more liquid these days, thanks to low interest rates and an influx of cash from the developing and oil-exporting countries that run trade surpluses with the U.S. What's more, through sophisticated financial products, the risk inherent in illiquid assets can be offloaded to hundreds of other players, making it more manageable.
Still, the increase in illiquid investments raises concerns. For one thing, even in liquid securities like stocks, what can seem like a ready supply of cash can dry up quickly if investors get spooked. Those problems are heightened when leverage is used.
Even if a fund plans to invest in an illiquid asset for the long haul, creditors can force its hand. If a leveraged investment racks up losses, the fund's lenders may demand more collateral, or even repayment of their loans. To meet those demands, the fund, whose losses are already magnified by leverage, could be forced to sell the investment well before the market recovers, adding to its burden.
"If the banks all pull the plug, that has a big impact on a fund's ability to ride out a short-term loss in value," says Chris McNickle of Greenwich Associates.
And the use of borrowed money is on the rise. In May, the sum investors borrowed from brokerage firms to buy stocks hit $317.99 billion, up about 14% from the previous record in March 2000, according to the New York Stock Exchange. Net borrowings by large bond-market dealers stood at about $1.33 trillion this month, up from $730 billion in 2003 and about $300 billion when the stock market peaked in 2000, according to Chicago market-research firm Bianco Research LLC.
More than anything, this borrowing represents a triumph of greed over fear. Investors use loans to juice up their bets without tying up much capital, and enjoy high-octane returns while holding seemingly conservative assets like mortgage bonds. The risk is that recently placid markets start to crack, turning these profitable leveraged bets into deepening losses. With funds that use leverage, it doesn't take a sharp move in a market to create a sharp drop in a portfolio's value.
Figuring out the risk profile of illiquid assets -- and funds that invest in them -- can be tricky. Typical methods for assessing risk rely on measuring volatility -- the choppier returns are, the riskier the investment. But because illiquid assets don't trade regularly, marking to market -- or using recent sales prices to determine an asset's value -- may not be possible. In these cases, a fund manager may instead use a mathematical model to value an asset, a practice called marking to model.
Such models tend to smooth returns, making an asset look much less risky, says Massachusetts Institute of Technology finance professor Andrew Lo, who is also a principal in AlphaSimplex Group LLC, an asset-management company that runs a hedge fund.
Using broker-dealer quotes for illiquid assets can also damp volatility because they are often based on an average of bid and offer prices rather than actual sales prices. What's more, price quotes can vary widely from one dealer to the next.
The Bear Stearns funds' situation demonstrates the considerable leeway funds have in valuing illiquid assets. The Enhanced Leverage Fund reported last month that it lost 6.75% of its value in April, but later put that loss at a far steeper 18%.
One reason the Bear Stearns funds' troubles worry Wall Street is the fear that other players own similar securities that have similarly been mispriced. If the funds' holdings were auctioned off, as their lenders had threatened to do, there would be a market to mark to -- albeit one that, because of the fire-sale quality of the auction, would value such securities well below what they otherwise might be worth.
Mr. Lo has found that returns for illiquid assets and funds that invest in them tend to have little variation from one month to the next. Paradoxically, it is this smoothness of returns that show how illiquid, and risky, a position might be.
Still, illiquid assets can be lucrative when held by investors with long time horizons, who don't have to worry about creditors suddenly calling in loans and who understand the risk they've taken on. "If you're a pension fund and you don't have any issues with being able to fulfill your obligations, illiquidity risk is a very good way to earn extra returns," says Mr. Lo.
Timber funds illustrate some of the potential, as well as the risks. These funds, in which investors hand over money to a manager who buys and oversees forest lands, can lock up investors for 10 to 15 years, typically returning their money after selling off the properties involved. Cashing out of a timber fund early can mean selling at a discount of 20%. For a direct investor in timber, selling carries the same vagaries of selling a home: You can guess what the price will be based on appraisals, but you won't know for sure until you put it to market.
"This isn't a good investment for short-term investors -- there's too much volatility," says Dick Molpus, of Mississippi-based timber-investment manager Molpus Woodlands Group. |
