As noted earlier, this will continue my series of posts on the deleveraging of financial markets.

This time it is the unraveling of a couple of hedge funds run by the investment bank Bear Stearns that is weighing on the markets.  The ‘High Grade Structured Credit Strategies Fund’ invested in cash and derivative instruments tied to CDO’s backed by sub prime residential mortgages.  As that market has been hit hard, due primarily to repricing of ARMs (i.e. significant increases in monthly payments required of home owners), delinquencies and foreclosures, those securities have been repriced downward.  Of course, to juice returns in the fund some leverage was used.  Leverage plus declining security values have meant margin calls by Bear’s fellow Wall Street investment banks who did the lending.  When one bank, Merrill Lynch, found it difficult to find buyers for their loan’s collateral, the result was severe downward pressure on those and similar CDO tranches.

And, when selling of large blocks of securities is not met with a wash of liquidity, the result is that other similar securities (in this case, certain kinds of CDO tranches of subprime mortgage pools) must be marked to market downward, along with those currently looking for a buyer.  This repricing pressure has the potential to negatively effect several investors (i.e. hedge funds) who hold investments other than this type, as they might be forced to sell those other securities to meet margin calls.

Meanwhile, deep concern has set in and Bear Stearns, seeing a huge problem not only across this fund but in its much larger, related High Grade Structured Credit Strategies Enhanced Leverage Fund and in its affiliated Everquest Financial, Ltd. holdings decided to provide a temporary solution to the problem: A $3.2 billion bandage in the form of a loan from Bear to the fund without ‘enhanced leverage’ in the name.  Most likely, in this way, existing investment bank creditors would have their margin calls met and/or be paid down.  Undoubtedly, the plan will be to find an orderly market to sell the securities in the fund and repay the loan.

www.bloomberg.com/apps/news

However, since apparently Bear’s colleagues on the Street were not interested in advancing more $ to the fund,  what is the real value of that $3.2 billion band aid loan on Bear’s balance sheet today?  As of the quarter ending Feb 07, the Bear had about 13B in shareholders’ equity against 394B of assets.  And, it still has to determine the ‘cost’ of the loan or other bailout of the larger ‘enhanced leverage’ fund, where borrowing was even more pervasive.

Why doesn’t the Bear just walk away from those troubled funds?  One reason could be that they own similar securities, as noted above, and ‘fire sale’ pricing would directly cause a mark to market hit to shareholders’ equity.  Another could be the Bear’s concern about its own reputation.

As I write this, S&P sees no problem in all of this on the Bear’s A+ rating. 

www.forbes.com/markets/feeds/afx/2007/06/22/afx3848541.html

Meanwhile, I am unshocked by the fact that just a few weeks ago, the Bear announced an IPO for Everquest Financial, another related player in the sub prime CDO market.  As we all know, when John Q. Public can buy into a hot ‘idea’, there must be something behind the ‘idea’ to worry about.

And, we will reiterate what we have been telling all of our clients every quarter, for the past four quarters:   "Perhaps the press has overstated the negative ‘wealth’ effect from falling house prices and what the real residential realty bogeyman will be is upwardly adjustable mortgage payments…unless mortgage brokers get even more creative."  To that we must add that it is those ‘creative’ mortgage brokers that have been forced to close in droves…many by the implosion in the sub prime CDO market.

To sum it all up, I would like to draw your attention to the ultimate irony in all of this:  Last year, Euromoney Magazine named Bear Stearns as the "Best in Risk Management" in the U.S.  Alas, that is no joke:

www.euromoney.com/article.asp

I do not know who finished second.

We wish the Bear the best in solving this very serious problem. 

Yes, you read that right.  Hedge fund growth slowed to only 37% year over year from a 53% previously.  Total hedge fund assets are now estimated at $2.5 trillion.  http://www.institutionalinvestor.com/Article.aspx?ArticleID=1361809 

At this slower rate of growth, hedge funds will control about $10 trillion in assets at the end of the next four year period (2011). 

Now, a more realistic assessment. 

I do not know if the $2.5 trillion is net of borrowings (which would be significant), but I do know that the financial press loves large numbers (see previous blog post on SWF’s).  More importantly, what does this mean for insurers?

Many large insurers have been HF investors for well over a decade now.  The acceptance of such vehicles as ‘proper’ for insurers has gradually come down the insurer asset size spectrum to where we now see insurers in the 1-5 billion size range seriously considering them.  (Of course, there are a handful of smaller insurers whose Boards have pushed them to dabble.)

Hedge funds are NOT an asset class.  If they are, then Mutual Funds are an asset class, and that would be a grossly incorrect characterization.  HF’s consist of several different strategies.  Thus, they might be considered for an insurer’s portfolio based upon what a given strategy/style can do for the portfolio.

Something that HF’s can probably not do is consistently beat equity market returns.  When lumped together, HF’s have tended to provide BELOW equity market returns.  So, why bother?  They have also tended to provide much lower volatiltiy than equities and lesser correlation with other assets typically held by insurers.  For more on this, we highly recommend AllianceBernstein’s report, "What Lies Beneath?" https://www.alliancebernstein.com/institutional/Registered/ArticleDetail.aspx?cid=32263

Because of this, in analyses we have performed for our clients, it is readily apparent that hedge funds can generally be expected to add a material amount of risk adjusted return to the traditional insurer’s portfolio.

However, before you begin to jump on the HF bandwagon (and risk trying to explain the risks inherent in HF’s to a Board of doubting Thomases), you should remember that using a hedge fund of funds is a great way to pay more fees WITHOUT a concomitant advantage in returns.  The most successful investors in hedge funds (and here we are speaking of certain pension and endowment investors) have focused on choosing individual HF’s after much detailed research about the quantitative and qualitative issues.

An asset class growing at a "paltry" 37% cannot be pushed aside as an alternative for insurer’s non fixed income (or ‘risky bucket’) portfolio.  However, caution, prudence and detailed research is advisable.