Gather 'round ye cassandras and dark oracles, nigh the time is come! The wounded bear roars and writhes, and surely, surely! his claws at last will prick the green tumescence of the credit pimple, and a pustulence of default and devaluation will gurgle across the land!
Or not. The crisis at two hedge funds managed by Bear Stearns has all the markings of a systemic-crisis-threatening event. (If you've not been following, tsk. Naked Capitalism has been doing a phenomenal job covering the story.) But I don't think anything bad is going to happen, because the bear and his friends in the forest (hedgehogs?) are, ultimately, protected by the Dragon.
First let's review the what happened. Bear managed a hedge fund that made leveraged bets in illiquid CDOs backed by subprime mortgages. That was a winning strategy for a long time, so, by popular demand, Bear opened a second fund taking on even more (um, "enhanced") leverage to reap those juicy mortgage yields. But, things have gone suddenly wrong in mortgageland, and the funds were forced to inform investors that they had lost a lot of money. Investors found themselves locked in, with lenders demanding that the funds put up more collateral or face forced liquidation of their assets.
Forced liquidation would have been, um, bad, from a green-pustulence-flowing-in-the-streets perspective. There are lots of hedge funds holding illiquid, hard-to-value synthetic debt based on iffy mortgages. With help from debt-rating agencies, fund managers are employing the strategy Wile E. Coyote would have followed, if he were smart enough to understand Gaussian copulas and stuff. It's called "Don't Look Down!" Since exotic securities don't trade very often, there is no clear market price, no clear value to which funds have to "mark" their portfolios. So hedge fund managers use models to make educated guesses of what their securities are worth. Since managers earn fees by seeming to perform well, they tend to use models that, lo and behold, spit out optimistic, all-is-well valuations of their portfolios. However, a "fire sale" at Bear would put Wall Street Panglossians under pressure, as all of a sudden market prices, not very nice market prices, would be attached to securities quite similar to the ones in their own portfolios.
Let's understand what we mean by "pressure" here. Imagine you're a hedge fund manager sitting on a pile of leveraged rocket science that you privately think has lost much of its value. You have two choices. You can use a model that captures your intuition, and mark down the assets, forfeiting any performance fees and your seven figure job too. Or you can hold tight, keep the faith. If you make it to the end of the year, you get a big performance fee, which you get to keep even your faith turns out to have been misplaced and your investors lose money. This is a no-brainer, right? Keep da faith!
But there is a wrinkle. If you take that hefty bonus, but you really did know that the fund didn't perform as advertised, well, there are technical terms for that. Theft. Fraud. The language of high finance can be arcane, but maybe you get my drift here. Currently hedge funds are relying on safety in numbers. If "industry best practice" is to value CDOs and XYZPDQs optimistically, then, hey, you can't be faulted for following "industry best practice", can you? But if anyone can make it stick that you knew, or should have known, your portfolio was trash... well, that's bad. Plausible deniability is the whole game here. If very low asset prices from some hedge-fund yard sale get published in the Wall Street Journal, some fund manager might get nervous, and mark down his assets too, bragging about "integrity" and other unprofitable hogwash. All of a sudden, "industry best practice" is what he's doing, and you've got to follow along or take a chance on Sing Sing. With each capitulation, each markdown, investors get more and more nervous, more and more inclined to remove funds, forcing more sales, liquidations, lower prices, a death spiral, the Great Depression.
There might have been some danger of this sort of thing happening on Friday, but the danger has passed. Bear put up 3.2B of its own money to save one of its funds. (Well-collateralized repo financing we are told, but if the collateral is trash... let's just call it a "mezzanine tranche".) That seems to have been enough to persuade creditors, some of whom had threatened to pull the plug abruptly and start selling, to give Bear some space to work out the debts of the other (more toxic) fund at, um, a measured pace. Does that matter? After all, if the assets are impaired, fire sale or no, they're not going to fetch a good price, right? It might go slo-mo, but the same scenario should unfold eventually, no?
I don't think so. Here's where the dragon comes in. Several years ago, Nouriel Roubini and Brad Setser warned very plausibly that the United States' current account deficits were unsustainable, that developing countries like China would not be able to fund America's huge and growing deficits for very long at all. They were (quite honorably) wrong. Among other things, they expected that China's central bank would be unwilling or unable to accept the future financial losses implied by massive purchases of US debt (which is likely to lose value in terms of the China's Yuan). China has instead accelerated its USD purchases, proving its willingness to accept very large losses (or else high future inflation) in order to meet its primary objectives: stability and growth.
Stability and growth remain China's objectives, and a financial crisis beginning in New York is every bit as threatening as a stock market crash in Shanghai. China could not have acted fast, as the US Fed did during the LTCM crisis. But, so long as only a few funds are in crisis and the unwindings are "orderly", I think China will find it in its interest to be a "bagholder of last resort", purchasing a few assets at prices high enough to prevent cascading markdowns or defaults against margin lenders. Fund investors will still lose money, but that rarely has systemic implications. As hedge fund proponents frequently point out, hedge fund investors are hedge fund investors because they can afford to lose money. (That's not really true, but we'll let it go here.) China won't buy anything directly. Look for secretive hedge funds claiming that US mortgage assets are undervalued, great opportunities, despite the continued freefall of housing. Just as fire sales threaten to puncture confidence and lead to mass markdowns, apparent arms-length purchases at high prices reassure that optimistic models are fine, permitting fund managers to do what they want to do — report good performance and take their fees without jeopardy.
Of course, if confidence in valuations does break, no one could bail out the whole market, it is too big. Eventually there may be some kind of reckoning. But the logic of the moment, in New York, Washington, and Beijing, is that in the long-run we are all dead, so let's put stuff off as long as possible and hope for the best. Anything that can be bailed out will be bailed out. The money is there, eager, and ready.
|Steve Randy Waldman — Tuesday June 26, 2007 at 6:08am||permalink|