The biggest hedge-fund bailout since LTCM

Two of broker Bear Stearn's funds narrowly avoided collapse last week as their dabblings with CDOs went awry. But as the era of cheap credit draws to a close, this is merely the first falling domino of many.

An old adage says that the more inflated a fund's name, "the less likely are the practitioners to know what they are doing", notes Anthony Hilton in the Evening Standard. Enter broker Bear Stearns's High-Grade Structured Credit Strategies Enhanced Leverage Fund. Along with another Bear Stearns hedge fund (the High-Grade Structured Credit Strategies Fund) it virtually collapsed last week. Their bets on complex securities backed by ailing subprime mortgages homeloans to borrowers with dodgy credit histories, a sector that has seen defaults jump sharply of late went wrong.

Last week, after the investment banks that had lent to the funds refused to come to their aid, seizing collateral instead, Bear Stearns lent the second fund $3.2bn, the biggest hedge-fund bail-out since the rescue of Long Term Capital Management in 1998. The fate of the less healthy and more leveraged Enhanced fund, which had equity capital of $600m but borrowed about ten times that sum, is still uncertain. The drama fuelled fears that losses could extend to other players in the mortgage markets and beyond, crimping lending and thus undermining the tide of easy money that has inflated financial markets all over the world over the past few years.

The Bear Stearns funds were dabbling in derivatives called collateralised debt obligations (CDOs). These bundle together different kinds of debt ranging from corporate bonds to securities underpinned by mortgages into packages that are divided into different sections and sold on to investors. The slices differ in terms of risk and interest paid. This packaging means that the top tranches of CDOs can receive high credit ratings: although each individual holding may be dodgy, the chances of all the holdings going bad at once are deemed low. CDOs are also highly leveraged.

The trouble is that CDOs are illiquid they don't trade in active markets, so "investors have a lot of leeway" in estimating the value of a CDO, as David Reilly points out in The Wall Street Journal. And investors in mortgage-backed securities haven't taken on board rising subprime default rates, Professor Nouriel Roubini of New York University told The Daily Telegraph. Losses will be "massive" once the assets are correctly priced, which is why Wall Street is "in a panic".

Merrill Lynch called off an auction of CDO debt it had seized from the Bear Stearns funds after selling just $200m of $850m of assets. The market clearly has little appetite for CDOs, which certainly implies that housing market risk has hitherto not been fully factored in. Now that investors are set to look more closely at the value of CDOs, it's no wonder there are jitters over systemic risk, notes Roubini. Low prices for CDOs could force other leveraged investors to revalue their holdings downwards, potentially setting off "a domino effect that could rattle markets globally", agrees Reuters.

If the trend towards higher leverage starts reversing, it could feed on itself. As Richard Beales explains in the FT, a bank reining in lending to a hedge fund could force the fund to ditch emerging-market stocks. That in turn would dent another fund's returns, forcing it to sell mortgage bonds or even its collection of Andy Warhol's artwork. Another example of the potential knock-on effect is that mounting risk aversion could make borrowing by private equity harder by putting upward pressure on interest rates, thus undermining deal-driven stockmarkets.

The US now faces a nasty credit crunch as banks' capital will be "decimated" by the worsening subprime mess, says Lombard Street Research. This will force the banks to curb lending, exacerbating the US hard landing and reducing global liquidity. Bear Stearns is just the tip of the iceberg, says Lombard Street. The era of easy credit is set to draw to a close.

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