Hedgistan: “Its gonna get a lot worse”
By Mike Whitney
-- -- Two columns of black smoke can be seen rising over
Wall Street and disappearing into the ice-blue New York sky.
Not quite. The plumes of smoke are all that’s left of two
major hedge funds which blew up just weeks ago leaving
nothing behind but a few smoldering embers and a mound of
The compiled assets of the Bear Sterns High-Grade Structured
Credit Strategies Fund—nearly $20 billion—have vanished into
the miasma of cyber-space where they will soon be joined by
$1.4 trillion of other, equally worthless, Collateralized
Debt Obligations (CDO).
If you look carefully, you can almost see the mangled and
bloodied bodies of the CDOs, the CSDs, the RMBS and the
other shaky debt-instruments being pulled from the wreckage
and tossed unceremoniously on the bonfire.
Is this how it all ends? The first whiff of trouble in the
housing market and then—in a flash--all the funds in
“Hedgistan” begin teetering towards earth?
“No Value”-“No Bids”
According to Bloomberg News, Bear Sterns announced last week
that there’s “little value left” in one of its funds and “no
value left” in the other.
Nothing, nada, zippo.
The news was like a bucket of cold water dumped on the stock
market leaving slack-jawed traders shuddering in
What does it all mean?
Does that mean that the entire hedge fund empire—which is
built on a foundation of dodgy loans and quicksand---may be
headed for the crapper?
No one really knows. But a pall has settled-in over downtown
Manhattan where gloomy-looking men in pinstriped suits are
waiting for the other shoe to drop.
Y’see, the hedge fund industry is based on the bizarre
notion that one does not have to produce anything of value
to make boatloads of money. You don’t even need assets any
more---just a risky loan that can be transformed into an
investment grade security through the magic of
“securitization” a sprinkling of Wall Street snake oil.
It’s like taking shards of bottle-glass and selling it as
the Hope Diamond. Who’s gonna notice?
The only catch is that--now that these toxic CDOs are going
to auction--there are no bids. That’s a bad thing.
“No bids” means that $1.4 trillion of shaky investments have
no discernable market-value. The CDOs were graded “mark to
model” which translates into “mark to fantasy”. It means
that the investment bankers and hedge fund managers got
together over Martinis one night and pulled a number out of
Now no one wants to buy them. They’re worthless.
The skydiving hedge funds just pulled the CDO rip-chord and
nothing came out but confetti.
And that’s just half the story. There’s trillions of dollars
in derivatives riding on these shaky CDOs. That’s enough to
bring down the whole market in a heap once interest rates
rise or liquidity dries up. Now it’s just a matter of “when”
now, not “if”.
This illustrates an important point, though. It shows what
it takes to be a good hedge fund manager:
Take a shabby sub-prime mortgage; chop it into “investment”,
“mezzanine” and “equity” tranches. Bundle it with other
equally suspect mortgage backed securities (MBS). Decide
(arbitrarily) what the CDOs are worth Tell your banker.
Leverage at a ratio of 10 o 1. Take 2% “off the top” plus
salary for your efforts. Buy a summer home in the Hampton’s
and a Lexus for the wife. Wait for the crash. Then repeat.
Congratulations; you are now a successful hedge fund
Oh yeah; and don’t forget to prepare a few soothing words
for the investors who just lost their entire life savings
and will now be spending their evenings squatting beneath a
nearby freeway off-ramp.
“We’re so very sorry, Mrs. Jones. Can we get you some
cardboard-bedding to keep off the rain?”
The problems that are appearing in the stock and bond
markets all started at the Federal Reserve when Fed-Chief
Alan Greenspan opened the sluice-gates in 2003 and lowered
interest rates to 1%. (Way below the rate of inflation)
Since then, trillions of dollars have flooded into the
markets creating multiple equity bubbles in real estate,
stocks and credit.
Serial bubble-maker Greenspan is to finance-capitalism what
Wrigley is to chewing gum. The greatest flim-flam man of all
The Fed has tried to conceal the massive increase to the
money supply, but the evidence is everywhere. (Many analysts
now calculate that inflation is running at roughly 13%) Food
and energy have skyrocketed. Housing prices have soared.
Everything has gone up except the cheapo imports which the
Fed uses to manipulate the inflation stats.
The gigantic housing bubble is mostly Greenspan’s doing.
After printing-up mountains of cash and creating artificial
demand through low interest rates; he promoted his
product-line with the typical huckster sales-pitch.
“Maestro” advised us that the extension of credit to
all-God’s creatures, worthy or not, is a good thing.
Here’s a clip of Alan praising subprime lending in a speech
on April 8, 2005:
"With these advances in technology, lenders have taken
advantage of credit-scoring models and other techniques for
efficiently extending credit to a broader spectrum of
consumers. . . . As we reflect on the evolution of consumer
credit in the United States, we must conclude that
innovation and structural change in the financial services
industry have been critical in providing expanded access to
credit for the vast majority of consumers, including those
of limited means. . . . This fact underscores the importance
of our roles as policymakers, researchers, bankers and
consumer advocates in fostering constructive innovation that
is both responsive to market demand and beneficial to
Yes, of course, with all these “advances in technology” and
new-fangled “credit-scoring models” why would we need to
verify a loan-applicant’s income or require that he scrape
together a measly $5,000 for a $450,000 mortgage?
That’s all so 20th Century!
Now that foreclosures are mushrooming at an unprecedented
pace, the Fed is trying to distance itself from the problem
by blaming the banks for their shoddy underwriting
practices. But the guilt lies with the Central Bank. Its all
part of their whacko plan to crush the dollar and create a
It may sound trite, but “inflation is theft”. Unfortunately,
inflation is also part of the ruling class’ strategy to rob
the poor, fuel the stock market with cheap credit, and move
jobs overseas. It is the autocrat’s method of “social
engineering”---shifting wealth from one class to another by
simply printing more money and pumping it through the system
via low interest rates. Remember, bankers know that people
will ALWAYS borrow money if lending standards are relaxed
and the money is cheap enough. At 1%, the Fed was basically
losing money on every transaction, but persisted with their
Anyone who cares to go back and trace interest rates moves
for the last 7 years will see that the Fed is really a
political organization that decides monetary policy entirely
on the basis an elite agenda that supports endless war,
outsourcing of American jobs, and domestic repression.
Are you surprised?
Now, a bad situation is about to get a whole lot worse.
Consumer credit rose last month by a whopping 12.9%---credit
card debt by 9.8%! Since housing prices have flattened out,
homeowners can no longer borrow on their dwindling equity
(Mortgage Equity Withdrawal; MEWs) which is forcing the
maxed-out American consumer to use plastic even though rates
are averaging from 18% to 27% monthly.
Automobile repos have also hit historic highs. But the real
damage is showing up in the subprime market where the
percentage of defaults continues to rise unabated.
In itself, a correction in real estate is not enough to
bring down the whole economy. Unfortunately, the contagion
from the subprime meltdown has spread to the stock market,
the insurance industry, banking and pensions. Not even
Secretary of the Treasury, Henry Paulson or Fed-master Ben
Bernanke are claiming that the subprime problems are
“contained” anymore. Just this week, the scholarly looking
Bernanke said to Senators on the Hill that the housing
market has “deteriorated significantly”.
It’s about time. If anyone still has any doubts about the
magnitude of fiasco, I recommend they look over these
eye-popping charts which tell the whole story. The housing
blowdown will spread the carnage from “sea to shining sea”.
The faltering housing market has drawn attention to an even
more colossal credit bubble that is limping towards earth as
loan requirements tighten and liquidity dries up.
The prevailing fear on Wall Street is that we may be seeing
the beginning of a global credit crunch.
The danger is not just the subprime loans or even the
mortgage companies that made the loans, but the overall risk
to the secondary market where these loans have been sold as
CDOs to the tune of $1.8 trillion.
In this new deregulated environment, the banks don’t have to
rely on savings anymore to make the loans. They simply
originate the loans, take their commission, and sell the
debt as CDOs. They’re even allowed to sell the risk of
default through credit default swaps (CDS) which are a form
of insurance that minimizes the banks exposure. These weird
innovations have spawned riskier and riskier loans and
increased the likelihood of damage to the broader market.
The Toxic Cycle of Debt?
Economics correspondent, Stephen Long, explains it like
“The problem that arises from the subprime mortgage collapse
is that it creates a toxic cycle of debt. Banks originate
loans or bundle up loans that mortgage companies have made
and sell the risk on to the hedge funds. Then the hedge
funds say, ‘Hey, we’ve got this product that has an
investment grade rating so we’ll borrow against it from the
banks.’ (oftentimes leveraged at a ratio of 10 to 1) Now the
hedge funds are trying to buy the original loans to stop
them from going into default.”(The hedge funds are forced to
slow the rate of foreclosures so they won’t go bankrupt.)
So, what happens when these shaky bonds (CDOs) are
Will the hedge funds fall like dominos just like the
subprime mortgage-lenders? Will we see liquidity evaporate
in the broader market triggering a plunge in the stocks and
a massive sell-off in the bond market?
CDOs were conjured up with the idea that vast amounts of
money could be made on very meager assets through a complex
expansion of leverage. They were promoted as “limiting risk”
by spreading it to a greater number of investors and
providing extra protection through derivatives. Mortgage
Backed Securities were sliced and diced into “more risky”
and “less risky” tranches depending on investor appetite.
Only now—to everyone’s surprise---“collateralized debt
obligations with stellar Triple-A ratings have been getting
hit by the subprime market’s woes.” (Wall Street Journal,
“Bernanke revises subprime outlook”) On top of that, the ABX
derivative index “has started showing pronounced weakness at
the top of its ratings structure.” (ibid WSJ, 7-19-07)
Get it? In other words, even the VERY BEST of these
multi-trillion dollar investments are beginning to falter.
The contagion is spreading through the entire market. The
CDOs are worthless. No one wants them. In fact, the whole
new regime of exotic debt-instruments which emerged from
2000-on, is barely hanging on by a thread. One minor
downturn in the stock market and the hedge funds will go
freefalling through open space.
A speech by Robert Rodriguez of First Pacific Advisors (CFA)
gives us a good idea of the enormity of the money involved.
In his “Absence of Fear” address in Chicago on June 28, 2007
“Since 2000 hedge funds have more than doubled in number,
while their assets have tripled. They too are using elevated
levels of leverage, as are PE (Private Equity) firms and
investors in highly leveraged fixed income securities. These
funds are heavy users of derivatives. The Global derivatives
market grew nearly 40% in 2006--the fastest pace in the last
nine years--to $415 trillion, per the Bank of International
Settlements. The amount of contracts based on bonds more
than doubled to $29 trillion. The actual money at risk
through credit derivatives increased 93% to $470 billion,
while that amount for the entire derivatives market was $9.7
trillion. The International Monetary Fund, in its April 2006
Global Financial Stability Report, estimated that
credit-oriented hedge fund assets grew to more than $300
billion in 2005, a six-fold increase in five years. When
levered at 5-6x, this represents $1.5 to $1.8 trillion
deployed into the credit markets. Fitch, in their June 5,
2007 special report, “Hedge Funds: The Credit Market’s New
Paradigm,” says that despite the upward trend in maximum
allowable leverage, “notably, no prime broker reported
raising margin requirements in response to historically
tight credit spreads and growing concerns about the general
level of risk-complacency in the credit markets.”
If Rodriguez’s “eye-popping” numbers are accurate and the
market slumps a mere 5%, “the value of a hedge fund’s assets
could lead to a forced sale of as much as 25% of its
assets”. If the market falls just 10%, the fund would get a
Yikes! That just shows how over-exposed the industry really
As the requirements on mortgages gets tougher and the
subprime market continues to languish; bankers will
naturally become more hesitant to loan zillions of dollars
to hedge funds and private equity firms. When credit gets
tighter, the hedge funds will begin to nosedive which will
send the stock market in a long-term swoon. That’s what
happens when a market is this over-leveraged. It’s
The markets are now perfectly poised for a full-system
breakdown. FDIC Chairman Sheila Bair expects a CDO time
bomb. She summed it up like this:
"Its going to get worse before it gets better. How much
worse, I don't know."
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