Several months ago, as a stunned subprime MBS market was still reeling from crumbling fundamentals, selloffs and wide spreads, the capital markets thought that the hedge fund industry - despite its conflicted history with the subprime MBS market - might be able to supply the necessary liquidity to keep the sector afloat until conditions improved. It seemed like a reasonable role for hedge funds to play, underscored by Fortress Investment Group's purchased of about $4 billion of loans from Fremont Mortgage.
Last week however, two major hedge funds managed by Bear Stearns were on the brink of collapse - hit by what market sources described as a lethal combination of credit, leverage and liquidity problems. The High Grade Structured Credit Strategies Enhanced Leveraged Fund and the High Grade Structured Credit Strategies Fund held about $20 billion in MBS, mainly via high-grade AAA' and high-grade AA' CDOs, according to market sources and press reports.
Conditions in the subprime MBS market, the source of collateral for the Bear Stearns CDO holdings, were not exactly rosy coming into last week. True enough, spreads had recovered somewhat, so that certain subprime issuers could execute better deals than they have been able to in weeks. As it turned out, those more generous spreads were a result of a temporary jolt from the CDO business.
"The stabilization you saw in the subprime market was only a technical rally in spreads as CDOs were buying to complete ramping in order to go effective," said one market source, who added that: "many were aware of this and expected further volatility. [They] just didn't know what would spark it."
CDO managers soon slowed down purchases of collateral, having satisfied their hunger for subprime product. That, says securitization sources, triggered a basic liquidity problem for the sector and helped chip away at the underlying value of much of the subprime sector. High leverage and the inescapable morass of flat and falling year-over-year housing prices undermined the subprime sector, buyside sources say.
"The Street is loaded to the gills with unsold CDO debt," one market source said. "One thing you have to realize is that in the past, CDOs had been buying a lot of other CDO debt."
Lately, CDOs have been representing about 10% to 30% of the underlying pool in typical residential MBS deals.
"So if CDO issuance slows down, who is the replacement buyer to buy that debt?"
Not Wall Street. Bear Stearns's problems spun out of control exactly because of the group's ill-judged hedging on the ABX index, said one market source. Investors and lenders began trying to recover their investments in the two funds after the value of the underlying bonds began to deteriorate. At first, JPMorgan Securities wanted to auction off its assets from the funds, but by Thursday afternoon, it had temporarily backed off of that plan. Meanwhile, say securitization sources and press reports, Merrill Lynch was planning an auction of its own, accepting bids on about $857 million in CDOs.
Whether the turbulence is more a result of dried-up liquidity or shaky credit among subprime MBS, the market is confronting a stark reality of the subprime MBS and CDO sectors: neither hedge funds nor the broader Wall Street community has quick answers for the puzzle facing that asset class. Among potential consequences of the fallout is that offering terms for repurchase agreements will be questioned.
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