Friday, July 13, 2007

Drunk On What?


No One is Safe When Hedge Funds Are Drunk on Credit

Would you invest in a hedge fund or any fund for that matter named "High-Grade Structured Credit Enhanced Leverage Fund" or how about the "High-Grade Structured Credit Fund?" Odds are you probably wouldn't.
Both infamous hedge funds were bailed out by their parent, Bear Stearns, last month. The CDO market (Collateralized Debt Obligations) started to come apart - fallout from the ongoing sub-prime mortgage wreck.
In fact, last month's bailout marked the biggest rescue since October 1998 when the Federal Reserve, its member banks and several Wall Street firms bailed-out Long Term Capital Management. That near-collapse almost crushed the global financial system, resulting in a dizzy 17% plunge for the S&P 500 Index in August of that same year.
It's amazing how Bear Stearns, one of the savviest fixed-income trading desks on Wall Street, can watch its two big hedge funds almost collapse. Technically, both products did collapse. The firm had to spend several billion dollars to rescue investors, and purchased an enormous amount of Treasuries last week in the process.
The scary part of this sobering tale is how an aggressive ratcheting in interest rates can literally cause an incredible stir throughout capital markets.
In June, the benchmark 10-year Treasury bond broke through its five-year trading range to hit 5.33% on the yield scale. That drove riskier assets like CDOs and other mortgage-backed securities sharply lower, resulting in the demise or near-collapse of a dozen hedge funds. And if bond yields continue to rise at the long end, then expect more disasters to unfold as markets come to terms with the end of the fixed-income bull market.
The good news, if there is any, is that the ongoing woes in the mortgage-backed market and the continuing hemorrhaging in the housing market will keep the Federal Reserve on the sidelines.
In fact, short-term rates might even decline before the end of the year because the housing wreck is not getting any better as more homebuilders reduce their earnings guidance this quarter. New home sales, existing home sales and mortgage refinancing activity all continue to decline as we progress into summer.
Unless bond yields rapidly surge above 5.75% or 6% in a very short period of time, which is highly unlikely at this point, the bulk of any more hedge fund failures should be contained or bailed-out by cash-rich parent companies. Although the financial sector has stalled since last winter, Wall Street banks have earned an absolute fortune since 2003 and harbor billions in retained earnings - enough to mop-up more of their own looming derivative-based disasters.
Interest rates must stay low. If they don't, the leverage tied to derivatives in this expansion will crater like an A-bomb, making the events of August-September 1998 look like a picnic.

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