Wall Street bond traders are raising eyebrows at Bear Stearns' (BSC) attempt to sell some $3.86 billion in mortgage-backed bonds—just as the big investment firm tries a last-ditch attempt to salvage one its ailing hedge funds. The big bond deal is prompting speculation that Bear Stearns traders are trying to raise cash by selling off some of the troubled hedge fund's better assets held by the Bear Stearns' High-Grade Structured Credit Strategies Enhanced Leverage Fund, which invested heavily in bonds backed by subprime mortgages.
The New York investment firm put the large block of mortgage-backed bonds up for sale June 12 and bidding on the huge block of bonds was set for June 14. Bond traders say the pool of bonds is unusually large and consists of 150 high-quality mortgage-backed securities, all of which carry a strong investment-grade credit rating. Most are residential mortgage-backed bonds issued by a variety of banks and Wall Street firms. A Bear Stearns spokesman declined to comment on June 13.
"This paper will move without much problem," says one bearish investor, who asked not to be named. But bond traders are speculating that once Bear Stearns traders find buyers for these generally highly rated bonds, the investment firm may then try to unload some of the poor performing investments held by the customer it's apparently helping. A follow-on sale of the dregs could set off more turmoil in the credit markets.
The big bond sale comes the same day that Bear Stearns reported disappointing second-quarter earnings, in part because of the implosion in the market for subprime mortgages—home loans to borrowers with shaky credit histories. In the quarter, Bear Stearns earned $362 million, or $2.52 a share, down from a year ago, when it earned $539 million, or $3.72 a share. On an operating basis, which excluded certain one-time charges, the firm earned $3.40 a share, about a dime below the Thomson Financial (TOC) consensus estimate. In early trading, shares of Bear Stearns were down about 1% at $148.17.
Less than a week ago, Bear Stearns disclosed that its High-Grade Structured Credit Strategies Enhanced Leverage Fund had lost 23% of its value, as of Apr. 30. The investment firm hasn't released performance figures for May and June for the fund, which invested heavily in risky bonds backed by subprime mortgages.
The fund, which once had $642 million in investor money, is now down to about $500 million. But fund investors have submitted requests to withdraw at least another $250 million, according to people familiar with the fund. Bear Stearns' asset management arm recently barred investors from redeeming their money from the troubled hedge fund (see BusinessWeek.com, 6/12/07, (see BusinessWeek.com, 6/12/07, "Bear Stearns' Subprime Bath"). Meanwhile, a related hedge fund—the High-Grade Structured Credit Strategies fund—was off about 5% as of Apr. 30. That fund began about four years ago.
People familiar with both hedge funds say they invest in risky mortgage bonds using leverage, or borrowed money. The firm's initial credit strategies fund can borrow up to 10 times the amount it collects from investors. Meanwhile, the enhanced fund can borrow at least three times as much as its companion fund. That deep leverage gives both hedge funds the ability to buy many more bonds than it otherwise would, which explains why Bear Stearns is looking to sell so many mortgage-backed securities.
If Bear Stearns is moving to liquidate its two hedge funds, that could spell the demise of Everquest Financial, a Bear Stearns affiliate that has purchased risky bonds from both hedge funds. Bear Stearns, in May, filed a prospectus to take Everquest Financial public (see BusinessWeek.com, 5/11/07, "Bear Stearns' Subprime IPO").
Despite Bear Stearns' second-quarter earnings drop, its hedge fund troubles didn't directly weigh on the firm's results. Still, there's concern about whether the pain in the subprime market will start to crimp profits at big Wall Street firms, which rake in fat fees from underwriting mortgage-backed bonds and generate big revenues from trading in those securities. The subprime housing market began to implode in February with a spike in defaults by subprime borrowers and the collapse of several mortgage lenders.
The rise in mortgage defaults—particularly in the subprime market—ultimately will impair the value of many bonds that are backed by those risky home loans. But up until now, most bondholders have not have had to readjust their valuations for those mortgage-backed securities. Bond investors are not required to reduce the value of a bond unless it's either downgraded by a credit rating agency or sold for a reduced price in the secondary market.
But traders are speculating that the big bond sale by Bear Stearns may set the stage for a second sale, this one involving a batch of poor performing mortgage bonds. If that were to occur, other hedge fund managers might be forced to mark down the value of some of their mortgage-related investments. That's clearly something bond bears are rooting for.
Do the Bears Have It?
More than pleasing the bear, a reduction in the value of mortgage bonds could force hedge funds to report losses to investors, hit Wall Street trading desks, and cause Wall Street firms to withdraw capital from market making. Depending on how much contraction followed, credit could tighten up for a wide range of borrowers, from home buyers to private equity firms raising money for the leveraged buyouts that have been supporting the stock market.
Then again, the bears have been wrong many times in predicting a total meltdown in the mortgage market. It's possible that Bear Stearns may have nothing more up its sleeve than selling this big batch of higher-rated mortgage bonds.