Mortgages on thin ice

Nobody was surprised when two Bear Stearns hedge funds got into trouble last month. They lost enormous amounts of money and the bank had to infuse billions to keep them afloat. Journalists and pundits clucked their tongues and shrugged.

Bear Stearns didn't disclose details but the outlines are clear enough. The funds had used their equity, plus a mountain of deterioration, to invest in bonds. Many of the bonds were backed by subprime - low-quality - mortgages that have gained such notoriety.

The hedge funds' strategy worked well as long as the high-risk paper performed and paid. But the moment their interest payments flagged, because borrowers were defaulting left and right, the value of the bonds plunged. And so did the shareholders' equity of the funds.

The strategy of leveraging equity through external capital and investment in high-risk assets is fundamental to modern economics. Take property developers who build housing or office space for rent; chipmakers building fabs, haulage companies that buy ships, telcos laying down infrastructure. All borrow to finance their investment.

And they can't know for sure whether the cash flow from the investment will cover their costs of repaying the principle plus interest payments. The lenders know it too and are supposed to protect themselves, including through the interest they charge, the proportion of the investment they're willing to finance, and collateral.

In such cases, the company's equity to debt ratio matters. So do the lender's controls. It must study and estimate the chances of the investment's success, and diversify risk among multiple lenders.

Sometimes, when money is cheap, the finances sector resorts to the same strategy. Investors are willing to buy into future (read, uncertain) cash flow, based on high leverage, in exchange for potentially higher capital gains. Bear Stearns' hedge funds didn't invent this wheel.

But there is a difference between real (such as property) and finance sectors. Real projects undertaking debt are based on an asset that's supposed to generate future cash flow. But the growing use of leverage in the financial sphere can distort the amount of credit, without any change in the scope of assets.

When you buy a house

Say you buy a house costing $200,000 and borrow $160,000. Your mortgage bank finances the loan to you by raising debt from an institutional investor. Against that loan, the mortgage bank has to set aside a certain amount of equity, which is what stops it from increasing its borrowing ad infinitum.

Therefore, as it can't lend and borrow without end, but as a function of its own equity, the mortgage bank needs to be picky about who it lets borrow money. Otherwise it is not exploiting its shareholders' equity optimally.

Now let's assume that a hedge fund, which is also a major borrower, buys the mortgage bank's loans portfolio, including your loan. That frees the mortgage bank's equity to lend some more, and relieves it of the risk inherent in your loan.

That effectively lowers the barrier of the mortgage bank's equity. It can lend more than it could have previously. And that, in a nutshell, is what has been happening in the States.

The systemic sickness in the American real estate market's financing methods is known. But the Bear Stearns fiasco does raise new points for thought.

1. How risk is measured

When examining the risk in a portfolio or investment strategy, analysts often use historic volatility as a gauge. In this case, that could be a double-edged sword.

The strategy that the Bear hedge funds had adopted (as had Long Term Capital Management - LTCM, which imploded nine years ago, Nobel prizewinners and all), dampens day to day volatility. But a pinpoint event magnified by the heavy debt component, such as the subprime problems, can suddenly rip a vast hole in the investor's equity, to the point of wiping it out entirely.

So in this case, looking at past results and their standard deviations is no help. It could hurt. Such analysts would postulate low risk where actually, it's high, but hidden. The correct way to analyze the fund's position is through "what if" scenarios.

Not convinced? Look. What does it matter if the fund consistently generated 1% a month with zero standard deviation - but then in one month, it suddenly loses 15% of its value, or more?  Past performance is useless as a gauge in that case. But all too many funds are totally opaque, giving investors no tools to judge.

2. How to price

A lot of the assets in the Bear funds reportedly had no regular market valuation. They were not liquid assets and had been priced using an economic, financial and statistical model. Pricing based on a historic model influenced by human bias, and a biased one at that, often proves to have been overly optimistic when trouble arises.

3. Lack of liquidity

Even when the assets are liquid ones that have a market price, sometimes the volume of trade is so thin that the holder can't sell even at that price. That doesn't matter until the time comes that they have to sell, as happened to the Bear hedge funds. Then the value in the books is meaningless, because it can't be obtained in practice.

4. The rating method

Leading rating agencies are being slammed for failing to foresee the credit problems and for downgrading companies with hindsight. The rating agencies don't deny it, by the way.

They claim however that there is an expectations gap. They respond to events that happened, and revise ratings accordingly, they say. But investors seem to expect them to foresee events.

Never mind who's right: investors must remember that when credit quality is gradually but steadily deteriorating, ratings are systematically biased upward, because they are updated after the event.

But worry not. Markets foresee things that the rating agencies do not and prices debt accordingly, not based on formal investment grade.

The author is the CEO of Compass Mutual Funds. The information herein is under no circumstances to be construed as a recommendation to buy or sell securities. The author and/or the company in  which he works may hold various securities, including securities mentioned herein.  In any case, this article is not to be seen as advice to buy or sell securities.