The past few months have been good for Stephen Vogt, chief investment officer of Mesirow Advanced Strategies. As the bottom has begun to drop out of the subprime mortgage market, returns of the Chicago-based firm, which manages $12.5 billion in funds of hedge funds, have been boosted by short positions taken by some of its fund managers.
When Alpha last spoke with Vogt (“Caging Contagion,” April 2007), he believed that hedge funds shorting the subprime sector were well positioned to weather the credit storm. So far, many fund managers who took that approach have fared quite well.
And then there is Bear Stearns. In February two hedge funds run by the 84-year-old, New York–based investment bank loaded up on collateralized debt obligations backed by subprime mortgages, hedging their positions by shorting the ABX indexes tied to home equity loans. The funds got hammered when those indexes rebounded, yet subprime CDO prices continued to fall.
In April, Bear’s High-Grade Structured Credit Enhanced Leveraged Fund fell 23 percent, causing investors to rush for the exits only to find that they were locked. Faced with margin calls from lenders and demands from investors for the return of $250 million in capital, the fund exercised its right to suspend redemptions. Its sister fund, the High-Grade Structured Credit Fund, which uses less leverage and suffered smaller losses, followed suit.
Although Bear Stearns’ funds reportedly owned highly rated CDO tranches, the absence of any meaningful secondary market for the securities came back to haunt the firm when it was hit by the margin calls. Losses from selling at the bottom could have obliterated the funds’ equity, so Ralph Cioffi, who managed both funds, was forced to call a time-out — imposing a gate to limit redemptions.
Cioffi has since been removed from day-to-day management of the funds, but he has been kept on as an adviser to help the firm figure out how to pay off the margin calls of the High-Grade Structured Credit Enhanced Leveraged Fund. Jeffrey Lane, a former executive at Lehman Brothers, has been brought on as chairman and chief executive of Bear Stearns Asset Management and is charged with straightening out the situation.
News of Bear Stearns’ troubles spooked the market, and, as prices plummeted, the margin calls intensified. When the funds couldn’t satisfy them, lenders seized the securities that had been put up as collateral and tried to sell them, depressing prices further. Merrill Lynch put $850 million of securities up for auction, but reports suggest that it was able to sell only a small fraction of that amount. Ultimately, Bear Stearns stepped in, pledging $3.2 billion in loans to bail out the High-Grade Structured Credit Fund.
The intervention by Bear Stearns took the market by surprise, in light of the firm’s refusal in 1998 to join the consortium of investment banks that helped bail out Long-Term Capital Management — even though Bear was one of the Greenwich, Connecticut–based hedge fund firm’s prime brokerages. According to sources close to Bear, the decision to intervene this time was based on the strong quality of the paper in the High-Grade Structured Credit Fund and a belief that the market for it will eventually rebound.
But Bear has since announced that its bailout effort was unsuccessful. In a letter to shareholders, the firm said it will “seek an orderly wind-down” of both funds.
Although Bear’s losses have unsettled the markets, the subprime sector’s troubles have yet to lead to a systemic threat. Vogt says that the early July announcements from rating agencies Standard & Poor’s and Moody’s of plans to downgrade hundreds of bonds backed by subprime mortgages were widely expected. Recent events have reinforced his belief that the markets have become more robust. “Things are priced down, and there is a lack of bids out there for some of this stuff,” he explains. “But you are not seeing a wholesale contagion.”
Vogt does worry about excessive leverage in some fixed-income hedge fund strategies. He is keeping a close eye on the high-yield market, where spreads have widened and several new issues intended to refinance leveraged buyouts were recently pulled because of weak interest from investors. “I don’t think this story is over,” says Vogt.
