By Dr. Hans Black
Interinvest Review & Outlook
Since the beginning of 2007 we have witnessed a series of interesting mini crises that have left many investors dazed and confused. Two years have passed since the top in the real estate market - assumed by most observers to be the summer of 2005 for residential property - and it is not entirely surprising that this sector has begun to see some fallout. With default rates spiking in the last quarter of 2006, problems in the subprime mortgage industry began to surface in January of this year and made lurid headline news at the end of February. New Century Financial, one of the leading subprime mortgage lenders, was summarily cut off from its lines of credit by its Wall Street backers and forced into bankruptcy. Others followed, and as the dominoes began to fall prior to the end of the first quarter, a number of larger banking institutions, such as HSBC, subsequently announced lower expectations for earnings due to the problems in this type of banking.
Simultaneously with these events, a number of hedge funds either ran into trouble or were rumored to be running into serious difficulties due to the use of collaterized debt obligations, or CDOs, in their portfolios. In recent weeks these difficulties have again made major headlines with the near collapse of two larger hedge funds specializing in this area and underwritten, in faith if not in fact, by one of the granddaddies of the business, Bear Stearns. The specific fund, known by its full (as in mouthful) name as the Bear Sterns High Grade Structured Credit Enhanced Leveraged Fund, was almost forced to close as other colleague brokerage firms, seeing the values surrounding this type of assets crumble, sent out large margin calls. Thanks to efforts by the management of Bear Sterns, who agreed in the final hours of the second quarter to put capital behind some of these problems, the market finished June without any severe meltdown. The significance of Bear Stearns' actions was to avoid a mark-to-market event or substantial repricing downwards of these kinds of assets, which are held ubiquitously in portfolios of banks' hedge funds and many other types of intermediaries.
As we have commented in similar articles in the past eighteen months, and of course privately to our friends and clients, the great problem of these instruments is that no one quite knows how to price them. In fact, the vast majority of mortgage securities are priced using a valuation model rather than any real price. Further complicating this mess is that these instruments are often rated "AAA" when of course one can seriously question whether such a valuation is justified. Much of this seems to be due to the implementation in recent years of risk-based capital rules as a result of the International Convergence of Capital Measurement and Capital Standards, known as Basel II. Under these rules, brokerage firms or banks may in fact hold more assets per unit of equity capital than they had previously, as long as such assets are rated "AA" or "AAA." For example, under Basel II rules a bank or brokerage firm must now set aside just 56 cents in capital to hold $100 or "AAA" - rated securities, or a leverage of roughly 200:1. For "BBB" securities they must hold 4.8 percent of the face value of the securities or a traditional leverage of 20:1. In case you are wondering, you have wondered correctly: many of the so-called new collateralized debt obligations (CDOs) have been given
"AA" or "AAA" ratings, thus enabling banks and brokers to take advantage of these new rules to rapidly grow their balance sheets. (For reference purposes, readers should recognize that the CDO market exceeds one trillion dollars at present and that total capitalization of all U.S. banks is only $850 billion).
The fact that a very large number of newly constituted CDOs and collateralized loan obligations have been given a "AA" or "AAA" ranking poses a particular problem for holders of these instruments. What would happen if a particular CDO should lose its present rating for a "BBB" or even "B", is that the capital ratios for the underlying brokerage firm or bank would immediately undergo a drastic change for the worse. This unfortunately may indeed occur if, as many argue, since the constituent part of collaterized debt obligations are not better than "B" they should be rated as such. Banks, then, have a choice either to dump the asset or come up with a lot more capital to hold it.
What is so fascinating about all of these events is the timing of the recent public offering for Blackstone. This well-known and highly successful private equity firm went public on June 22, slightly ahead of the schedule originally planned. Without being too cynical, the IPO was a big success and given the ongoing difficulties in the collateralized debt obligation market, is there any wonder that Blackstone decided to accelerate their IPO date? Perhaps even more crucial to the timing Blackstone employed for this IPO were the beginnings of rumblings - and loud rumblings they were - from U.S. and British politicians who were increasingly questioning the tax treatment given to these kinds of companies on their respective sides of the Atlantic. The extremely generous tax treatment in question allows private equity firms to treat as a capital gain the so-called "carried interest" or 20 per cent profit they earn on increases in their firm's investment funds. Given that it is taxed at the U.S. Federal capital gains rate of only 15 per cent rather than 35 per cent of ordinary income, this has been a big boost to the principals of these funds. Stephen Schwarzman, chairman of chief executive officer of Blackstone, compounded this situation by somewhat inflammatory comments recently about the ability of private equity firms to engage as corporate raiders. Key, of course, are reminders of the actions by some notable corporate raiders in their heyday of the late 1980s, so it is not surprising that Democrats in the House of Representatives as well as Republicans in the Senate are looking at tax rules regarding these kinds of companies. The prospectus for Blackstone assumes a 17 per cent federal tax rate, but all this may change as they engage in a more traditional tax structure. Similarly, companies in the U.K. in the hedge fund and private equity industries have also been enjoying very generous tax provisions which have explained, in good part, the preponderance of these players in London. Given that the British government is running an increasing deficit and that the new prime minister, Gordon Brown, is rumored to be not as generously minded on these kinds of activities as his predecessor, tax changes may be brewing there as well.
We are obviously not alone in the expressing our sentiments about the spreading problems in the real estate mortgage business, neither are we alone in recognizing the timing that Blackstone and others since then have used with respect to an IPO or a filing of a future IPO. For some time now we have been advocating portfolios with reduced or no exposure to real estate and, of particular important, portfolios substantially underweight in financial companies. We currently do not own shares of major brokers and own a few banks on a global basis, but they can hardly be considered big weightings. It is also important that we confess to our readers that the more we read on the subject of CDOs and the machinations that are going on with the repackaging of consumer or real estate debt, the more we tend to worry. Unfortunately, many investors may be involved in these sectors without really understanding what they are in. Today's preponderance of hedge funds, whose growth has exploded, and the equally alarming growth of fund of funds make this a particularly worrying problem.
We seem to be getting visits on a regular basis now from financial people putting together fund of funds, advocating that their investors accept additional leverage on the fund of fund level. The fund of fund manager will choose twenty different funds assuring diversity monitoring and hopefully decent performance, and on top of that the introduction of additional leverage on the fund of fund level therefore amplifies returns. As many are learning however, paying 3, 4 or even 5 per cent in fees leaves little room for error and should some of the leveraged investments not work out, what seems to be a relatively stable investment can very quickly go sour. I should be quick to point out, however, there are obviously excellent funds around, but the sheer growth of the industry will inevitably lead to some severe difficulties. Most alarming in our opinion, are the problems which we identified at the top of this essay, namely those in the CDO area. Although we have commented on previous occasions both in writing and in meetings with clients regarding these difficulties, they seem to be more acute than ever. We would advocate that a careful examination of reports in July and early August from leading financial firms and the accounting treatment of these problems will be paramount. Furthermore, issues such as the proper pricing of underlying tranches or assets in more complex structured products will probably be something that our readers will see a lot of in the months to come.
Editor's Note: Dr. Hans Black is editor of Interinvest Review & Outlook, published by Interinvest Corp., a global money management firm, P.O. Box 51462. Boston, MA 02205, 1 year, 12 issues, $125. www.interinvest.com.
