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Stock Research – Another Hedge Fund Warns- Basis Capital – This Is Just The Beginning!!!!

Wow, it’s just starting and it’s not going to stop. Basis Capital is an Australian hedge fund. They run about a billion dollars under management. What you have to keep in mind however is that hedge funds use LEVERAGE, big leverage. The average hedge fund manager in the United States is using 6 times the capital base of the money he is managing, as leverage. In the race for performance or the elusive alpha, some hedge fund managers are pushing the envelope and using as much as...

basis capital, Australian hedge fund, hedge funds, subpime hedge fund, private capital, prime broker

Wow, it’s just starting and it’s not going to stop. Basis Capital is an Australian hedge fund. They run about a billion dollars under management. What you have to keep in mind however is that hedge funds use LEVERAGE, big leverage. The average hedge fund manager in the United States is using 6 times the capital base of the money he is managing, as leverage. In the race for performance or the elusive alpha, some hedge fund managers are pushing the envelope and using as much as 10 times leverage. This can cause serious problems because when leverage goes against you, it’s DEADLY.

An example is now the latest announcements coming out of Basis Capital. Apparently this hedge fund was invested in the US home loans to investors are less than creditworthy. The hedge fund claims that the collateral in their portfolio is sound, but sound is a matter of judgment. Unfortunately for Basis Capital, the prime broker clearing for the hedge fund doesn’t agree with them. The prime broker has re-priced this so-called sound collateral.

What does it mean?

The hedge fund now has to go into a crisis mode to survive. Immediately many investors will ask for their money back. This is the step that kills off the hedge fund. In order to prevent a run on the bank, as they like to say, the hedge fund has announced that they may restrict redemptions, which is the right of the investor to withdraw their money at, will. If investors are allowed to withdraw their funds, the collateral securing the underlying investments usually collapses because other smart money knows that that collateral has to be sold in order to fund the redemptions.

Prior to originating a hedge fund, most hedge funds will install restrictive covenants in their investor agreement that build in what are called gates. These gates limit by quarter what can be withdrawn from the fund. It’s about self-preservation. In this case Basis Capital and its two hedge funds require 90 days notice before capital can be withdrawn. Once again this policy attempts to prevent a forced liquidation of the underlying collateral securing the hedge funds’ investments.

Basis Capital has warned that the true extent of their problems might not become evident until September. What does that mean? These people mark to market every day. They have the finest computer pricing systems in the world. PhD’s in mathematical modeling are a dime a dozen in the hedge fund industry, and yet this hedge fund doesn’t know where it stands financially. This is a breakdown in the system, and it has great meaning to the rest of the hedge fund industry.

What happened to Basis Capital is very simple. In the range of assumptions they used to make their bets they determined normal risk parameters. They did not give any consideration to the possibility that the investments they were making might, just might move outside their normal variability ranges. In other words they excluded worst-case possibilities from their consideration. The melt down of the sub prime lending market is such a possibility and it has HAPPENED. For an elaboration of this article, please see our website.

 

Stock Research – Hedge Fund Fraud Leads To $160 Million Bear Stearns Settlement

It was announced recently that a Federal Bankruptcy court judge ordered Bear Stearns, one of America’s top tier trading firms to pay $160 million to investors who lost money with a hedge fund that cleared through Bear Stearns. While doing stock research on publicly traded brokerage corporations, we came across the settlement. This spurred us on to thinking, what does this mean for the everyday investor, and what does it mean for stock research in general. Here’s the real stor...

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It was announced recently that a Federal Bankruptcy court judge ordered Bear Stearns, one of America’s top tier trading firms to pay $160 million to investors who lost money with a hedge fund that cleared through Bear Stearns. While doing stock research on publicly traded brokerage corporations, we came across the settlement. This spurred us on to thinking, what does this mean for the everyday investor, and what does it mean for stock research in general. Here’s the real story.

Hedge Fund’s Asset Base SKYROCKETS

Hedge funds have become a significant force in the investment world. At the beginning of the 1990’s, hedge funds controlled less than $40 billion in assets, less than Warren Buffett’s personal investment portfolio. Today there are more than 9000 hedge funds controlling in excess of $1.1 trillion dollars of assets.

Hedge funds also use leverage, averaging some six times their asset base. This means the industry today controls investments of about $7 trillion dollars. These investments are on both the long and short side. The mutual fund industry can only go long, and never on margin, which means no leverage.

Now leverage is a two-edge sword. When things are going your way, it creates excessive returns or alpha. When trades go against you however, it can wipe out your investment in lightning like fashion. The hedge fund borrows money on its asset base from prime brokers, and other lending institutions. The lender always charges a fee, and the fees are big. For the brokerage firms involved, these fees may make up the vast bulk of their bottom line depending upon the firm involved.

Hedge funds must clear through clearing firms that are referred to as prime brokers. The prime broker sees every trade the hedge fund does, unless the hedge fund employs multiple prime brokers. Now lets say, the hedge fund lays on a massive trade using margin borrowed from the prime broker, and the trade goes against you, meaning paper losses are sustained. What happens next?

The hedge fund has to make a decision as to whether to close out the trade or not. Some funds believing that the momentum will turn, will double down, or increase the investment. The success of this transaction lies in whether or not the momentum is in fact changing at the time of the double down. If not, than the second investment will be under water as well.

Now a prime broker will never allow a hedge fund’s trades in total to be under water. This would mean that the hedge fund has gone negative equity, and the prime broker would be at risk. The prime broker never wants to be at risk, nor will it allow itself to be.

Enter the Manhattan Investment Fund

What happened with the fraud we mentioned in the title of this article is that a hedge fund called the Manhattan Investment Fund clearing through Bear Stearns lost nearly $400 million of their assets. These assets belonged to rich investors, and the fund’s managers made the wrong bets on Internet stocks in the late 1990’s. Apparently Manhattan Investment Fund sought to cover up or delay the inevitable consequences of its trading activities by issuing FALSE reports to its investors.

This led to the creation of an inflated track record, which allowed the hedge fund to bring in even more money, which in turn allowed them to pay off early investors with money from new investors. In other words a classic Ponzi scheme began.

Bear Stearns probably caught onto the scheme when one of its managing directors met an investor in the Manhattan Investment Fund at a party, and the investor talked about how his reports from the hedge fund showed a 20% return. The managing director understood from internal knowledge at the firm that the actual trades going through Bear Stearns were in conflict with what the investor was reporting.

Bear Stearns did follow up with the hedge fund’s manager Michael Berger who is now a fugitive at large. Berger got out of the problem by telling Bear Stearns that Bear Stearns was one of only 8 or 9 prime brokers that the hedge fund was doing business with. In other words, we’re losing money with you as a prime broker, but not with the other prime brokers we deal with. It’s a great story, and even makes sense, but apparently Bear Stearns did not check out the story by calling the other prime brokers to see if it was true that the hedge fund was doing business with them as well.

Somebody at Bear Stearns figured something was amiss because months later, Bear asked the hedge fund to put up additional margin or cash in order to raise the margin requirement to 50% from 35%. The fund sent over another $141 million as margin payments. When the fund went out of business subsequently, Bear Stearns was secure, and did not suffer a loss.

Judge orders Bear Stearns to PAY

The bankruptcy judge controlling this case has ordered Bear Stearns to pay $160 million to the investors in the hedge fund. The judge’s ruling stated that Bear Stearns as prime broker, failed to properly supervise the fund’s activities prior to the 2000 collapse of the Manhattan Investment Fund.

This ruling is going to be appealed because to allow it to stand would create much greater risk for the prime brokerage industry than the industry feels it is being properly paid to manage. Bear Stearns only made $2.4 million in profits from the hedge fund’s activities, and now it is faced with a $160 million judgment.

What you the Investor need to know – Diversification?

If you are an investor in hedge funds, what you need to know is that any hedge fund can go belly up. That’s right, any of them. You cannot outthink someone who while running a hedge fund, is trying to defraud you. The only answer is DIVERSIFICATION in your personal investment structure. You must own an assortment of hedge funds if that is your investment vehicle choice, and not just one. Your funds should also use different investment strategies, and not just be equities long, or domestic, or any other classification.

Since you are searching for the elusive alpha (outsize returns), it your responsibility as an investor to be aware that fraud exists. Even just plain bad investment strategies can result in the loss of all your capital since these funds are using 6 to 1 leverage in the attempt to create performance.

You might also want to consider a FUND OF FUNDS vehicle. This is when you invest your money with a fund manager who makes no direct investments himself, but instead selects other hedge funds for you to be invested in. This involves a double layering of fees. If the returns are there for you year after year, than it doesn’t matter, but be careful, fraud does exist, and so do poor investment managers.

Goodbye and Good Luck

Richard Stoyeck

 

Stock Research – Hedge Funds – If Bear Stearns Doesn’t Know – Who Knows???

As the hedge fund world becomes bigger and bigger as more and more hot money seeks the elusive alpha of maximum performance, it is becoming apparent that more and more newspaper space will be devoted to hedge funds, and private equity. Recent news has taken us into the inner sanctum of Bear Stearns, truly a dominant investment firm in the world today. It might be argued that Bear Stearns is the best managed Wall Street firm in existence. Some might say Goldman Sach’s. In any ...

bear stearns, subprime, subprime mortgages, subprime loans, hedge fund, hedge funds, private equity

As the hedge fund world becomes bigger and bigger as more and more hot money seeks the elusive alpha of maximum performance, it is becoming apparent that more and more newspaper space will be devoted to hedge funds, and private equity. Recent news has taken us into the inner sanctum of Bear Stearns, truly a dominant investment firm in the world today. It might be argued that Bear Stearns is the best managed Wall Street firm in existence. Some might say Goldman Sach’s. In any event Bear Stearns would have to be on the short list.

Investment firms for almost a decade sat by and watched hedge funds form, and amass vast investment capital pools while successfully charging 2% management fees, and 20% of the profits. Some of these hedge funds in a few years, have grown to possess capital bases equal to that of investment banking firms that have been around for generations. Taking some of the risks that were involved to achieve this performance is now coming home to roost.

Bear Stearns is the latest firm to stub its toe in the hedge fund industry. The firm is FAMOUS for quantifying and judging RISK before making its bets. This time however it seems that Bear Stearns threw its usual caution to the wind in embracing the formation of two hedge funds over the last year or so.

The second hedge fund was considered a more highly-leveraged version of Bear’s High –Grade structured Credit Strategies fund which was formed last year. Both funds were managed by Ralph Cioffi, who up until recent events took hold, had the reputation of being a MASTER at this game, and the game is the subprime mortgage bond business.

Most people are not aware of it but Bear Stearns is the finest fixed income trading firm on the planet bar none, and this has been true for several generations. This makes recent events even more perplexing to understand.

Jimmy Cayne who is Bear’s CEO is embarrassed at the very least, and certainly upset enough that there will be major changes in the leadership of the units responsible for the pain being inflected on the firm’s reputation. This should not have happened at Bear Stearns, that’s the point.

Actions Taken and Implications

Mr. Cayne has made the decision to inject $3.2 billion of Bear Stearns capital into a bail-out of the older fund. Bear is also negotiating with the banks that put up the credit facility for the other fund, the highly leveraged High-Grade Enhanced Leveraged fund. What Bear is trying to prevent is the forced sale of the debt obligations underlying the fund’s investments. These issues trade by appointment as they say, which means they rarely trade at all. Bear knows the Street smells blood, and will take advantage of any weakness that Bear shows.

So what are the implications of this latest hedge fund debacle? It clearly shows that the most sophisticated investors on the planet who put their money into hedge funds may in fact have NO IDEA what they are investing in. Instead, they are betting on the institutional reputation of the firms standing in back of the hedge funds. In this case nobody knew more about this market segment than Bear Stearns, yet they caught in a terrible position.

This is not Cayne’s fault, but as CEO, it is always his responsibility. I believe him to be the finest Wall Street executive of his generation. Nevertheless, his underlings certainly let him down, and they are among the highest paid people in the world today. Some of these industry veterans are drawing $10 million dollar annual incomes. Let the investor beware is the rule of the day, especially when it comes to hedge funds.

But Wait – There’s More

The average hedge fund uses about six to one leverage in order to obtain the performance success we have become accustomed to seeing in the hedge fund world. Investors in Bear Stearns’ fund called Enhanced Leverage put up about $638 million of their own money. The fund was then able to borrow about 10 times that amount. They used repo-financing and a credit facility at the Barclay’s Bank.

Enhanced Leverage then went out and invested about $11.5 billion in both bonds and various and assorted bank debts on the long side. On the short side, they had about $4.5 billion through credit default swaps. These transactions were originated on the ABX Index, all of which were tied into subprime mortgage bonds.

I know you are asking how it all came undone. What happened is that the underlying bonds of the whole market segment are what you could call the subprime market came undone. Back in February, this hurt Bear’s two funds. The funds and the hedges laid on by Bear went under water in March simultaneously. The hedges should have performed when the market worsened, and they didn’t. That was the killer. The hedges did not do what they were supposed to do.

In late May, Bear knew they had to do something. What Bear chose to do was close down the redemption process. In other words, not allow any investors to withdraw their remaining funds, which would create a run on the hedge fund. This is similar to Franklin Roosevelt closing down the banks in 1933, to prevent a run on the banks from taking place.

The banks who lent the money to the Bear Stearns sponsored funds quickly began selling down the securities in the funds in an attempt to back into some kind of positive equity balance. This was all the result of margin calls brought about the funds’ poorly performing, and now distressed investments. Bear finally agreed to a bail-out of one of the funds injecting $3 plus billion dollars into the fund. The firm as of now will not rescue the other fund, known as Enhanced Leverage.

In our opinion, Bear will not be the last firm to experience problems with hedge funds, and investors are in for a further rude awakening as the hedge fund industry continues along its under-regulated path of seeking maximum investment performance. Many hedge funds are overextending, and frankly have no idea as to their actual open positions in the financial world.

Bear and nobody is better than Bear says it will be another week or two before it knows the extent of the losses of its investors in these two funds. If that is true of the best managed risk taking firm in the world today, how much confidence can you have in the hundreds of other hedge funds out there that are poorly managed compared to the legendary Bear Stearns.?

The answer is you’d better sleep with your pants on, if you think your money is safe in the hedge fund world. You think you’re sleeping on a nice warm bed. What you don’t realize is that the bed is sitting on a railroad track with a 100 mile per hour train bearing down on you. The problem with hedge funds is the leverage. Six to one is normal, and then you get the ones that go crazy and start approaching 10 to 1 leverage in the race for performance. It’s great when the market is on your side, but when the market goes against you; these entities literally go out of business.

Warren Buffett has always talked about being able to sleep at night with your investments. He also talks about what would happen if you wound up in a coma, and woke up 10 years later? Would the investments you made ten years ago still be good, or not? Would you like to wake up from a coma, owning hedge fund investments for the previous ten years, maybe yes, maybe no, but as an investor, you better be able to answer that question?

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