Those crack financial reporters over at the New York Post have proved my point again this morning, twice.First, they have shown that they work as a sort of in-town wire service for The New York Times, speaking to all those hedge fund managers and financial market sources too Republican or too greasy to admit of regular dialogue with the Gray Lady. I have made this point before, to general disbelief and disregard among the chattering classes. CC, you stand corrected.
Second, the Post bloodhounds have turned up evidence that the margin leverage screw tightening I recently identified as an almost guaranteed outcome and potential accelerant of the developing subprime mortgage meltdown is indeed underway:
Big Wall Street firms' love affair with lending cash to hedge funds specializing in trading mortgage-backed securities is officially over as margin requirements are getting tougher, making an already brutal market even more costly.
For the past five years, hedge funds specializing in trading mortgage- and asset-backed bonds have borrowed as much as 15 times their capital base, making their positions - and profits - larger.
It was a symbiotic relationship: the hedge funds got easy funding on generous terms and the investment banks guaranteed themselves plenty of new-issue business and order flow for their trading desks.
Portfolio managers at three New York mortgage hedge funds told The Post that over the past week, however, large investment banks like Lehman Brothers, Merrill Lynch and Bear Stearns ended the party.
A few weeks ago, when the story broke that Bear Stearn's subprime-focused hedge funds were on the ropes, there were those who pooh-poohed my contention that Wall Street banks and other prime brokers would quickly tighten the screws on lending to participants in the subprime sector. Among other things, they remained sanguine that these lenders would behave as they and their analogues did during the sovereign debt crisis of the 80s, simply shutting underperforming loans in the vault and whistling loudly whenever the bank regulators asked to see the portfolio. In response, I expressed my doubts that the high priests and temples of Mammon on earth would show such altruistic restraint in the face of pressures to their own capital base.
It should surprise none of my Faithful Readers that I have been proved correct, once again. The Post continues:
A partner of an $850 million mortgage arbitrage fund said he received a demand for almost $50 million of additional collateral from Lehman and Bear Stearns early last week.
"To keep my existing positions I had to come up with that much within 48 hours. None of the positions were in trouble, either in price or with respect to underlying collateral. [But] they should know, [Lehman and Bear] structured and sold me the deals," the manager said.
When an investment bank demands additional collateral to keep a loan - known as a repo or repurchase agreement - afloat, the hedge fund manager is faced with stark choices. The manager can avoid the demand by quickly selling the position - in all likelihood booking a loss in the current market.
He also can raise cash by selling other positions. Or the fund can inject its own capital to meet the call.
A manager of a smaller $50 million start-up hedge fund confirmed that banks are tightening lending standards across the board.
"The dealers want more collateral for every kind of trade," he said, describing the situation as particularly acute with respect to the funds that trade in so-called structured product bonds like collateralized debt obligations or bonds made from other sub-prime mortgage bonds.
"Whereas [investment banks] used to loan out 95 to 98 cents on the dollar for CDOs they originated, they are now only willing to loan out a maximum of 85 cents now," the hedge fund manager said.
Let's see: margin requirements gapping out three to seven-plus times, causing forced liquidations into an illiquid market and putting continued downward pressure on asset prices. Sounds like just the sort of train wreck I predicted. Perhaps a slow-motion train wreck, but a train wreck nevertheless.
Let's just hope the train goes off the rails somewhere outside of Omaha and that it isn't carrying nerve gas.
© 2007 The Epicurean Dealmaker. All rights reserved.
