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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35363  
Subject: Sub prime hedgie troubles Date: 6/21/2007 11:43 AM
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http://www.nytimes.com/2007/06/21/business/21bonds.html

Personal opinion: if Bear Sterns Hedge funds and others like them go under from bad investments, I'll be delighted. In fact, if the entire hedge fund industry goes broke, I'll be mroe delighted.
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Author: coolprash Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20799 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/21/2007 4:58 PM
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Hi Loki,

Why do you say

"if Bear Sterns Hedge funds and others like them go under from bad investments, I'll be delighted. In fact, if the entire hedge fund industry goes broke, I'll be mroe delighted"

yours sincerely,
coolprash

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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20800 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/21/2007 6:17 PM
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"if Bear Sterns Hedge funds and others like them go under from bad investments, I'll be delighted. In fact, if the entire hedge fund industry goes broke, I'll be mroe delighted"


Because, until they are subjected to investigation and regulation, I assume hedge funds are organized criminal organizations that make money for the rich by cheating. Given their fees and that we know mututal funds with much lower fees can't beat the average, they must be doing something ordinary investors can't. We have evidence of cheating. So the burden of proof is on the hedge fund industry to prove they are not guilty, since reason says they are.

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Author: markr33 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20801 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/21/2007 6:18 PM
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Why do you say

"if Bear Sterns Hedge funds and others like them go under from bad investments, I'll be delighted. In fact, if the entire hedge fund industry goes broke, I'll be more delighted"


It's really very simple. These people are the most sophisticated investors that exist today. They draw funds from the richest and most successful people, and from money managers that are eminently qualified to properly manage their fiduciary duties. By and large, these people are among the most sophisticated (investing-wise), and are the people that are most aware of the risks involved in what they are investing their money into. And because of those risks, they enjoy a higher return, and along with that higher return, there is a greater possibility of loss. If "we" (meaning government, the public, the financial industry, or the stewards of monetary policy) bail them out when the going gets tough and some of those losses are occurring or about to occur, then the message being sent is that they can take all the risk they want (in the future) because there will always be someone to bail them out. Bad message. Bad policy.


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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20802 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/21/2007 7:15 PM
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And because of those risks, they enjoy a higher return, and along with that higher return, there is a greater possibility of loss.

I don't believe this. I think higher risk equals higher return is magical thinking pushed by the finance industry. Day trading, which is much of what hedge funds do, is very high risk but does not increase average return—with added costs it ends up less. As far as I understand derivatives, which is something else they do, it is a zero sum game.

There are legitimate high risk high return approaches. When a company with a low credit rating issues a junk bond, they pay the investor more interest. A new company attracts venture capital, it does so by giving investors a far higher stake in the company per investment dollar than buying shares of publically traded companies.

Risk/reward is common sense for these. When someone can show me how trading more aggressively provides higher reward on the average for higher risk, then I'll believe it. As far as I can tell, it's just a slogan.

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Author: markr33 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20805 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/21/2007 10:38 PM
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<< And because of those risks, they enjoy a higher return, and along with that higher return, there is a greater possibility of loss.>>

I don't believe this. I think higher risk equals higher return is magical thinking pushed by the finance industry.


So why do lower rated bonds have a higher interest rate than higher rated bonds do? And why do investments in equity have a better long-term return than investments in debt (which is more secured than equity is)?

Day trading, which is much of what hedge funds do

The few hedge funds that I am familiar with do not engage in day trading. One of them makes equipment lease loans at very high rates with the capital item as security (they get rates in excess of 18% plus a 3% origination fee, a very good business). Another one invests in deeply distressed companies. And another one has been buying heavily discounted mortgage paper. Talk about high risk!

, is very high risk but does not increase average return—with added costs it ends up less. As far as I understand derivatives, which is something else they do, it is a zero sum game.

They are actually a negative-sum game due to the transaction costs.

There are legitimate high risk high return approaches. When a company with a low credit rating issues a junk bond, they pay the investor more interest. A new company attracts venture capital, it does so by giving investors a far higher stake in the company per investment dollar than buying shares of publicly traded companies.

Risk/reward is common sense for these. When someone can show me how trading more aggressively provides higher reward on the average for higher risk, then I'll believe it. As far as I can tell, it's just a slogan.


I don't think day-trading provides a higher reward on average. In fact, day trading isn't really "investing" and shouldn't be considered in a discussion of risk-related returns of investments. Day trading is more a form of gambling, some people (I know exactly one such person - he used to trade large sums for one of the worlds central banks, now he trades for himself) are good at it and can consistently profit, but the vast majority cannot.



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Author: theHedgehog Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20806 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/21/2007 11:11 PM
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Loki: I don't believe this. I think higher risk equals higher return is magical thinking pushed by the finance industry.

markr33: So why do lower rated bonds have a higher interest rate than higher rated bonds do? And why do investments in equity have a better long-term return than investments in debt (which is more secured than equity is)?

The fact that investments with a higher return have a higher risk does not mean that increasing risk will result in increased returns. If memory serves, the only thing you can conclude is that if it doesn't have a higher risk it will not have a higher return. This may sound overly picky, but it's the way it works.

Hedge

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Author: markr33 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20807 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/21/2007 11:28 PM
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<<<Loki: I don't believe this. I think higher risk equals higher return is magical thinking pushed by the finance industry.>>>

<<markr33: So why do lower rated bonds have a higher interest rate than higher rated bonds do? And why do investments in equity have a better long-term return than investments in debt (which is more secured than equity is)?>>

The fact that investments with a higher return have a higher risk does not mean that increasing risk will result in increased returns.


I agree. For example, investing in Ponzi schemes has very high risk, but very low return.

If memory serves, the only thing you can conclude is that if it doesn't have a higher risk it will not have a higher return. This may sound overly picky, but it's the way it works.

Yes it is.


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Author: TMFGalagan Big gold star, 5000 posts CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20808 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/22/2007 8:57 AM
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So why do lower rated bonds have a higher interest rate than higher rated bonds do?

Conversely, why are there periods of time during which the additional yield on junk bonds fails to make up for the actual default rate?

I bet the rates those Ponzi schemes offered were sky high!

dan

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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20809 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/22/2007 9:03 AM
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The few hedge funds that I am familiar with do not engage in day trading. One of them makes equipment lease loans at very high rates with the capital item as security (they get rates in excess of 18% plus a 3% origination fee, a very good business). Another one invests in deeply distressed companies. And another one has been buying heavily discounted mortgage paper. Talk about high risk!

Most of the heavy volume on the markets comes from hedge fund momentum traders. I agree that isn't the only strategy hedge funds use, nor is derivatives. The problem is, with no oversight, legitimate high risk strategies cannot be differentiated from momentum trading and cheating.

It is possible to do the legitimate high risk/high return approach on the secondary market. On the average junk bonds have historically paid more even accounting for defaults than investment grade bonds. But to get returns hedge funds need to get to cover the expenses, not to mention to satisfy their clientele, takes a lot more than just normal junk. That's where things like distressed companies and sub-prime mortgages. Making direct loans at high rates is an example of direct high risk/high return investing.

There would be nothing in an open-books hedge fund industry to prevent legitimate high risk investing—the kind of stuff you are describing. But I don't think that kind of investing is going to provide enough opportunitiess for most hedge fund money. Legitimately providing capital to those, such as start-ups or people who are stretching to buy a house, is good economics, and it is appropriate that those who risk capital for these purposes be rewarded. But when investing in start-ups turns into a sure thing thanks to investment banking pump and dump scams (as c. 2000) or when sub-prime is government-backed, then the risk part disappears. And I don't believe momentum trading and derivatives has anything to do with this kind of risk taking. So if the hedge funds doing this are going to make enough to justify their existence, they are either playing zero sum with other hedge funds, or they have found ways to take money from investors who are not playing the game, for which we have seen evidence (and there is a lot of suspicion of collusion, especially with small caps, where hedge funds can probably work together to force momentum, circumventing rules that prevent large mutual funds from doing so).

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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20810 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/22/2007 11:16 AM
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Let me try this again.

I object to the slogan "greater risk leads to greater reward." I think it is misleading and dangerous and offers a false explanation for greater rewards that come from rigging the system on the claim of risk.

There are two kinds of higher risks: higher risks in which there is historically a higher average return on the investment and higher risks in which there is a zero-sum (or less after costs) game. They should not be confused.

The former involve those who receive capital having to provide a greater potential return to investors in order to receive capital, given the risks. This includes seeking working capital by offering shares in the company instead of borrowing the money. It includes start-ups offering higher %s of the company per investment $ to attract venture capital compared to buying shares in well-established companies. And it includes having to pay higher interest rates for loans than what is paid by borrowers who are more likely to pay the loan back. All these possibilities then become available on the secondary market, so over time we expect stocks to do better than bonds and high yield bonds to do better than investment grade bonds, obviously with periods where this may not hold.

The latter, higher risks from active trading, is something different. By playing momentum and using derivatives to exaggerate returns, you have the potential for greater returns by taking on greater risk. But trading does not provide working capital and no one is paying a higher return to traders because they have provided working capital to a riskier investment.

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Author: theHedgehog Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20811 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/22/2007 11:22 AM
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Loki: I object to the slogan "greater risk leads to greater reward." I think it is misleading and dangerous and offers a false explanation for greater rewards that come from rigging the system on the claim of risk.

Me too. How about "Greater risk is required for greater reward, but doesn't guarantee it."? Nah, It'll never catch on. It doesn't have a good beat and it's not easy to dance to. :)

Have a good weekend.

Hedge

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Author: Alfred4 One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20816 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/22/2007 5:27 PM
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The few hedge funds that I am familiar with do not engage in day trading. One of them makes equipment lease loans at very high rates with the capital item as security (they get rates in excess of 18% plus a 3% origination fee, a very good business). Another one invests in deeply distressed companies. And another one has been buying heavily discounted mortgage paper. Talk about high risk!


I would like to thank all of you for all the knowledge you so generously share. I have enjoyed your posts for several years now. So it's past time that I give something back. I hesitate to write because my writing skills are so lacking and you get murdered on these boards for miss spelling or grammatical errors.

What brings me to write is I have gained by chance some information about credit risks that may be useful to you. Namely “who really gets left holding the bag when mortgages default and just how risky are Mortgage Backed Securities”.

My wife and I was guest this weekend with a couple whose husband works in the commercial capital markets (not the residential capital markets but both are structured in the same way.) After a polite amount of time I asked “What do you do in the capital markets”? He said we securitize commercial mortgages. Wow! I never dreamed I would talk one on one with some one who could explain in detail how the MBS system and tranches work.

So I put the question to him “who really get left holding the bag when these MBS bonds default?”

He, being a patient type, first explained how the pool of mortgages is assembled from portfolios of mortgages that they buy from originators and later securitize.

The process:

A skilled clerk examines each mortgage in a portfolio of mortgages and makes a notation of the quality of each mortgage then puts it in a pile that is now referred to as The Pool.

The next step is to mentally divide the Pool into tranches. Tranches are a concept of risk and not a physical division of the mortgages in the pool.

The securitizer, sometimes with the help of software, calculates how many bonds are to be issued for each of the tranches. The different tranches represent different degrees of risk. The top tranch has very little risk and pays the least interest of all the tranches where as the lowest tranch has considerable risk but pays the most interest...in the range of 18% or better. The interest rates paid on the tranches is based on the 10 yr treasure bond plus a varying number of basis points added depending on the risk of the tranch.
Bonds are then issued on each tranch. Fewer bonds are issued on the lowest tranch than the other tranches and all the tranches are backed by the very same pool!

My next question was to define what is considerable risk? How is risk assigned?

Now no one really signs an affidavit but if they did it would make it very easy to explain the meaning and significance of a tranch and how risks are dristributed.

. Let's pretend all the people in the lowest tranch had signed an affidavit or agreement
that said “we the members of the lowest tranch are willing to stand good for all the grief (non payments of loans, early repayments of loans and all costs associated with foreclosures) coming from any and all loans in the entire pool if you will pay us 18% interest”. Let's further pretend all the people in the tranches above the lowest have signed similar affidavits but demanded a lower rate of interest than the bond holders in the tranches below them.

Now no one really signs such an agreement but it comes very close to explaining the way risks are assigned. The lowest tranch assumes 100% of the risks until they are wiped out! The honor is then past to the next tranch above. (No one in the upper tranches is ever out one penny until the tranch below is wiped out.)

The people designing the securitization assume there will be 1 -2 % defaults in a typical pool in a normal times and take this into consideration when deciding how many bonds to issue for each tranch. (I think this process is called pricing the pool).

In concept the bottom tranch is acting as an insurance company. (We will pay them 18% on the money they put into “C” tranch bonds if they will stand for all losses until they are wiped out and then the “B” tranch takes over the insurance duties).

I'll bet not many people have ever had tranches explained to them in this fashion. I had no idea that the risks were assigned in this manner. Having a difficult time accepting this as fact, I asked my neighbor who also works in the capital markets if the above is an accurate description and she said “Yes…it's sort of like the last man standing”.

I have known both of my sources for over 10 years.

Here is what happens when the grief starts to come in from the loans as the lowest tranch starts to get hammered.

All monies coming into the treasury of the pool manager come from borrowers making their monthly mortgage payments. Normally the pool manager takes part of this income stream and makes the coupon payments to the bond holders of each tranch at their promised coupon rate. However if the incoming revenue is short because of non payment of loans or other grief, this shortage is deducted from the amount set aside for coupon payments to the lowest tranch and they receive less than expected, but the higher tranches continue to receive their full coupon.

If revenue shortfalls continue long enough the lowest tranch can go into default.

After the lowest tranch gets wiped out, the tranch above drops down a notch to become the new lowest tranch and the process of whoever is the lowest tranch continues to accept all the grief from the entire pool of mortgages.

After this explanation I said “It must be very risky to buy a bond in the lowest tranch.” He calmly replied: Mind you these people are making 18% and they have had a string of good years since 2000 in the commercial real-estate. Besides that they don't loose everything when a loan goes bad, the securitizer starts foreclosure on be half of the tranch and in the process if they find any fraud in the loan it gets kicked back to the originator for a full refund of capital. So if times are good and the grief is not over the assumed 1% of the pool, the high risk takers are well rewarded for their risk by making 18%, almost 4 times what they would make on Treasuries.

Who are the buyers of the lowest tranch? They tend to be Hedge funds who are betting with other people's money and are willing to take high risk for high returns.

So who gets wiped out first when the loans start to default? The people who bought the highest interest paying bonds in the pool are the first to go.

. You can tell what tranch you are in by how much interest they are paying you.

Before you flame me and you have sources in the capital markets, please see if you can confirm the above description of equity tranches.

Alfred4



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Author: tedhimself Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20818 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/22/2007 10:43 PM
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Alfred: Nothing wrong with your writing and I found your explanation to be interesting and educational.
Thanks,
Ted

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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20819 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/22/2007 11:54 PM
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http://www.nytimes.com/2007/06/23/business/23bond.html?hp

Bail out. At least not government.

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Author: theHedgehog Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20820 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/23/2007 12:28 AM
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Here's what Faerber has to say about CMOs in "All About Bonds and Bond Mutual Funds". This book convinced me that I had no business trying to mess with bonds or bond funds. :)

"CMO pools are divided into from 3 to 17 tranches (or slices), and investors buy bonds with varying maturities in these tranches. For example, the classic CMO has four tranches. The first three (Class A, Class B, and Class C) pay interest at the stated coupon rate to the bondholders of each tranche. The fourth tranche (often referred to as a Class Z, or Z-bond class) resembles a zero-coupon bond, where interest is accrued. The last tranche is always the Z tranche.

"The cash flows received are used first to ay the interest on the first three classes of bonds and then to retire the bonds in the first tranche. All prepayments go to the first Tranche A. Then when all the bonds are retired, the prepayments continue to tranche B. This process continues until class B bonds are paid off, and then C bonds follow. Z bonds receive no payments (interest or prinicpal) until all the other tranches are paid off. The subsequent cash flows are used to pay off the accrued interest, and then the return of principal to retire the Z bonds."

As you can see, this is not quite what your friend had to say. The Class Z tranche looks like an open-ended zero coupon from this description; where the rewards are high unless it goes bad, and you have no idea when you get your money.

Hedge

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Author: Alfred4 One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20821 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/23/2007 10:29 AM
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Ted, thanks for your reply and the kind encouragement.

Hedge writes:
As you can see, this is not quite what your friend had to say. The Class Z tranche looks like an open-ended zero coupon from this description; where the rewards are high unless it goes bad, and you have no idea when you get your money.


Hedge, My education continues. I have learned there are two or more types of tranches. One is exactly as you described. I believe it is called a duration tranche. Where the A tranche is retired 1st and the B tranche is paid off next and so on.

My source just called me as I was writing this reply.

He said that in the tranches he creates, when the money comes in the coupons for the A tranche are paid first then is funds are available the B coupons are paid and so on. There are no staggered pay-offs..All tranches are retired at the same time.

I am going to have lunch with my friend today. I will try to get confirmation on the names of the tranches.

Thank you both for your replies. I am interested in learing all I can about this hot topic of capital markets.

Alfred4

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Author: Chapter3 Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20823 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/23/2007 2:31 PM
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Fascinating discussion. Thanks Alfred and others.

C3

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Author: hockeypop Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20824 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/23/2007 5:41 PM
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Thank you both for your replies. I am interested in learing all I can about this hot topic of capital markets.

Alfred4


Best wishes for your success with this. A couple of comments, and I will be a bit preachy, out of experience. It is NOT new, but has been around for years.

You've suggested it, but this is a VERY complicated concept and not an investment, rather either a career or speculation.

What you and your friend may be suggesting, IMO is a typical bastardization of a good financial process. Tranches (mortgages), derivatives (interest rates), futures (commodities) and similar concepts are important devices which keep their financial or business markets liquid, and in every instance START as a conservative concept that deals with risk.

The problem is that at the levels you seem to be suggesting the risk becomes SO tenuous to determine that I don't feel it can be judged as an investment by most "normal" investors, nor indeed most professional ones (most "high level" investment managers like the Yale or Harvard funds or some corporate funds don't get to the levels you are suggesting). When someone like us (and I've been there) get into this, it is my experience that the only ones who make money are the middlemen. For examples of smart people who get killed by similar speculation research the bankrupcy of Orange County California because of their use of derivatives. For tranches, it is more difficulty because mortgage/loan brokers come and go so quickly.

Finally, this "game" is more fun in a rising market. It is magnitudes more difficult if the markets are falling.

Danger!

Hockeypop



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Author: Alfred4 One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20825 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/23/2007 10:50 PM
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<Finally, this "game" is more fun in a rising market. It is magnitudes more difficult if the markets are falling.

Danger!

Hockeypop>


I agree with you. From what I have learned these fancy derivatives are not for the faint of heart or retired folks. My interest in CDOs CMOs MBSs is strictly intellectual curiosity.

Investments with this much risk is very inappropriate for someone my age. Mark Twain said it best “I am for more concerned with the return of my money than I am with the return on my money”. But after 9/11 when the FED slashed short rates to the point T-Bills were paying 3 %, I felt my money was almost un-employed.

So I watch this board and Macro Economics and Trends to get Ideas and to keep up with what conservative investors are doing now.

Thanks for your concern for my financial safety.

Alfred


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Author: markr33 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20827 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/24/2007 12:15 AM
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Who are the buyers of the lowest tranche? They tend to be Hedge funds who are betting with other people's money and are willing to take high risk for high returns.

This is absolutely true, the primary buyers of the lower tranches are hedge funds and "high wealth individuals" with good connections on Wall St. Those 18% mortgages were in great demand by such folks when real estate was rising because their was a perception of "no risk". Access to those high yielding tranches were mostly restricted only to the best customers. Now the real risk is showing up.

Many years ago, I purchased some CMOs from the upper tranches, but when interest rates started dropping, most of the principal was returned to me early.


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Author: markr33 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20828 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/24/2007 12:34 AM
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http://www.nytimes.com/2007/06/23/business/23bond.html?hp

Bail out. At least not government.


Least!!! But it could be nearly as bad. Two comments -

1) How is Bear Stearns justifying this action with respect to their fiduciary duty to all their clients (of the other funds that aren't failing) and their investors?

2) This could be "spreading" the risk. If all the big investment houses transfer this hue risk to themselves, that increases the likelihood of a future government bailout. I think the government might hesitate to bailout a bunch of rich folks who make risky investments, but wouldn't hesitate to bailout the very firms that help allocate most of the capital the companies of the USA need.

I don't like it.


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Author: rustybell Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20829 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/24/2007 11:53 AM
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This could get real ugly...particularly for bond fund holders - how much of that higher performance is due to derivatives (CDO's)?

Like Loki, who cares about the hedge funds and their "investors", yet this could wreak untold havoc on credit markets...globally.

http://www.financialsense.com/fsu/editorials/tustain/2007/0623.html

it is not always easy to sell a package of these Mortgage-Backed Securities (MBS). The process of selling such a device demands that the credit quality is assessed – and because the underlying lender is marketing to sub-prime borrowers, the package of debt in the MBS is heavily composed of mortgages quite likely to go into default. So a credit ratings agency will give it a low credit score.

This makes it difficult to sell, which is where a bunch of smart investment bankers join in.

The investment bankers slice the MBS into several chunks or "tranches". These are known as Collateralized Debt Obligations, or CDOs for short. The idea is to create some higher risk assets and some much safer ones, slicing up the MBS into what are called equity, mezzanine and investment-grade bonds.

The equity takes the higher risk, and so it earns the higher return if things go well. But if things start to go wrong, the equity is lost first...and then the mezzanine. However, even if there's quite a high rate of failure in the higher risk end, the investment-grade bonds still get fully paid out. This persuades the credit ratings agencies to give them a respectable stamp of approval, thereby creating out of low-quality mortgages a respectable amount of highly-rated bonds.

In this way the bankers might, for example, convert a large package of MBS into perhaps 70% investment grade bonds, 15% mezzanine, and 15% equity.
The original mortgage lender is in a hurry to get the whole MBS off its book, remember, selling the MBS into the financial markets. That way he replenishes his cash and can go out marketing more mortgages to more sub-prime borrowers.

The investment bank is well motivated to slice up the MBS, and it had better be good at selling all this debt on. It won't want to keep much – if any – of the newly created CDO tranches, since the bank earns its money primarily by distributing the MBS, rather than by taking risks with the chance of subprime mortgage borrowers not making their repayments on time.

It is relatively easy to sell the high-grade investment bonds. Stamped with an investment-grade rating, these bonds are sold off to mostly respectable investment institutions. But the mezzanine, and particularly the equity, are less easy to dispose of.

In effect the 30% of the mortgages in the original MBS which were deemed on a statistical basis to be likely to fail, are concentrated into what investment insiders call "Toxic Waste". How can these bonds be sold off?

Enter the hedge fund.
Somehow, and possibly even using some its own money, a bank sets up a hedge fund whose objective is to trade in the high-risk CDO equity and mezzanine instruments. Let's say the bank puts up the first $10 million. The hedge fund then buys the equity tranche of the CDO from the bank.

With a bit of luck, and this is what happened over recent years, the housing market goes up. Now the equity is floating higher in the water, because there's a cushion of higher house prices preventing those original sub-prime borrowers from defaulting. This rather obscure equity instrument, which is not traded anywhere and is not liquid, appears to be worth more than it was at issue. It gets marked up in value, and much faster than the underlying houses, because all the price volatility is concentrated in this thin slice of CDO equity.

The hedge fund is now a performer! And that means it will be rewarded by further investment from outside. So what started as a vehicle with a little investment bank money can grow the funds it manages under its own steam – and that can make its managers very rich.

Next, and this is what hedge funds are all about, it will leverage its risk, too. The hedge fund goes out to a lending bank, holding its high-performing but illiquid toxic waste in its hand, and it asks to borrow money using the waste as collateral. The bank has access, whether directly or indirectly, to cheap money from Japan – where interest rates remain at just 0.5% – and so it has the prospect of lending for spectacular profits.

Now the MBS wheel is fully in motion. The hedge fund loses no time in marking up the value of its equity CDOs on the basis of rising house prices. There is an overwhelming pressure to do so, since the hedge fund's managers are rewarded based on performance – a figure which is far too easy to manipulate if your investments are illiquid and hard to value in the absence of an open market price.

The toxic waste gets marked up without the waste itself getting tested on an open market.


Marked up by modeling...not by marking to market...we are talking fairy tales here! At least in an environment of rising rates, falling home prices and epidemic foreclosures. And all this with the collusion of the rating agencies like Moodys and Fitch who remain tardy at biting the hands that feed them!

Danger...dissembling house of cards

Rusty



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Author: ranshdow Three stars, 500 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20834 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/24/2007 4:32 PM
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Excellent post, Alfred. From it:
The people designing the securitization assume there will be 1 -2 % defaults in a typical pool in a normal times and take this into consideration when deciding how many bonds to issue for each tranch.

and

After the lowest tranch gets wiped out, the tranch above drops down a notch to become the new lowest tranch and the process of whoever is the lowest tranch continues to accept all the grief from the entire pool of mortgages.

Now this is interesting to me. Say a pool goes into default sufficient to anihalate the lowest tranch, putting the next higher tranch into the position of insuring the next defaults. Say that the market starts pricing this tranch's bonds at a rate as bad or worse than the original price of the lowest tranch out of what to me would be market irrationality. My question is, are they now mispriced? Afterall, the default rate of the entire pool shouldn't change just because some mortgages went into default- the individual default rates of individual mortgages are in essence unlinked, independent variables.

Sounds like a possible mkt opportunity for the big boys.

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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20835 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/24/2007 4:36 PM
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This could get real ugly...particularly for bond fund holders - how much of that higher performance is due to derivatives (CDO's)?

Like Loki, who cares about the hedge funds and their "investors", yet this could wreak untold havoc on credit markets...globally.


I don't know about credit market in general, US or global, but as I've noted many times, the affect of sub-prime defaults on bond funds depends on the bond fund. Conservative funds, which have only minimal exposure to sub-prime mortgage securities and other in-effect sub-prime will only see a small impact. These are the kind of fund, notably ones that track the Lehman Aggregate Bond Index, that most people have in retirement accounts. Many other funds, such as all other Vanguard bond funds (except, I suppose the junk funds) have almost no mortgage securities exposure, and the exposure of GNMAs to sub-prime is iminimal.

What would be more of a problem for these kind of bond funds would be if whatever is happening with mortgage junk leads to higher interest rates across the board.

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Author: blacktreechaser Three stars, 500 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20837 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/24/2007 7:45 PM
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Good info about the tranches...

I just remember when GNMA funds were giving very competative returns, some articles came out about investing in CMO's. The jist of the articles said CMO's are not for individual investors...Insitutional investors would get the best CMO packages, the individual investor would get the junk.

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Author: hockeypop Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20838 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/24/2007 8:33 PM
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What would be more of a problem for these kind of bond funds would be if whatever is happening with mortgage junk leads to higher interest rates across the board.

Well first you get a flight to quality, which creates a lack of liquidity which may increase interest rates, but it may also create additional defaults as no one will buy at any price (it starts at the edges and works in).

Lest we forget $0 downpayments and short term interest rate buydowns are only a bit more wild than 5% (uninsured), 5% insured, possibly irrationally escalating housing prices, etc.

On occasion Mr. Market forgets about the concept of rational risk and just stops buying, even pretty good loans. In the worst of times you have the Saving and Loans defaults.

It is times like that that Warren Buffett and others swoop in (as he did with high yield corporate junk bonds) and re-remind us that risk is NOT bad, except when investors don't properly calculate it, making a TON as the only guy with cash.

At my age, those speculative days are happily far behind me.

Enjoy your posts and lurking here!

Hockeypop

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Author: TheNajdorfDefens Big funky green star, 20000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20906 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/28/2007 2:35 PM
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"if Bear Sterns Hedge funds and others like them go under from bad investments, I'll be delighted. In fact, if the entire hedge fund industry goes broke, I'll be mroe delighted"


Because, until they are subjected to investigation and regulation,


This is dumb.

There have only been about 12-25 high-profile investigations of hedge funds just in the past year, plus dozens more of smaller ones.

Hedge funds, like any asset managers, are regulated by multiple states, Feds, and regulatory agencies.

Try the real world next time. It's fun!

Naj

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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20909 of 35363
Subject: Re: Sub prime hedgie troubles Date: 6/28/2007 4:57 PM
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Hedge funds, like any asset managers, are regulated by multiple states, Feds, and regulatory agencies

...in theory.

In practice the authorities leave them alone.

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Author: TheNajdorfDefens Big funky green star, 20000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20913 of 35363
Subject: Re: Sub prime hedgie troubles Date: 7/1/2007 11:55 PM
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In practice the authorities leave them alone.


This is wrong. For every HF manager I name who's been arrested, indicted, charged & settled, or fled the country one step ahead of the authorities, will you give me $100?

Didn't think so.

Naj

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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20916 of 35363
Subject: Re: Sub prime hedgie troubles Date: 7/2/2007 2:58 PM
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There are a lot more hedge funds out there who haven't been investigated.

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Author: Wradical Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20959 of 35363
Subject: Re: Sub prime hedgie troubles Date: 7/9/2007 11:58 AM
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I have some good friends who run Hedge Funds!

Kahuna,CFA
_____________________________________
Sounds like another verse to "I've Got Friends in Low Places"
(apologies to Garth Brooks)

Bill




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