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Fund Blowups Clobbering Secondary Market
Asset Backed Alert, Harrison Scott Publications Inc. (March 14, 2008)

The secondary market for asset- and mortgage-backed securities felt another bout of pain in recent days, as the holdings of a troubled Carlyle Group hedge fund flooded into the market and credit-crunch-related fears kept buyers at bay.

The upshot is that market conditions, which have been shaky at best for some time, are unlikely to improve in the foreseeable future. "This week has probably been the toughest to date," said David Castillo, who oversees structured-product trading at broker-dealer Further Lane Securities.

While the Carlyle Capital fund is just one of many alternative-investment vehicles collapsing amid the ongoing credit crisis, the liquidation of its assets over the past few days has had a particularly strong effect on market technicals. Much of that had to do with the entity's size: Prior to its blowup, it was holding more than $21 billion of top-rated mortgage bonds, most bought on borrowed money.

When Carlyle was unable to meet demands of repayment from margin lenders late last week, those institutions - including Bear Stearns, Deutsche, J.P. Morgan and Merrill Lynch - began selling its assets. By the middle of this week, they had unloaded more than $10 billion of the investments.

Washington-based Carlyle acknowledged on Wednesday that it expected margin lenders to seize the remaining holdings of its fund, leading to a shutdown of the vehicle. As those investments continue to stream into the secondary market, meanwhile, it is becoming harder for other sellers to compete for the attention of already jittery investors.

As a result, many sellers have given up hope of holding out for prices consistent with what they believe their ABS, MBS and CDO holdings are worth, agreeing to discounted sales instead. "Now, people are searching for liquidity wherever they can, instead of where they like," Further Lane's Castillo said.

For example, super-senior bonds backed by so-called option-ARM mortgages were trading this week at just over 70 cents on the dollar, down from more than 90 cents in late February. Option-ARMs permit borrowers to defer monthly payments by adding to their principal balances, and have been among the worst-performing types of home loans in recent months.

In the home-equity loan sector, an unidentified player was seeking 65 cents on the dollar this week for a large block of senior "third-payer" bonds - triple-A-rated securities whose maturity dates put them third in line to be paid with cashflows from the underlying credits. The seller was also seeking a buyer for longer-dated senior bonds from the same issue at 55 cents on the dollar. In late February, both batches of notes probably would have fetched about 10 cents more.

To be sure, the overall pace of secondary market trading has dropped only slightly since last month, even as the ongoing turmoil keeps many investors on the sidelines. That's largely because in addition to Carlyle's vehicle, a number of smaller hedge funds are unloading assets as they try to meet margin calls from lenders that are nervous about declines in the values of their investments.

Most of the fund managers are selling their highest-quality holdings in hopes of raising cash quickly in order to stave off collapses, one bond salesman said. "Subordinates are completely dead. Nobody will even touch them now," he added.

Lenders, including Thornburg Mortgage, have faced margin calls as well. At the same time, many money-losing hedge funds are simply getting rid of assets as they prepare to shut down.

There has also been a domino effect on demand. As leveraged players like hedge funds switch from buying to selling, just about the only active investors left are "cash" buyers, often with less purchasing power. And as those buyers sift through a resulting surplus of offerings, they have been able to grab discounts on top-rated securities that are steeper than ever.



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