Bear Stearns' hedge-fund snag isn't the stuff of a market-shaking debacle. Gordon Fowler Jr. is CIO of Glenmede Trust Company, an independent wealth-management firm based in Philadelphia.

Summary

June has been a rocky month for the world's stock markets. The latest source of worry has been the news surrounding hedge funds managed by Bear Stearns.
Bear's hedge-fund woes combine most of the classic elements generally required for a substantial market retreat: over-investment in assets with relatively low risk premiums, cheap credit and lots of leverage.
The events around Bear are still unfolding, but our guess is that it won't result in a sustained and substantial shock to the system.
Instead we'd be inclined to guess that this shock will come a little later and, quite possibly, it will involve investing in Asia.

Review and outlook

The stock market lost steam in June, shedding about 1.7% of its value. People cite different reasons for this miniature sell off. Bear's troubles top the list lately. The sort of mess Bear's hedge funds have landed themselves in is somewhat characteristic of the events that can cause the kind of panic that brings bull markets to an end. At a guess though, this is a minor tremor and not the "big one" that we will feel somewhere down the road.

Still, if you like reading about the history of financial markets, Bear's troubles have a familiar ring. Combine low yields for high risk securities (low risk premiums), cheap credit and too much leverage and you have all the ingredients for a financial implosion. The one missing ingredient is the catalyst that takes investors and creditors "by surprise" and results in cheap and plentiful credit not being quite so cheap and plentiful. In this case the catalyst was the collapse of the sub-prime mortgage market. Bear had several hedge funds that invested in sub-prime mortgages (or variants of these instruments) using debt, in part anyway, to fund the acquisitions.

When you take an historical perspective on such things, you realize that it doesn't matter what specific assets are in play. Over the last few hundred years, U.S. investors have collateralized debt with railway lines, utilities, emerging-market debt, Texas office buildings, junk bonds and Internet companies. In each case, the basic idea is that you are paid for taking risk by earning more money on your assets than the interest rate you pay on your debt. This generally works quite well -- until it doesn't.

To be fair Bear "hedged" some its risk by offsetting its purchase of these instruments with the sale of an index of sub-prime mortgage debt. When prices of sub-prime mortgages declined earlier this year, the hedging strategy worked for a while. The hedge, however, was not a perfect match. (Generally, if it is, you don't make any money.) Eventually the prices of the assets decline sufficiently so that, from the perspective of the lenders, the assets are no longer sufficient to collateralize the liabilities.

Up to a point

In these situations, bankers or government officials gather in what were once smoke-filled -- now probably soda-can strewn -- rooms to decide how to sort things out.

It seems that Bear's take on how to sort this particular thing is to ask for more time to make good its obligations. Time is a critical variable in these situations. Such crises tend to pivot around fairly illiquid assets -- and when illiquid assets have to be sold quickly, Wall Street comes in for the kill, triggering a "fire sale" that many not cover the fund's obligations. A slower sale can give the seller a chance to find a more generous buyer who is capable of holding the assets for a longer period of time.

As this is being written, Bear isn't altogether out of the words. It seems to have mitigated the immediate problem by lending the hedge funds they manage some of their own capital. This doesn't out their risk, but it appears to have contained the specific problem.

Ripples from Bear's troubles may continue to be felt, however. This is just the sort of event that can attract regulatory attention and result in "bad press" for individual companies and markets alike. Financial institutions that provide leverage to hedge funds and other similar entities might make highly leveraged investors remove some of the risk from their portfolios.

As we noted last month (familywealthreport.com/members/1216.cfm Review and outlook: Goaded by fear of missing out), hedge funds' net long equity positions had apparently got to be quite high, indicating that these funds were taking above-average levels of risk. Historically, these relatively high initial risk levels have been associated with flat equity markets over the succeeding six months as hedge funds bring their equity exposure back down to normal levels.

This sort of prudent pause would probably be quite healthy for the market over the long run -- provided there is enough liquidity and capital around to cover the losses. Another scenario though: if this problem clears up over the next month or so, the market forgets this warning message and continues to pump up asset prices and lower risk premiums.

Froth factor

This would set us up for the "big one" at some point. My guess is that we're not yet at that point for several reason. First, stock-market valuations relative to bond yields are still at a reasonable level. The two big market declines of the last few decades (1987 and 2000 to 2002) were preceded by a very narrow gap between the earnings yield on stocks (the inverse of the price-to-earnings ratio) and the yield on Treasury bonds. This gap serves as a proxy for the risk premium between risky and risk-free debt. When the risk premium is virtually zero, the rationale for leverage and credit begins to unravel. Currently there is still a reasonable gap between the earnings yield on the S&P 500 and the Treasury bond.

Another problem arises when there's massive over-investment in one sector of the economy. This can make it hard for the assets bought with credit to earn a return that will cover interest and debt repayment. Over-investment certainly happened during the Internet bubble when the supply of technology and telecommunications equipment services far outstripped demand. Shady accounting at Enron and Worldcom temporarily covered up this problem in the early part of the decade.

The recent residential-housing bubble is a candidate for this sort of problem. Interestingly, a frothy housing market isn't just a problem in the U.S. It's also an issue in Europe and parts of Asia. Our guess is that housing will be a drag on the U.S. economy and cause some blow ups like the hedge funds at Bear, but it isn't, in its present state, enough to send the markets over the edge for a sustained period of time.

If we had to guess the source of the "big one," it would involve China and India. Introducing such a large portion of the globe's population to a free-market economy provides numerous opportunities for growth. There are, of course, the Chinese and Indian stock markets which have already had their ups and downs. There are, however, lots of other ways to invest in these markets including real estate, factories and equipment, and services and goods in other countries that are China and India 'plays." Though China and India have the potential for creating "bubble" economies, it would also seem that these economies also have considerable room for growth. The great thing about these economies is that while they are riding a boom of export-related growth, their populations are large enough to sustain good, internal growth.

Lessons from San Andreas

So if the "big one" isn't necessarily around the corner, what should you do? It may be worth taking some lessons from Californians, who live with the constant threat of another sort of "big one" occurring.

First lesson Don't be afraid to take risk where it is being adequately rewarded. One of the great things about the California ethic is the capacity to get up every morning in the face of "shaky" prospects and devise some of the world's most creative services and technologies. Likewise, even if there is "a big one" looming over the markets, it is worthwhile taking risks in a diversified portfolio. The risks that seem to be the most favorably priced are international equities and domestic, larger-cap growth companies.

Second lesson Although it is important not to be paralyzed by fear, it is wise not to be blind to risks. California has tough building codes. They practice emergency drills. For a portfolio, this means lightening up on those overvalued assets that have the greatest potential to fall. (Irritatingly, these assets may even run up substantially in price prior to a fall.) Small cap stocks would seem to be a good candidate for this list. We would also be tempted to keep exposure to U.S. real estate fairly measured.

California's best rick control is its size and diversification, however. A major earthquake running through Silicon Valley would be a horrific event for the state. But California is a big sprawling network of regional economies that wouldn't all be hit by the big one simultaneously. Similarly, portfolio diversification has the potential to cushion the blow of a financial big one. -FWR

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