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CI Signature Manager commentary 0803 PDF Print E-mail

This is commentary from CI Signature's management team on the recent event of Bear Stearns purchase by JP Morgan.

Please email me if it triggers any questions.


Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund collapses

-March 17th, 2008- The headline above marked the beginning of an unprecedented global deleveraging cycle that continues to grow in scope. Illiquid and complex mortgage-backed securities had begun to fall in value last spring, margin calls on the Bear Stearns funds could not be met and the assets of the highly leveraged fund were seized by lenders and liquidated. That was June.

This process is continuing today at another level – the entirety of Bear Stearns. Bear Stearns itself is leveraged 30 times its equity base and heavily invested in –you guessed it – mortgage-backed securities. When its lenders grew tougher in the past few weeks, demanding higher margin rates and better-quality collateral, the bank ran out of liquid securities. A small change in high-grade mortgage asset values was all it took to evaporate the equity.

The sale of Bear Stearns to JP Morgan reduces counter-party risk in the financial system but that focus will now turn to others. The involvement of the U.S. Federal Reserve highlights the magnitude of the counter-party risk concerns and the need for aggressive policy action.

The contagion in credit markets finally reached high-grade mortgages in February. The repricing of credit risk began with sub-prime mortgages last summer but migrated last fall throughout the entire credit spectrum right up to government securities. In February, even mortgage pools from government-sponsored entities (Fannie Mae and Freddie Mac) sold off in an unprecedented way. It was credit risk repricing at the high-grade level that triggered the collapse of investment fund Carlyle Capital last week.

If you want lots of leverage, you need top-quality collateral – so the most leveraged financial business models owned residential mortgage pools, which had been assets with low perceived risk levels. Canada is not immune in that our government-backed mortgage pools have underperformed government bonds. Similarly, the Montreal Accord is aimed at resolving the asset-backed commercial paper troubles in Canada and preventing a fire-sale of assets. The accord’s organizers realize that distressed market prices are below potential longer-term recovery values.

Financial firms broadly have struggled to maintain access to funding since December. Investors fearing losses on banks’ loan portfolios have been reluctant to provide more loans to banks. This was seen in bank borrowing costs and the interbank lending market. Central banks have made repeated efforts to keep liquidity flowing to prevent precisely what happened to Bear Stearns. Financial firms without stable capital bases and sufficient liquidity are being pushed out of business as their funding costs soar. This ultimately will concentrate business with the incumbent, deposit-taking banks.

We expect the debt market troubles to persist throughout the year. The fundamental problem is U.S. home values. Until there is stability in home prices, which will require government intervention and stimulus, financial valuations will remain depressed. We do not anticipate dividend cuts or further capital issues for Canadian banks. U.S. financials are clearly more exposed. We see fantastic long-term value in the sector.

Eric Bushell, Chief Investment Officer

John Hadwen, Portfolio Manager