Downgrade Hammers Brokerage Stocks - TheStreet

Downgrade Hammers Brokerage Stocks

Lehman and Bear Stearns drop as subprime worries spread.
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Brokerage stocks were hammered anew after an analyst downgraded the group, citing the risks highlighted by big losses at two

Bear Stearns

(BSC)

hedge funds.

Bear and its rivals fell between 1% and 4% in midday action after Punk Ziegel analyst Richard Bove said the debt market has grown too fast, exposing firms to risks that are both huge and difficult to calculate. He said investors should sell the stocks.

Bove said the collapse of Bear's High-Grade Structured Credit Strategies Fund and High Grade Structured Credit Enhanced Leveraged Fund shows that recent developments on Wall Street could "open investors to sizable losses."

On Wednesday,

Goldman Sachs

(GS) - Get Report

fell $4.07 to $215.33,

Merrill Lynch

(MER)

slid $2.29 to $83.81, and

Morgan Stanley

(MS) - Get Report

tumbled $2.40 to $70.45.

In a letter to clients Tuesday evening, Bear tried to put a positive spin on its admission that two of its troubled hedge funds were nearly worthless. But there's no sugarcoating the damage done to Bear's clients, its reputation and, perhaps, the broader outlook for risk-taking.

Bear's clients learned Tuesday that the High-Grade Structured Credit Strategies Fund and its sister vehicle, High Grade Structured Credit Enhanced Leveraged Fund, are respectively worth 9 cents on the dollar and zippo.

"In light of these returns, we will seek an orderly wind-down of the funds over time," says the letter, which comes a month after the funds managed by Bear Stearns veteran Ralph Cioffi nearly collapsed under the weight of bad bets on the swooning subprime mortgage business.

"Bear Stearns has been working to achieve the best possible outcome for investors under these circumstances," reads the letter. But it's hard to imagine a worse outcome for investors, whose equity was $638 million in the more highly levered fund and $925 million in the less levered fund as recently as March, according to

The Wall Street Journal

. Sources say investors had been expecting a recovery of around 50 cents on the dollar for the less leveraged fund.

The letter to clients explains a story familiar to most in the investment community: The funds were hit with redemption requests and margin calls in early June, sold assets to raise money, but couldn't raise enough cash to meet these margin requirements.

Just as with some individual investors who overextend themselves on credit, Bear Stearns' lenders, prime brokers including Merrill Lynch and J.P. Morgan Chase, and possibly others, feared the struggling hedge funds would go under after the subprime market tumbled in February and March, and demanded they repay some of their debts. The irony, of course, is that the margin calls helped facilitate a downward spiral for the funds and self-fulfilling prophecy for its lenders.

Lenders "moved to seize collateral or otherwise terminate financing arrangements," the letter states, and the net asset value of the funds dropped as subprime markets plunged.

The credit markets and parts of the stock market -- particularly Bear's own shares, which are down nearly 20% this year -- have already felt subprime pain.

Elsewhere in the sector,

JPMorgan Chase

(JPM) - Get Report

was recently down 3.8% despite a Wednesday morning earnings beat, and

Lehman Brothers

(LEH)

was off more than 4%.

Bear Stearns has pledged some $1.6 billion for the high-grade fund but nothing for the more highly leveraged enhanced vehicle. The firm's letter explains that about $1.4 billion remains outstanding on the credit line.

The letter also outlines efforts the firm has taken to "restore investor confidence in

Bear Stearns Asset Management." This includes appointing Jeff Lane as chairman and CEO of the asset-management firm, known as BSAM. Likewise, Tom Marano, head of Bear Stearns' mortgage department, was assigned to the team to help sell off the funds assets, the letter notes.

The letter also outlines that BSAM's risk management methods have been "restructured" to report directly to Mike Alix, Bear Stearns' chief risk officer, "creating an additional layer of oversight."

However, "risk" is starting to become a dirty word again as bets in riskier asset classes crumble in the wake of the Bear funds' implosion. The spillover is really a reduction in risk appetite, evident in credit markets other than just subprime. The high-yield bond and leverage loan markets that finance leveraged buyouts have virtually hit a wall as investors in those markets demand more return for the risk they're taking. Risk premiums on the derivatives index tied to high-yield bonds have widened to 395 basis points, or 3.95%, over comparable, no-risk Treasury bonds, from its low of 250 basis points in early June. And, the index tracking leveraged loans has widened to 295 from 115 basis points at its June low point.

Deals to finance

First Data

(FDC) - Get Report

and Chrysler LBOs are meeting with some trepidation as banks,

private-equity firms and investors work out a more reasonable risk/return equation.

In this opaque market where valuation is based on models and trading is over-the-counter, not via transparent pricing systems such as stocks or cash bonds, the devaluation of Bear's funds could be far-reaching. The fear is that Bear's pain could have a cascading effect that forces hedge funds and others on Wall Street to offload other hard-to-sell assets in a fire sale. According to various news reports, the two Bear funds were once invested in over $20 billion in debt instruments (including the leverage involved).

The bears say such sales could force selling amid all types of securities -- and that could lead to a ratcheting up of lending standards and reduce the liquidity that has been such a boon to the stock market.

"The fears surrounding this are all about leverage," says one fund-of-funds manager who declined to be named. If more money managers are forced to mark down the value of the assets in their portfolios, banks and brokerages that lend money to hedge funds via the prime brokerage business may be marking up the fees they charge for extending that leverage.

If more funds sell more assets, the market will become more and more transparent and the outcome could get even uglier. The market has been watching the ABX index -- used to hedge bets on mortgage securities -- lose value as more and more problems emerge with subprime debt.

As another hedge fund manager wrote in an email Wednesday morning: "Now we wait for the fallout."

The fallout is already under way.

The Wall Street Journal

cites large lists of subprime assets for sale Tuesday, some of which were managed by an Australian hedge fund called Basis Capital.

Traders are trying determine which lenders might be exposed to that fund and others that may be struggling. The brokerage firms with the biggest prime brokerage businesses, in other words lending to hedge funds, include Lehman Brothers, JPMorgan Chase, Merrill Lynch and Goldman Sachs.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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