The credit crisis that has been rocking the stock market continues to ripple through the economy and spread beyond sub-prime mortgages to broader sectors of the housing market and other financial institutions and hedge funds. Whether this is overblown or not, we awoke this morning to learn about the closing of American Home Mortgage (AHM) Investment from Melville, Long Island, a lender to the sub-prime mortgage market. On Monday, we heard about Sowood Capital Management, the Boston-based hedge fund, deciding to sell its portfolio containing leveraged positions in bonds and derivatives at fire sale prices to Citadel Investment Group.

Let us not forget that this whole thing began with the demise of two hedge funds managed by Bear Stearns Asset Management from investing in collateralized debt obligations (CDOs) backed by sub-prime mortgages. These marvels of modern financial engineering sunk in value (to the tune of 90 percent) as the default rate in sub-prime mortgages granted to homeowners with sketchy credit ratings began to rise.

Over the next few weeks, I am going to report on a story for Advanced Trading examining what happened to the Bear Stearns hedge funds and other hedge funds that are unraveling because of similar exposures to CDOs. Rather than wait to write the story for our October issue, as I gather information, I’m going to blog about the findings, seeking your feedback and opinions. There are still many unanswered questions about what went wrong at Bear Stearns and lessons to be learned by pension funds and insurance companies that invest in these illiquid instruments. Were these funds allowed to leverage up to the hilt without any oversight from the parent brokerage company, an expert in mortgage backed securities? Was there risk management on the trading desk or at the portfolio management level? Did their internal models signal anything was amiss? To what extent do hedge funds invest in CDOs?

Yesterday I spoke with Rob Hegarty, managing director and Securities and Investments Practice Leader at TowerGroup in Needham, Mass. to get his take on the credit situation with sub-prime mortgages and its impact on Bear Stearns' funds as well as other hedge funds. He was kind enough to give me a primer on CDOs. According to Hegarty, collateralized debt obligations are nothing more than a packaging of sub-prime mortgages and other debt obligations. “You’re pooling them in a CDO to make them easier to trade,” says Hegarty. “So the CDO goes out as a pool of sub-prime mortgages in the southeastern U.S. with an average down payment of less than 10 percent," he continues. Then the banks put a designated yield on the CDO because it’s higher risk. The yield also factors in other characteristics such as the maturity greater than 20 years.

“Once the debt gets securitized, the only thing that drives the actual price for those is when they trade hands,” says Hegarty. “So when they stop trading, it’s really difficult to value those CDOs. That’s what happened in the Bear Stearns case,” the analyst says.

But perhaps what really triggered the crisis is that creditors (large investment banks, such as Merrill Lynch) seized and tried to sell $800 million of bonds held as collateral for loans to the funds. It’s hard to know what came first: Was it the lenders asking Bear to put up more collateral that forced Bear to market-to-market its positions in CDOs? Or, was it Bear Stearns knowing the bonds were worthless, then tried to sell them into a falling sub-prime market. “Then everybody else was afraid that Bear Stearns was going to sell the positions because everybody else would have to mark-to-the market price," says Hegarty.

And was there enough information to price the CDOs – since some sources say these instruments don’t trade? Hegarty says there can be a disparity between the internal theoretical price and the market value. “The reality is there is enough transparency between the sub-prime market and the CDOs that they can always gauge the sub-prime market,” Hegarty insists. “At the end of the day, I doubt that it was lack of information,” continues Hegarty. He says most of these meltdowns are a result of “just being too leveraged and concentrated in a single security. There is no question that hedge funds were big fans of the CDOs," he adds.

Hegarty points to Sowood Capital, the Boston hedge fund, “that went belly up” as another victim of the credit crunch. “It was happy to get out,” says Hegarty noting that Citadel came in as the buyer of last resort.Unfortunately, “the overall blood letting in the sub-prime market “ is not over, says Hegarty.

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