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July 7, 2007

Sophisticated Investors: Sophisticated Losses

The Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund [The Sausage Fund] and the High Grade Structured Credit Strategies Fund [The Junior Sausage Fund] have the sophisticated debt market in turmoil. It seems the two Sausage Funds were highly leveraged and made wrong bets causing margin calls and asset seizures whereupon Bear Stearns [The Sausage Factory], decided to extend a $3.2 billion credit line to the two Sausage Funds in the hope of staving off disaster.

The interesting thing to note is that none of the players are novice investors, they are highly qualified "Sophisticated Investors," the kind who are allowed to invest in options and hedge funds. I guess there is a difference when it comes to losses: the Sophisticated Investors have a lot more significant zeros in their losses than the unwashed masses could ever hope to collect. :-)

But the irony does not end there. Let's have a look at these RMBSs and CDOs. A lot of folks who could not afford a home because they could not afford an ordinary mortgage, got the loans anyway because there was too much liquidity in the market and the money had to be put to work. The last time something like this happened, that I recall, was when banks were awash in petrodollars in the late '70s and all those petrodollars had to be put to work so the banks could pay interest on their petrodeposits. The logic was simple, governments can't default. Famous last words. The Brady bonds used to resolve the issue are still with us, I believe. But getting back to the story, securitization is used to reshuffle the risk inherent in these sub-prime mortgages creating the RMBS securities. So far so good. But the high finance world had to go to the next step, to securitize the trash end of the RMBS tranches. Sort of like making a meal from leftovers. Of course, these are all Sophisticated Debt Instruments to be sold to Sophisticated Investors such as CALPERS.

But, where does CALPERS get its money from? Whose money is it anyway? "Approximately 1.5 million California public employees." I have my very serious doubts if more than a handful of these public employees would qualify as "Sophisticated Investors." Yet these unwashed investors had their retirement funds invested alongside "Sophisticated Investors" for the sole reason that they were bunched together in CALPERS.

But the irony does not end here yet, there is more! It was not too long ago that CALPERS was castigating public companies and their management for not looking out for the best interests of their shareholders. CALPERS took Home Depot to task. Yet CALPERS places high risk bets with their member's funds. And why beholdest thou the mote that is in thy brother's eye...? (Matt. 7:3)

To sum up, a California public employee loans his retirement funds, which he cannot aford to lose, to a sub-prime home owner who cannot afford to pay it back. I wonder how the operators of CALPERS, The Sausage Factory and The Sausage Funds fared.

Denny Schlesinger

Brady bonds
RMBS = Residential Mortgage Backed Securities
CDO = Collateralized Debt Obligation

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