"...Wasn't Bear Stearns supposed to
report the losses at its two mortgage-bond hedge funds on Monday this
"BEAR STEARNS Investors Await Tally
on Losses," said the Wall Street Journal two weeks ago. The
two-week deadline, set by America's
fifth-largest securities firm itself in an email to investors, came and went
So far, no news from Bear Stearns, nor from the WSJ. No news either from the co-chief
executive officer and director of the two funds in question. Which is odd. For Ralph Cioffi
did so love to talk!
The High-Grade Structured Credit
Strategies Fund and its heavily-geared cousin, the High-Grade Structured
Credit Strategies Enhanced Leverage Fund, have been run by Cioffi since 2003, a true pioneer of the credit
derivatives market. He was still talking up the potential for leveraging debt
upon debt as recently as February this year, even telling a bond conference
in New York
that "we're looking at somewhat immature markets that are going through
a growth phase. There is a catharsis and a cleaning-out process."
But today? Not a sausage. Maybe Cioffi's too busy with catharsis...or perhaps cleaning
Why the delay, you might ask, in pricing
the alphabet soup that Cioffi first began to
develop in the early 1990s? Maybe the difficulty in pricing these assets has
got something to do with the way they were created. To quote the man himself,
from an interview with Wall Street & Technology in
"In the dealer-to-customer market
[for credit default swaps], traders mostly construct contracts over the phone
and via Bloomberg e-mails. Transaction and settlement records are created
through a good deal of cutting and pasting of documents, and confirmations
sometimes do not arrive for as long as 90 days."
bosh, loadsadosh! Ninety-day settlement for a
cut-and-paste job created on the fly over the phone. Any wonder Cioffi's team are having trouble putting a price on the
collateralized debt obligations (CDOs) built upon
just this kind of credit default swap two years later?
"When we execute via
Bloomberg," Cioffi went on, "we have to
notify our back office through an e-mail, we calculate the settlement amount,
the dealer sends us the amount and then we notify the buyer or seller of
protection, so there are a number of steps."
A number of steps, eh? This non-standard
and seemingly haphazard process was employed before the tech' team moved in
and enabled trading in credit defaults to balloon. In the US, Bear
Stearns' credit default traders were early adopters of MarketAxess,
run off the DTC's own CDS matching service. Now,
with trading in credit derivatives running at twice the volumes of only two
years ago according to Fitch Ratings, "there is plenty of room for
shocks ahead," reckons Harald Malmgren, an economic consultant in Washington.
"Volatility is coming back to the
market. We could see crack-ups of some household names."
Could Bear Stearns be the first
household name to crack up? It doesn't seem likely, not with the rest of Wall
Street willing to step up and cover the two hedge funds' embarrassment. Back
at the start of July, however, the bank said it might take until yesterday -
July 16th - to price up the junk littering its mortgage-derivative funds,
because "in light of the Funds' circumstances, this process is more
time-consuming than in prior periods."
In other words, Bear Stearns didn't have
a clue how much money it had lost. Nor would you if you had sunk all your
money - or rather, all your clients' money - in CDOs
built upon CDSs reckoned against MBSs based on mortgage loans made to people with no hope
of making their monthly repayments.
More worrying still for the Fed, the
SEC, and their fellow regulators in Europe - where credit hedge funds in London and Milan
have already hit trouble, too - Bear Stearns was at least present when these
monsters were born. Much of the evil afterbirth, the ultra-high risk credit
derivatives that the investment banks wanted to sell on, has wound up in
pliant and placid institutional funds instead.
Indeed, your own retirement and
insurance funds may perhaps have become investment landfill for
some of this toxic waste. And again, little secret was made of the trouble
ahead back in summer 2005:
"Critics fear the explosive growth
in CDOs could spell trouble for Wall Street, since
many of the institutional investors buying them are not fully aware of what they're
biting into," wrote Matthew Goldstein for TheStreet.com
nearly two years ago. "To compound matters, independent pricing
information about these specialized bonds is hard to come by. With a limited
secondary market for trading CDOs, buyers often
must rely on the Wall Street firms that underwrite them for an idea on what
In particular, "All of Wall Street
may come to rue the day Bear Stearns sold $16 million in collateralized debt
obligations to Hudson United Bank," Goldstein reported. "The sale
prompted a complaint to New York Attorney General Eliot Spitzer from Hudson
United, which believes Bear Stearns gave it bad prices on the sophisticated
Bad prices on entry look certain to be
awful on exit. The fact that yesterday came and went without any news from
Bear Stearns itself suggests that Cioffi remains
clueless at best about the real value of the mortgage-backed derivatives his
funds are still holding. Starting right back at the beginning, with the
underlying mortgages themselves, might now be the only route left.
Mortgage-backed securities, credit
default swaps, collateralized debt obligations, synthetic CDOs...even
in something like plain English, none of these assets is liquid or tradable
in the way that an equity or a 400-ounce bar of
investment-grade gold is tradable. Each of these cut-and-paste jobs, in
contrast, represents something approaching a legal contract packed full of
sub-clauses and waivers - and judging the value of legal agreements at speed
is a long way from simply "marking to market" a portfolio of liquid
"Mark to model is a joke,"
says Janet Tavakoli, head of Tavakoli
Structured Finance, a consulting firm in Chicago. "What you need to do now is
vet the underlying collateral," she says - meaning the underlying
"It's grubby, roll-up-your-sleeves
kind of work," says Tavakoli - and it's all so
very different from the easy, click of a mouse work done by Cioffi and Bear Stearns when they first piled into the
mortgage-bond derivatives market.
By : Adrian Ash
Head of Research
correspondent for The Daily Reckoning in London,
is head of research at www.BullionVault.com
– giving you direct access to investment gold, vaulted
in Zurich, on
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