"...Wasn't Bear Stearns supposed to report the losses at its two mortgage-bond hedge funds on Monday this week...?"

"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 yesterday.

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 out.

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 August 2005:

"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."

Bish, 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 they're worth."

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 bonds."

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 securities.

"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 mortgage debt.

"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

Bullionvault.com

City correspondent for The Daily Reckoning in London, Adrian Ash is head of research at www.BullionVault.com – giving you direct access to investment gold, vaulted in Zurich, on $3 spreads and 0.8% dealing fees.

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