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The bond market has no clothes.
You remember Hans Christian Andersen's story of the emperor's new clothes? After he had been fleeced by some shady merchants, everyone told the emperor how beautiful his new clothes looked, how rich the colors were, how fine the fabrics, until a little boy, who didn't know enough to flatter, said, "But he's naked." And the embarrassed emperor ran as fast as he could for cover from the unleashed laughter of his subjects.
Something very similar is happening in the bond market right now.
Investment losses at a little $20 billion hedge fund -- and yes, in a $24 trillion bond market, this is a small fish -- and Merrill Lynch's (MER, news, msgs) insistence on an auction of some of that fund's assets could make Wall Street admit that prices for trillions of dollars in assets are fairy tales made up in the backrooms of the investment banks themselves. Most immediately affected is the $2 trillion market for pools of securities backed by mortgages, corporate bonds and leveraged loans called collateralized debt obligations (CDOs), and by extension, the entire $30 trillion market for synthetic derivatives modeled on those pools.
That would require a massive re-pricing of portfolios all across the globe. It would turn some winning portfolios into losers and turn modest losses into debacles. It would force pension funds and insurance companies to make up massive shortfalls in the value of their portfolios. Some hedge-fund managers and Wall Street investment bankers, whose bonuses are determined by profits based on these fictitious prices, might see bonuses disappear completely. They might even -- be still my heart -- have to give back performance-based fees.
You should know what's going on so you can decide whether you want to risk your nest egg in this kind of debt market.
Little hedge fund that couldn't
So let me tell you a story.Once upon a time -- April 2007 to be exact -- a little hedge fund called the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund got in trouble. The fund's experienced managers had made big bets on the direction of prices in the market for securities backed by mortgages. And those bets turned out to be wrong. So wrong that the fund lost almost 7% of its value in April, according to the fund's own accounting. Those losses got even bigger very quickly. By mid-May, the fund put them at 18%.
That made some of the investors in the fund and some of the banks that had lent money to the fund very nervous. The fund, you see, had started with just $600 million in actual capital and then borrowed some $6 billion (yes, that's billion) more to make its bets on the market. The Wall Street Journal estimates that, at the high point, those bets were valued at $15.5 billion. But investors knew that if the lenders who had put up all that borrowed money started to demand their money back, the fund would be forced into a fire sale. The more nervous of these investors started to withdraw money from the fund, forcing the fund's managers to sell some of its assets to raise cash.
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That was itself a tricky operation. No money manager likes to sell into a falling market because: (1) you don't get good prices for what you have to sell, and (2) the selling that you're doing can make prices fall even faster, which increases your need to sell, which sends prices falling faster, and so on.
To get around those problems, managers often sell the most liquid stocks and bonds in their portfolios first. For example, the market for U.S. Treasurys is so huge that selling by a $20 billion hedge fund is unlikely to move prices much, so a manager might begin by selling those assets.
But there was another good reason to sell liquid assets first. Bonds that trade frequently in public markets have prices that are set by those frequent trades. Bond traders know the price of a U.S. Treasury note due to mature on Aug. 15, 2012, with a coupon yield of 4.375%, because that bond has been bought and sold over and over again in a transparent public market with visible bids that indicate what buyers are willing and pay and what sellers want to receive. If a trader wants to sell or buy that bond, he knows exactly what the price of that transaction will be.
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Not so with CDOs and their derivatives. Unlike Treasury bonds, which are remarkably standardized financial products, CDOs are handcrafted. No two are exactly alike in the way they distribute risk, the amount of this and that they mix, the yields they offer and how they react to market stress. And unlike Treasury bonds, which trade frequently, CDOs trade infrequently. And when they do trade, they often trade privately, which provides very little price information to the public market.
Making up their own prices
Wall Street still has to value its portfolios, of course, even in the absence of public prices. To solve that problem, the investment houses that invented, packaged and marketed these infrequently traded securities and their derivatives invented mathematical models that priced their products. You knew what a Merrill Lynch or a Morgan Stanley (MS, news, msgs) or a Goldman Sachs Group (GS, news, msgs) derivative was worth because the investment bank told you what it was worth after running their models.Continued: A conflict of interest
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