Can bond market stand to be exposed?

You may note a certain inherent conflict of interest here. The investment houses that were selling these products were also valuing these products. Their ability to sell more of these products was, to a great degree, dependent on those calculated prices behaving the way the models said they would. It wasn't that those privately calculated prices couldn't go down, but that they had to move in predictable fashion.

Were those calculated prices real? In the absence of actual buying and selling, those prices were as real as they could be. But in the absence of public buying and selling, the question was essentially meaningless. Those prices were the only prices.

Until someone conducts a public sale.

And that's exactly where the hedge fund hit the fan. Like the other investment banks on the hook to the Bear Stearns hedge fund, Merrill Lynch wants its money back. Unlike other lenders such as Goldman Sachs and Bank of America (BAC, news, msgs), however, Merrill Lynch refused to unwind its loans through private deals with Bear Stearns (BSC, news, msgs). Those deals would avoid any public sales that might damage the prices of these assets as calculated by computer models. A plan worked out by Blackstone Group (BX, news, msgs), a private-equity buyout firm that went public June 22, would have required creditors to avoid any margin calls on their loans for 12 months in exchange for a $1.5 billion, fully collateralized, injection of new money from Bear Stearns itself.

Merrill Lynch instead seized the $850 million in collateral that backs its loans to the hedge fund and, on June 20, began to sell it at auction.

An auction, of all things. With lists of assets. Relatively public bids for those assets. Relatively public sale prices. My God, it almost sounds like a market.

I have my suspicion about why Merrill Lynch rejected the Blackstone plan. Waiting 12 months without recourse as a market that is clearly in trouble unwinds further isn't exactly an attractive proposition. Seeing the questionable collateral backing your loan spread over another $1.5 billion loan isn't exactly enticing either.

And then there's the once-in-a-portfolio-lifetime chance to see how far from actual market prices calculated prices might be.

Merrill's risky gambit

The auction is only a pale reflection of a public market, though. Merrill Lynch will get more information on prices out of the exercise than any other investment bank will. Among investment bank competitors, only Merrill Lynch will know precisely how much difference there is between the prices of these assets as carried on the books of portfolio managers throughout the global financial industry and the prices these assets might bring in an actual sale.

With the market for many of these assets under stress -- Wall Street lingo meaning, "They're falling like a stone and we can't find any buyers" -- in the recent bond market panic of mid-May to mid-June, information like that would be an incredible competitive edge, certainly worth any losses Merrill Lynch might suffer in the auction of an $850 million portfolio.

But it is a dangerous game that Merrill Lynch is playing. The likelihood is that it won't be able to keep all this pricing information to itself, and what it can keep to itself for the moment will become common knowledge on Wall Street in short order. Once prices from real sales are out there, portfolio managers will be forced to mark down the value of their existing portfolios to actual sale prices. And that will set the re-pricing avalanche in motion.

How big and destructive could that avalanche be? Think of just this one example: The safe Treasury market took a hit of 10.5% in the four-week May panic. That's a 10.5% loss in the most liquid, accurately priced debt market in the world. Think an illiquid market with prices that only exist in computer models will do better?

What should you do? At the very least, call up the manager of every fixed-income mutual fund and ETF you own, and the manager of your pension fund, and the manager of the company that insures your home or health, and ask them about their exposure to CDOs and mortgage-backed derivatives and this avalanche. Don't be put off by their talk about investing only in the safest parts of this market. The truth is no one knows what is safe in this market and what isn't.

Look out below!

Updates to Jubak's Picks

Buy Thompson Creek Metals (TCMRF, news, msgs). Thanks to all the Canadian readers who responded to my June 15 column, "A safe-money bet? Think Canada," by saying, "So what took you so long?" and then offering other Canadian stock picks. I'm adding one of those, Thompson Creek Metals, to Jubak's Picks with this column.

Thompson Creek, until recently named Blue Pearl Mining, is the second-largest publicly traded producer of molybdenum in the world. During the first quarter of 2007 the company produced 3.8 million pounds of molybdenum at a cost of $5.63 a pound. Molybdenum, which in the high-purity form produced by Thompson Creek is mainly used as a lubricant in the oil and gas industry, at that time sold for a realized price of $25.74 a pound.

What I like about Thompson Creek -- even more than that spread -- is the plan to increase production by designing a mill, increasing mining activity at its existing mines and opening the new Davidson project to mining in late 2008. All these steps would increase production to 29 million pounds in 2009 from a projected 21 million pounds in 2007.

As of June 26, 2007, I'm adding shares of Thompson Creek Metals to Jubak's Picks with a target price of $20.20 by December 2007. (Full disclosure: I will buy shares of Thompson Creek Metals for my personal portfolio three days after this column is posted.)

Continued: New developments

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