Jun 22, 2007
Extracted from The King
Report, Issue 3658 of Thurs June 21, 2007
An enormously important story
appeared in yesterday's WSJ:
"On Wall Street, the
Bear Stearns hedge funds' problems point to another sensitive
issue: Markets for exotic investments like derivatives linked
to subprime mortgages have exploded in size in the past few years,
but it is often hard to attach an accurate value to those assets...
Unlike stocks and Treasury
bonds, whose prices are continually quoted and easily obtained,
many of these derivative instruments trade infrequently and don't
have clear market prices. To come up with market values for these
instruments... investment funds often rely on their own valuation
For hedge funds, the incentive
to abuse the murkiness of the market can be huge, because they
are compensated by fees base on the values of their portfolios..."
Long-time readers know that
we have wailed at the abuse of 'marking by model' for years.
We have also asserted that hedge funds and other financial
entities should be forced to reveal 'unrealized gains' on derivatives
in their statements to customers and regulators.
A red flag is gains late in
a quarter or at yearend. Theoretically a fund could generate
ill-gotten gains via 'marking by model' on derivatives and indefinitely
'roll' those gains into the future.
We have also maintained for
years that Easy Al and others of his ilk have prevented the scrutiny,
regulation and curtailment of derivatives because financial
entities can manufacture earnings from the 'marking by model'
The WSJ article continues:
"There is no indication
that Bear Stearns's fund managers sought to mislead lenders or
investors about the value of the funds. Indeed, the firm's approach
to valuing its securities seems to be in line with guidelines
set up by Moody's Investors Service, which evaluates hedge-fund
practices. But the crisis does point to the kinds of valuation
problems hedge funds and their investors or lenders can run into,
even when they follow sound practices."
"A forced sale of the
Bear Stearns funds' assets now could trigger a broader repricing
of mortgagebacked bonds and lead to losses and margin callsThat
prospect might have given some of Bear Stearns's lenders, which
include Merrill, Citigroup Inc. and Barclays PLC of Britain,
an incentive to help out the funds. But Merrill and others decided
to bail out of the funds yesterday...
"'No one in the subprime
business wants to ask the question of whether they need to re-mark
all the assets. That would open the floodgates Everyone is trying
to stop the problem, but they should face up to it. The assets
may all be mispriced.'"
Would Merrill retaliate against
Bear for its reluctance to bailout LTCM? The Introduction to
Genius Failed" by Roger Lowenstein:
"David Komansky, the
portly Merrill chairman, was worried most of all. In a matter
of two months, the value of Merrill's stock had fallen by half-$19
billion of its market value had simply melted away. Merrill had
suffered shocking bond-trading losses, too. Now its own credit
rating was at risk.
Komansky, who personally
had invested almost $1 million in the fund, was terrified of the chaos that would
result if Long-Term collapsedKomansky recognized that Cayne,
the maverick Bear Stearns chairman, would be a pivotal player.
Bear, which cleared Long-Term's trades, knew the guts of the
hedge fund better than any other firm. As the other bankers nervously
shifted in their seats, Herbert Allison, Komansky's number two,
asked Cayne where he stood.
Cayne stated his position
clearly: Bear Stearns would not invest a nickel in Long-Term
Capital. For a moment the bankers, the cream of Wall Street,
were silent. And then the room exploded."
If Wall Street is forced to
realistically price certain derivatives and financial instruments,
and we're talking about trillions of dollars of paper, even a
miniscule change in valuations could destroy present and future
earnings, as well as lead to restatement of past earnings and
unleash Congressional fury.
The NY Times:
Bear Stearns Staves Off
Collapse of 2 Hedge Funds
"But by the end of
the day, some of the less-risky securities did change hands.
At the same time, several lenders, including JP Morgan Chase,
Goldman Sachs and Bank of America, reached deals with Bear Stearns
that forestalled a need to sell securities in the open market."
Our 'hokey government economic
stats' bandwagon is filling quickly but our 'marking by
model derivative abuses' bandwagon is just starting. However,
choice seats could fill even more quickly than the 'hokey
government economic stats' bandwagon. So jump aboard now
to avoid the rush.
Jun 21, 2007
The Market Strategist of M. Ramsey King Securities, William
J. King, has over 30 years equity trading and management experience
with major Wall Street firms including Nikko Securities International,
E. F. Hutton, Nomura Securities International, Dean Witter, and
Jeffries and Co. Bill King is the author of the daily commentary