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Murky Markets

Bill King
The King Report
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 models...

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' of derivatives.

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 "When 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
Bill King
website: The King Report


About Bill King: 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 The King Report.

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