Replies

OK, first, I know that Ambrose is something of a gold-bug. True ‘nuff.

But some of what he says is quite true in here.

Some quick background:

The problem inside these Bear Stearns hedge funds is twofold:

1. They’re using very high leverage ratios. If you or I were investing in stocks and our brokers allowed us to trade on margin, about the most we’d be able to margin would be 2:1 — ie, we’d be able to buy twice as much stock as we had cash in the account *for certain stocks*. If we were buying solid, reputable companies with solid books and an established history, we could put down $0.50 per dollar of stock we bought.

For a new, untried, small-cap company that is like many of the dot-com startups in the late 90’s, the SEC now requires that guys like you or I put down $1.00 for every $1.00 of stock we buy. ie, there is no margin allowed on these stocks any more.

If you or I were buying commodities contracts or such, we could get a 10:1 ratio, as long as our position was profitable. As soon as the position turned on us, we’d either have to put up more money to cover the shortfall, or our broker would try to call us *once* — and if he couldn’t get in touch with us, he’d sell out our position until our account met margin requirements.

Bear Stearns was leveraged somewhere between 15:1 and 20:1 on some of these hedge fund assets. Merrill was making a margin call as soon as they started to figure out that the securities in Bear’s hedge funds weren’t worth so much any more.

Merrill did try to sell some of the better quality stuff in the Bear fund: they got, as Ambrose indicates, only $0.85 per dollar of indicated value. The “crap” in the fund was reported to receive bids as low as $0.15/dollar.

This is HIGHLY important for reasons I will explain next.

2. What is in these hedge funds? Some of the assets are CDO’s (collateralized debt obligations) and CDO-squareds (CDO-like beasts made up of other CDO’s of varying credit qualities, derivatives and non-cash instruments).

I could bore you to tears with a bunch of financial “engineering” jibbery-goo, but I won’t. Instead, I’ll put this in terms most everyone can understand.

Let’s say you own some stock in some company. Let’s not worry about which company — let’s just say it is a widely known company — eg, Microsoft, IBM, Dupont, GM, whatever. Pick a big, well known company.

Let’s say you’re asking the bank for a loan, and the bank wants to know what your assets are. Part of what you own is this stock, so you look up the price of the stock, you multiply by how many shares you own, and wha-la, there’s how much that stock is worth, right?

If the banker wants to challenge you on that asset you own, you point to the market, and say “I could sell that stock right now for the price indicated, therefore that stock is worth that amount of money.” Period, end of discussion. Whoever was challenging you pretty much has to shut up at that point. The market spoke and it said what your stock was worth.

Clear so far? Market people have a term of this type of valuation mechanism: “mark to market” — even if you didn’t sell the stock, when you wanted to value that asset you owned, you turned to the market, viewed what the stock was selling for at that moment in time and the market was the ultimate arbiter of what that asset is worth.

This is NOT how the contents of these hedge funds are valued. These CDO’s and CDO-squared trade very, very rarely, and the market isn’t “deep” (ie, there aren’t a lot of buyers even in good times) and there is no way you can just pull up a web page and say “So what is this thing currently trading for?”

Instead, these assets are valued by what is known as “mark to model” — some whiz-kids wrote up a computer program, installed it on a computer in the hedge fund, and this program looks at current interest rates in the market, the performance of some of the crap inside the CDO’s and CDO-squared, and spits out a number saying “This here asset is worth $XXX.nn”

These numbers are complete fantasy, of course. An asset is worth what a willing buyer is willing to pay a willing seller. That’s it. Everything else is just talk.

What happened when Merrill tried to sell some of these CDO’s and CDO-squareds is that the buyers became a real market: Merrill was putting these assets up for sale, trying to get what the model(s) indicated was the current value of the CDO’s/CDO-squared.

And the buyers in the market said “The model is BS. Here’s what we’re offering.”

That’s a real market. When a seller is desperate, the buyers don’t step right up and say “Golly, we feel sorry for you — here, lemme offer to make you whole.” Nooooo. The buyers smell blood in the water, and they look to get something at a good price — the same as any retail shopper wants to do during a going-out-of-business sale.

And make no mistake — that’s what is going on here: the Bear funds would be going out of business if Merrill sold off the assets to meet a margin call. No one in their right might would pay $1.00 per $1.00 of valuation. Everyone is going to be looking for a bargain.

OK, ‘nuff theory. Here’s where the fear is starting to ramp up:

A bunch of hedge funds, pension funds, investment banks, etc, are holding the bag on these CDO’s and CDO-squareds. They’re all mark-to-model. If Bear hadn’t coughed up $3.4B to make the margin call that Merrill is asking for, then the contents of Bear’s fund would have set the price expectations for a LOT of other CDO/CDO^2’s out there. And suddenly, a whole lot of funds that might have been leveraged might have been getting their own margin calls, asking them to either put up a lot more cash, or sell their assets.

The problem here isn’t just the mark-to-model, and it isn’t just the leverage. It is the combination of the two.

Let me put it in common homeowner terms: Let’s say you have a no-money-down mortgage on a house. The real estate market was hot-hot-hot when you bought the place, but suddenly, toxic waste is discovered in your neighborhood. All your neighbors are also carrying no-money-down mortgages too.

So the first guy to get a call from his bank is the guy with the ultra-premium house in the neighborhood. The bank says they want him to deposit 20% of the house’s value, or otherwise the bank will foreclose on the house and sell it.

The other homeowners in the neighborhood hear this and start to panic — if this first house goes on the market and doesn’t sell at the high valuation price (because the number of people who want to pay top dollar for executive homes in neighborhoods known to contain toxic waste is surprisingly low...), then as the asking price keeps going down, down, down, other people in the neighborhood might start getting calls from their mortgage lenders too.

If people had put down 20% up front, they wouldn’t be getting a call from a banker until the prices really dropped drastically. If they owned their houses outright, they wouldn’t be getting any calls at all.

Let’s say the toxic waste thing turns out to be easily fixed. All the people who were foreclosed by their banks are going to be bitter — because if they just didn’t have the bank breathing down their necks, they could have hung on through the little toxic waste flap, and come out of it with no harm, no foul.

But because they really didn’t control the disposition of the property, their actions were forced by the lender.

If these hedge funds weren’t leveraged to the hilt, they could just sit back and wait until this sub-prime flap was over. If the CDO’s were traded like stocks, the margin lenders might be more confident in letting the hedge funds slide. But because we have a combination of a market that will plummet when the first CDO’s are actually traded, and we have extreme leverage... we have a very, very bad witches’ brew of fiscal stupidity here.

Possibly a 1929-like brew.

The problem is, no one really knows what is inside those CDO’s and (especially) the CDO-squareds. There is scant ability to really evaluate the risk here, thanks to the whiz kids who created these CDO’s and CDO-squareds to deliberately add some “toxic waste” sub-prime mortgage debt in with some investment grade mortgage debt.

Sorry, my previous reply was cut short:

As to Ambrose’s evaluation of the sources of liquidity: he’s spot-on. The Yen carry trade (borrow Yen at slightly over 0% APR and convert it into $USD or Euro’s) has been a huge source of liquidity for the last six years.

Greenspan injected huge amounts of liquidity into the US market after 9/11.

And China has boatloads of dollars as a result of our incredibly high trade deficit and current account deficit with China. One of the ways China has sought to ameliorate this, and deliberately keep long-term interest rates low in the US (which helps keep the consumer spending) has been to buy US Treasuries in the 10 year range. The 10 year T is used as the benchmark for a wide variety of loans.

Gold won’t cure this right now. There isn’t enough gold in the world to replace the current levels of liquidity without everyone taking a huge haircut in valuation levels.

But at some point, the liquidity merry-go-round is going to stop. The Yen carry trade is already no longer as lucrative as it was as the Bank of Japan started to raise interest rates. The PRC has indicated that they’re going to start diversifying their debt portfolio, which is banker-speak for “we’re not going to buy quite so many US Treasuries any more”, which will result in interest rates on T’s going up a bit.

There are hedge funds in the EU who have invested (heavily) in US mortgage debt who are going to get a rude surprise (if they haven’t already). If they’re leveraged to US investment banks, then the BIS might start getting involved. I’m not too worried about what the BIS has to say at this point. Right now, I’m more interested in what Fitch’s, Moody’s and S&P start doing in how they rate the debt in some of these portfolios.