The hauntingly empty lobby of Bear Stearns
Yesterday’s showdown over the fate of two big Bear Stearns hedge funds “marks an important test of the financial markets’ resiliency,” according to this morning’s Wall Street Journal. So the natural question is: how did the financial markets score? What does the report card look like on the day after several investment banks flinched from pushing these two funds over the edge?
If “Plays Well With Others” was one of the subjects being tested, several of the investment banks who were exposed to the losses at the hedge funds scored very well. JP Morgan Chase, Goldman Sachs and Bank of America all reached negotiated deals with Bear Stearns to limit their risk. Although the details are sketchy, it seems that these deals involve Bear Stearns buying back collateral assets the banks had seized, forestalling a need to auction them off.
Merrill Lynch didn’t score quite as highly in this category, and late yesterday afternoon proceeded with an auction of Bear Stearns assets it had seized. We’re told the auction met with mixed results. Some of the higher-quality assets with less exposure to the subprime market met fetched what the Journal calls “reasonably high prices.” Other assets—variously described as “sludge,” “junk in investment-grade clothing” and “immoveable objects” by traders we talked to—faired less well. The Naked Capitalism blog describes them as fetching “atrocious prices.” Deutsche Bank also seems to have opted to auction off its collateral rather than cut a deal with Bear Stearns.
But at a more fundamental level, the test may have revealed a foreboding weakness in the credit derivatives market. JP Morgan, Goldman and Bank of America are said to have pulled back from auctioning off the collateral because earlier feelers put out to potential buyers revealed that the assets they had seized would have “fetched so little in the market,” according the Journal. The idea is that if they had brought down the the Bear funds, the investment banks would have hurt themselves as well. As Alphaville puts it, "So the picture becomes clearer: eat, be eaten, eat each other, but stop before you accidentally eat yourself."
But something even more ominous also may have convinced the banks to reach a settlement a real market test for these assets—the CDOs rarely traded and are priced according to complex mathematical models—might have demonstrated that they were worth far less than they were valued at on the books of hedge funds and investment banks. This could cause a ripple effect, forcing re-valuations at many hedge funds that hold similar assets, and at the banks that lend to them.
“As its two credit focused hedge funds with about $20bn of highly leveraged assets are put on ventilators, there is real pressure in the market for the creditors not to sell the collateral for fear of undermining the value of the CDOs and other debt packages. As we all know, they are near impossible to price accurately, due to the nature of the underlying distressed assets, and if these CDO’s are valued downwards, then all hedge funds who own similar subprime assets will have to do the same and hey presto we have a falling market, more defaults and the house of cards comes tumbling down,” Finbar Taggit writes today.
In short, by flinching from auctioning off the CDOs, JP Morgan and the other banks that reached deals with Bear Stearns may have prevented what some feared would become the much heralded “systemic event” in which the collapse of one hedge fund brings down all the others. But the cost of doing so appears to be keeping the actual market values of many of these assets more or less financially illegible. And keeping markets and regulators illiterate when it comes to reading the risks of these products.
One trader we spoke to described the outcome as a “cartoon moment.”
“As long as Wiley Coyote doesn’t realize he’s run off the cliff, he won’t fall,” he said. “These guys don’t want to look down because they are afraid there may be no there there.”
Bear's Woes Test Markets' Mettle [Wall Street Journal]
Bear Stearns Staves Off Collapse of 2 Hedge Funds [New York Times]
Subprime sector hit by $1bn assets sale [Financial Times]
Bear feast - be sure not to eat yourself [FT Alphaville]
The hauntingly empty lobby of Bear Stearns