Opaque Derivatives, Transparent Fed, `Bubblenomics': Timshel
By Mark Gilbert
bloomberg.com
June 27 (Bloomberg) -- The most stunning aspect of the demise of two hedge funds belonging to Bear Stearns Cos. is the almost total absence of transparency surrounding the bailout.
The debacle may finally provoke regulators, who have long suspected that buying derivatives is akin to running through a fireworks factory with a lighted blowtorch in each hand.
Their focus is likely to fall on how to assign prices to complex derivatives, created by cooking together different flavors of securities whose values are driven by other assets such as stocks, bonds or mortgages.
The efforts by Bear Stearns's creditors to extricate themselves from their investments have laid bare one of the derivatives market's dirty little secrets -- prices are mostly generated by a confidence trick.
As long as all of the participants keep a straight face when agreeing on a particular value for a security, that's the price. As soon as someone starts giggling, however, the jig is up, and the bookkeepers might have to confess to a new, lower price.
Bear Stearns's share price has dropped about 4 percent since June 12, when the Wall Street Journal first reported the woes at the bank's High-Grade Structured Credit Strategies Enhanced Leveraged Fund. The Standard & Poor's 500 Index has gained about 0.5 percent in the same period, while the S&P's index of seven investment banks and brokerages has dropped 3.2 percent.
The brinksmanship has been dizzying to watch for the past two weeks, even through the fog of unidentified sources, rumor and speculation. Would the lenders to the two funds dump their collateral in a fire sale, trashing the entire market for collateralized debt obligations? Would Bear Stearns backfill the deficits?
Too Big to Fail?
The sheer size of the derivatives arena gives regulators nightmares, with trading volumes dwarfing the value of the underlying securities that the derivatives are based on. A record $251 billion of new CDOs sold in the first quarter, according to the Bank for International Settlements.
The unraveling of the Bear Stearns hedge funds has pulled back one corner of the curtain shielding the activities of hedge funds and their investments in derivatives, giving a glimpse of who is on the hook if the bets sour.
It seems that the skin in the game isn't from other hedge funds, Asian central banks, or widows and orphans. Instead, step forward the usual Wall Street suspects: Merrill Lynch & Co., Lehman Brothers Holdings Inc., Bank of America Corp. and their investment-banking peers.
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Transparency is all the rage among modern central bankers, who are still in the early stages of the shift to chorusing in plainsong from speaking in tongues. The Federal Reserve faces a particularly tricky exercise in linguistic gymnastics when it meets to set borrowing costs tomorrow.
The outcome itself seems a foregone conclusion; all 112 economists in a Bloomberg News survey expect the Fed to keep its key interest rate unchanged at 5.25 percent. The accompanying statement, though, needs to smooth the rollercoaster ride taken by expectations for where monetary policy is headed.
The Fed rate was expected to decline to 4.75 percent by the end of this year, according to the median forecast of 74 economists surveyed in December by Bloomberg News. This month's survey showed the current expectation is for no change -- though the range swings from a high of 6 percent to a low of 2.5 percent.
The Fed needs to find a way to reconcile concern that inflation is accelerating with evidence that the economy is stumbling. Too soft, and the central bank might reignite unwarranted speculation that interest-rate cuts are imminent and that parts of the economy such as the subprime mortgage market are in even worse shape than anyone suspected. Too hard, and the bond market might take fright.
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For all of the recent focus on bubbles, whether in Chinese stocks, modern art, global real estate or rare stamps, too much attention is paid to financial assets and too little to the underlying economy, according to Ian Harwood, head of economics at Dresdner Kleinwort in London.
``Economic and financial euphoria tend to reinforce each other on the upside -- and then nastily interact on the downside,'' Harwood wrote in a research report published last week. ``The prudent investor would be well advised to employ a `bubblenomics' mode of analysis.''
Both the U.S. and U.K. economies are currently at the mercy of their housing markets, Harwood wrote. In Japan, the damage wrought at the beginning of the 1990s ``is now fully cleaned up.''
The euro area, though, is in the strongest shape. ``This economic entity has never experienced Japanese or Anglo-Saxon style excess,'' with companies keeping borrowing low and household savings staying high, Harwood wrote. ``This, to us, augurs well for the longer-term sustainability of the current upswing which has surprised continually by its strength and produced a steady improvement in consensus growth expectations.''
(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)
To contact the writer of this column: Mark Gilbert in London at magilbert@bloomberg.net
Last Updated: June 26, 2007 19:45 EDT |
