Speculation Gone Wrong, Or, Tops are a Process

Tonight’s article is about speculation in the current market environment.  Let’s start with the front page of Wednesday’s Wall Street Journal.  Two medium-large hedge funds at Bear Stearn are likely to be closed down, and the collateral sold by Merrill Lynch, unless an alternative deal can be worked out.

Working out such a deal won’t be easy.  Debt-based hedge funds are frequently long and short credit obligations that are complex, and often unique.  The obligations are difficult to trade, partially because there are few who traffic in the securities, and there is often little trading in the securities to validate the pricing levels that the hedge fund use to calculate their valuations each evening.  Positions are not so much marked-to-market, but marked-to-model.  Illiquid as they are, an auction will test the markets to see how much of a discount is needed to move the securities.  How much slack assets do their competitors have to snap up debt obligations at a bargain?  When the liquidation is done, will there be anything left for the hedge fund investors?  Merrill just wants its money back, will they take their time to get the best price, or will they conclude that the market is decaying, and decide to sell as rapidly as possible?

Now there are a decent number of these investors, and reputedly bright, as this Bloomberg article points out.  There are lots of smart people on Wall Street, perhaps too many, and some always prove to be “too clever by half.”  What is the ratio of vultures to carrion?  So far, more vultures, which is bullish.  The results of any auction will be reflected in the prices, which may overshoot on the downside, if only because when too much liquidity is demanded at once, the prices of what is being sold will suffer.  But if there are a lot of vultures, that will not happen.

Part of this problem is the general willingness to extend credit at low incremental yields.  (Spreads were tight when the worst of the subprime mortgages were originated.) Fundamental bond investors (like me) have been worried for a while, but usually it takes a few years of lending at low spreads before something breaks.  Consider the following articles:

Spreads are too tight, particularly on riskier debt.  More subordinated debt is getting issued.  Covenants are weaker than before.  More CCC-rated debt is getting issued than ever before.  Private equity seeks more and more financing, substituting debt for equity, and making the overall financial system less flexible.  Liquidity is just another way of saying that risky lending takes place at low spreads versus safe debt.

The last two articles cited describe the problem, but also how it might end ugly.  In my opinion, it will take a few entities blowing up before the markets change.  In the fixed income markets there are players who fell that they must deploy cash to justify their existences; they only sell once a crisis is proven, and the client is complaining.  That is why the debt markets react more slowly to a crisis than the forward-looking fundamentals would indicate.  Men have lost their jobs for not grabbing enough yield in the bull phase; this leads others to invest in securities of dubious quality, but possessing stellar YTNJs [YTNJ = Yield To Next Job]. 8D

Part of this mess is a failure of the ratings agencies.  It’s tough to be proactive when most of your revenues come from those you rate.  The ratings agencies have been slow to downgrade through much of the last two years, as subprime creditworthiness deteriorated.  We faced the same problems in corporate credit back in 2001-2002.  The venue changes, but the conflicts of interest don’t.

This will not end well, which is not to say that the sky is falling.  These troubles could take years to unfold.  Tops are a process, not an event, and fundamantally driven investors almost always sell too soon, seeing the crisis well in advance, but not realizing that those in troubles have many ways of delaying the pain.  It is always amazing to see how resourceful some can be during a crisis.  So, be aware of the problems at hand, but don’t give in to imminent panic.  Before the a crisis occurs, the vultures will have to be glutted or scared to death, and we aren’t near that yet.