There are two popular views that I am seeing among those that are in the media limelight at present regarding subprime mortgages. There may be more, but I will point at James Cramer’s assertions that this is an illiquidity event, and not a credit event, and the assertions of Bill Gross that this event heralds a wider credit event, and soon. Neither are correct in my opinion.

Cramer is in over his head on this topic; if you’ve never been a mortgage bond manager, but only an equity manager, you might view this in a way akin to a short squeeze. The hedge funds that got killed didn’t have enough equity to carry their positions through some market chicanery. There are no credit losses being allocated to the securities at present, and only the 2006 vintage stinks.

Plausible on the surface. My old boss at the Mt. Washington Investment Group would always say, “Liquidity follows credit quality.” Bonds with improving credit quality tend to become more liquid, and vice-versa for bonds with deteriorating credit quality.

One of my biggest professional investing mistakes was buying a gaggle of Manufactured Housing ABS bonds back in late 2001. I only bought bonds in vintages prior to mid-1997, because I knew later credit quality was horrid. I also stuck mainly to AA-quality mezzanine bonds. All of those bonds are still “money good” today, but when the market fell apart due to the horrid 1998 and after vintages, the bonds with relatively good underwriting got taken to the cleaners as well. Money good bonds trading in the 60s? It can happen.

Markets are discounting mechanisms; with asset-backed securities, if the projected losses make it virtually certain that a tranche of a securitization will lose principal, the tranche will quote like the losses have already happened. It doesn’t matter tht the losses won’t allocated for a few years; the tranche will trade at the discounted value of reduced future payments, at a high discount rate, if it trades at all.

The issues with the Bear Stearns funds are future credit issues, which produce present liquidity issues. It gets noticed there first because of the concentration of the risk in the fund, and the leverage employed. This is similar to what happened in 1994, when the prime mortgage market blew up over extension risk. There was no contagion there; many in the bond market absorbed losses from rising rates, but only a few notable players that took on the negative convexity risks in a big way got killed.

Derivatives are funny, or maybe I should say, people using derivatives are funny. Alan Greenspan thought that derivatives spread out the risk, making the system more stable. Nothing could be further from the truth, at least in terms of spreading out the risk. With derivatives, some market players, out of greed, concentrate the risk because they are trying to make a killing. When the negative part of the credit cycle hits, the speculators get destroyed. Contagion happens when the lenders to the speculators face major losses also. In 1998, that was the worry over LTCM.

With derivatives, speculators absorb the losses that previously might have been borne by the banking system. (Now, those speculators could be DB pension plans, endowments, or wealthy individuals, working through hedge funds.) If the banks overlend to these speculators, they can bear risk as well.

My view is that there are a small number of greedy players that hold most of the credit risk from subprime mortgages, and that their ultimate owners have enough capacity to bear losses that there is no significant contagion risk to the debt and equity markets, even if some players are wiped out, and the banks take modest losses.

That said, I would wait awhile to buy any subprime mortgage ABS, even at the AAA level. The market is dislocated, and has not fully realized the true level of losses that will be taken. The same goes for Alt-A loans, and make that a double!

In summary, this will not be a “piece of cake,” but the losses will be concentrated among a small set of investors. As for the CLO market, it will have its troubles, but not yet. Prudent investors will avoid it, but there may be some rallies there in the short run, away from subprime and Alt-A.

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:

• The Power of Three
• Game Theories, Calling the end of Cheap Debt
• The Coming Credit Meltdown

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.