We keep reading about bonds being misvalued and how hedge funds don't know what they own. The confusion over this issue is manifold. So let's look at what's causing the misvaluation.
First, let's understand that everything has a value. There's a price for all merchandise. The price is what you get when it trades.
When you buy a "structured" product you are buying a made-up product, something put together by a broker, typically one of these pieces of paper that was slapped together by a Bear Stearns (BSC) or a Lehman Brothers (LEH) or a Merrill Lynch (MER) . Many firms attempted to sell me structured paper in my years at my hedge fund. I always said no because of rules I put in place years and years before that came from an opening where I had people coming in and out of the fund.
When I did such an opening I had to figure out the value of everything. I had one of these structured products and the firm that I bought it from was reluctant to tell me the value of the security unless I SOLD it. It was always priced at the price I bought it at and I thought that might be unrealistic. Just so you know how confusing all of this stuff can be, I thought it was up from where I bought it--par--and they had led me to believe it was up and they were being conservative marking it on my sheets at par.
I wasn't happy with such an amorphous price so I asked for a written piece of paper valuing it. I got one: 90.
Ninety!
I was furious. But that's what they said I would get if I sold it because they didn't have any buyers for it. I said how could their be no buyers? They said that nobody else wanted it besides me.
When I asked them to go find some, they said why should they, I didn't want to sell it, I just wanted a price on it.
So, here's a piece of paper I thought I was up on, that they said I was down on that ultimately was being marked at where I bought it!
I said that was it, I would never own a piece of paper like that again. I blew it out, at $90, just hit their stupid bid.
Several months later I went back to ask them where that piece of paper was. They had no idea. I was done with "structured" product.
Fast forward to now. Tons of firms bought structured products of mortgages all of which seemed like a pretty good thing as long as employment held up. Employment? Yep, that's what determined the pricing and the success of all mortgage bonds for years and years and years. As long as people kept getting employed, these bonds were money good.
Ever since the depression that relationship held up. Everyone at Lehman and Merrill and Bear knew that. They all knew it at Countrywide (CFC) and Accredited (LEND) and Bank of America (BAC) .
But then a combination of encouragement by the Fed of the use of unregulated mortgage paper to give people the American dream -- and if you check the minutes of tons of congressional hearings you will see that push by Greenspan and Bernanke -- plus abnormal short-term interest rates to overstimulate housing, led to a bubble that we are all familiar with.
When the rates rose, the bubble burst, and with it the pricing that these structured products were built on.
The headline risk to owning this stuff became too great as clients would ask of their funds, "Hey, do I own any of this stuff that Bear owned??" So the firms had to sell, or at least get prices, and I have just described to you the pricing process. Some clients didn't trust the pricings and redemptions forced the sales. We all know that.
Here's the new wrinkle though, and the one that is causing this next wave of problems: home equity loans. There are two types of structured product you need to be aware of, the first-lien -they own the home bonds. And they second lien-home equity structured product.
If you own a structured product from 2005 to 2007 made up of second-lien paper that paper is selling right now for about 20 to 30 cents on the dollar. Why? Because the defaults are running so high that the bonds are not paying what people thought. And it is getting worse every month. Second-lien mortgage bonds with heavy concentrations of Florida and California are worthless. That's how bad things are.
Some structured product is made up of both first and second liens. Again, depending upon the region, you have some of this paper trading at 50 cents to 60 cents on the dollar.
Some paper is made up of first liens but there are second liens against the first liens that aren't in the bonds. Those are paying at varying prices, 60, 70, 80, because no one knows how much of the first lien has second lien against it. Why is that? Because a homeowner who bought a home in 2005 who then took out a home equity loan that is resetting right now is more likely to default than not.
So put it all together: you have illiquid securities no one wants to buy with varying streams of paper that no one knows anything about that are defaulting at mounting rates. How much of this paper is there? We don't even know! I have seen numbers ranging from $500 billion to 2 trillion from this period alone. No one has a handle on it. What is it worth? How about the ratings agencies? What the heck do they know? DO they know the likelihood of a particular piece of paper having more defaults? No. They can guess. Their models don't work though, they were based on employment, remember?
So, this stuff is choking everyone who bought it. Now because of the fed's cuts, they got a reprieve from a lot of the clients who were reassured that with the fed cutting and pumping liquidity these pieces of paper will be bought by somebody. That's actually a good bet, which is why it is right for the fed to cut despite the inflation troubles.
Yes, this is that big a problem. This is the principal paper that people traded away from treasuries. Nutty, but true.
Bottom line: nobody knows what this stuff is worth. But if you wait long as the resets with home equity loans kick in, any bonds that have too much prime where there could be a lot of second lien connected - invisibly -- with it, will indeed default.
Which is why, alas, it is impossible to value most of this stuff, except when you sell it.
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