Wall Street Fears Bear Stearns Is Tip of an Iceberg

http://online.wsj.com/article/SB118274074999546759.html?mod=home_whats_news_us When problems bubble up, the high-yielding securities are the first to falter. Hedge funds, insurances, even some big banks involved in buying subprime mortgages may have snapped up these bonds and could be at risk. Among the first of the big holders of these type securities are BSC. If problems in the mortgage industry worsen, high quality securities could suffer, as well, affecting more investors and drying up liquidity in the housing market. Many hedge funds and other institutions are paid in part on performance, so it is often in their interest to price, or "mark," their assets aggressively, attaching the highest possible value to them. The higher the value, the more compensation the fund manager receives from the fund's investors. Moreover, hedge funds typically don't keep investors abreast of the details of day-to-day trading. As a result, any losses the funds suffer may be significant by the time investors learn of them. That can be especially true for illiquid assets, which may not show much price movement for months and then dip sharply when confronted with the one-two punch of declining fundamentals and nervous investors. ... Still, the increase in illiquid investments raises concerns. For one thing, even in liquid securities like stocks, what can seem like a ready supply of cash can dry up quickly if investors get spooked. Those problems are heightened when leverage is used. Even if a fund plans to invest in an illiquid asset for the long haul, creditors can force its hand. If a leveraged investment racks up losses, the fund's lenders may demand more collateral, or even repayment of their loans. To meet those demands, the fund, whose losses are already magnified by leverage, could be forced to sell the investment well before the market recovers, adding to its burden. Figuring out the risk profile of illiquid assets -- and funds that invest in them -- can be tricky. Typical methods for assessing risk rely on measuring volatility -- the choppier returns are, the riskier the investment. But because illiquid assets don't trade regularly, marking to market -- or using recent sales prices to determine an asset's value -- may not be possible. In these cases, a fund manager may instead use a mathematical model to value an asset, a practice called marking to model. Such models tend to smooth returns, making an asset look much less risky, says Massachusetts Institute of Technology finance professor Andrew Lo, who is also a principal in AlphaSimplex Group LLC, an asset-management company that runs a hedge fund. Using broker-dealer quotes for illiquid assets can also damp volatility because they are often based on an average of bid and offer prices rather than actual sales prices. What's more, price quotes can vary widely from one dealer to the next. The Bear Stearns funds' situation demonstrates the considerable leeway funds have in valuing illiquid assets. The Enhanced Leverage Fund reported last month that it lost 6.75% of its value in April, but later put that loss at a far steeper 18%. CDS banks, hedge funds, and insurance companies have taken both sides of this trade. e.g BSC sustained losses, while Deustsche Bank and hedge funds such as Paulson & Co. and Balestra Capital have benefited by betting on higher defaults.