News of the ongoing collapse of subprime invested hedge funds at Bear Stearns in this morning's Wall Street Journal will come as no surprise to the typically well-informed Going Private reader, particularly after a pair of musings in these pages on the topic. It probably isn't interesting for me to say "I told you so." What is interesting, however, is to try to decode the deeper meaning in some of the language in the Journal's article.
Since 2000, Wall Street has created more than $1.8 trillion of securities backed by subprime mortgages, according to industry newsletter Inside Mortgage Finance. Now, the housing-market slump is causing a spike in mortgage delinquencies and defaults, which hurts the value of those bonds. Worried investors, in turn, are further driving down the bonds' prices.
On Wall Street, the Bear Stearns hedge funds' problems point to another sensitive issue: Markets for exotic investments like derivatives linked to subprime mortgages have exploded in size in the past few years, but it is often hard to attach an accurate value to those assets. (Emphasis mine).
The huge [downward] revision [of the hedge fund losses] at least in part reflected conversations Bear Stearns hedge-fund managers had with bond dealers, three of which told them in late April that some of the funds' assets were worth less than the values stated on the funds' books, according to a person familiar with the matter.
So far the turmoil doesn't seem to be significantly hurting the broader bond markets. But as the Bear Stearns funds unwind positions, investors and traders could reassess the value of other debt securities. As a result, investors far beyond the reach of the funds could find their holdings of similar debt worth less than they thought. (Emphasis mine).
Unlike stocks and Treasury bonds, whose prices are continually quoted and easily obtained, many of these derivative instruments trade infrequently and don't have clear market prices. To come up with market values for these investments -- a process known as "marking" their positions to market -- investment funds often rely on their own valuation models.