In some fables and fairy tales, what seems real often turns out to be a fantasy. Examples include the omnipotent-sounding voice in "The Wizard of Oz" and the invisible but allegedly fabulous cloth in "The Emperor's New Clothes." The same also holds true on Wall Street, as Bloomberg columnist Mark Gilbert notes in "Opaque Derivatives, Transparent Fed, 'Bubblenomics': Timshel," though revelations like these usually don't lead to happy endings.
The most stunning aspect of the demise of two hedge funds belonging to Bear Stearns Cos. is the almost total absence of transparency surrounding the bailout.
The debacle may finally provoke regulators, who have long suspected that buying derivatives is akin to running through a fireworks factory with a lighted blowtorch in each hand.
Their focus is likely to fall on how to assign prices to complex derivatives, created by cooking together different flavors of securities whose values are driven by other assets such as stocks, bonds or mortgages.
The efforts by Bear Stearns's creditors to extricate themselves from their investments have laid bare one of the derivatives market's dirty little secrets -- prices are mostly generated by a confidence trick.
As long as all of the participants keep a straight face when agreeing on a particular value for a security, that's the price. As soon as someone starts giggling, however, the jig is up, and the bookkeepers might have to confess to a new, lower price.
Bear Stearns's share price has dropped about 4 percent since June 12, when the Wall Street Journal first reported the woes at the bank's High-Grade Structured Credit Strategies Enhanced Leveraged Fund. The Standard & Poor's 500 Index has gained about 0.5 percent in the same period, while the S&P's index of seven investment banks and brokerages has dropped 3.2 percent.
The brinksmanship has been dizzying to watch for the past two weeks, even through the fog of unidentified sources, rumor and speculation. Would the lenders to the two funds dump their collateral in a fire sale, trashing the entire market for collateralized debt obligations? Would Bear Stearns backfill the deficits?
Too Big to Fail?
The sheer size of the derivatives arena gives regulators nightmares, with trading volumes dwarfing the value of the underlying securities that the derivatives are based on. A record $251 billion of new CDOs sold in the first quarter, according to the Bank for International Settlements.
The unraveling of the Bear Stearns hedge funds has pulled back one corner of the curtain shielding the activities of hedge funds and their investments in derivatives, giving a glimpse of who is on the hook if the bets sour.
It seems that the skin in the game isn't from other hedge funds, Asian central banks, or widows and orphans. Instead, step forward the usual Wall Street suspects: Merrill Lynch & Co., Lehman Brothers Holdings Inc., Bank of America Corp. and their investment-banking peers.
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