Debt-Based Assets Face Day of Reckoning

The bond market has no clothes.

You remember Hans Christian Andersen's story of the emperor's new clothes? After the emperor had been fleeced by some shady merchants, everyone told him how beautiful his new clothes looked, how rich the colors were, how fine the fabrics, until a little boy, who didn't know enough to flatter, said, "But he's naked." And the embarrassed emperor ran as fast as he could for cover from the unleashed laughter of his subjects.

Something very similar is happening in the bond market right now.

Investment losses at a little $20 billion hedge fund -- and yes, in a $24 trillion bond market, this is a small fish -- and Merrill Lynch's(MER) insistence on an auction of some of that fund's assets could make Wall Street admit that prices for trillions of dollars in assets are fairy tales made up in the backrooms of the investment banks themselves.

Most immediately affected is the $2 trillion market for pools of securities backed by mortgages, corporate bonds and leveraged loans called collateralized debt obligations, or CDOs, and by extension, the entire $30 trillion market for synthetic derivatives modeled on those pools.

That would require a massive repricing of portfolios all across the globe. It would turn some winning portfolios into losers and turn modest losses into debacles. It would force pension funds and insurance companies to make up massive shortfalls in the value of their portfolios. Some hedge-fund managers and Wall Street investment bankers, whose bonuses are determined by profits based on these fictitious prices, might see bonuses disappear completely. They might even -- be still my heart -- have to give back performance-based fees.