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
( 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.
You should know what's going on so you can decide whether you want to risk your nest egg in this kind of debt market.
Little Hedge Fund That Couldn't
So let me tell you a story.
Once upon a time -- April 2007 to be exact -- a little hedge fund called the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund got in trouble. The fund's experienced managers had made big bets on the direction of prices in the market for securities backed by mortgages. And those bets turned out to be wrong. So wrong that the fund lost almost 7% of its value in April, according to the fund's own accounting. Those losses got even bigger very quickly. By mid-May, the fund put them at 18%.
That made some of the investors in the fund and some of the banks that had lent money to the fund very nervous. The fund, you see, had started with just $600 million in actual capital and then borrowed some $6 billion (yes, that's billion) more to make its bets on the market.
The Wall Street Journal
estimates that, at the high point, those bets were valued at $15.5 billion.
But investors knew that if the lenders who had put up all that borrowed money started to demand their money back, the fund would be forced into a fire sale. The more nervous of these investors started to withdraw money from the fund, forcing the fund's managers to sell some of its assets to raise cash.
That was itself a tricky operation. No money manager likes to sell into a falling market because: (1) You don't get good prices for what you have to sell, and (2) the selling that you're doing can make prices fall even faster, which increases your need to sell, which sends prices falling faster, and so on.
To get around those problems, managers often sell the most liquid stocks and bonds in their portfolios first. For example, the market for U.S. Treasuries is so huge that selling by a $20 billion hedge fund is unlikely to move prices much, so a manager might begin by selling those assets.
But there was another good reason to sell liquid assets first. Bonds that trade frequently in public markets have prices that are set by those frequent trades. Bond traders know the price of a U.S. Treasury note due to mature on Aug. 15, 2012, with a coupon yield of 4.375%, because that bond has been bought and sold over and over again in a transparent public market with visible bids that indicate what buyers are willing to pay and what sellers want to receive. If a trader wants to sell or buy that bond, he knows exactly what the price of that transaction will be.
No so with CDOs and their derivatives. Unlike Treasury bonds, which are remarkably standardized financial products, CDOs are handcrafted. No two are exactly alike in the way they distribute risk, the amount of this and that they mix, the yields they offer and how they react to market stress. And unlike Treasury bonds, which trade frequently, CDOs trade infrequently. And when they do trade, they often trade privately, which provides very little price information to the public market.
Making Up Their Own Prices
Wall Street still has to value its portfolios, of course, even in the absence of public prices. To solve that problem, the investment houses that invented, packaged and marketed these infrequently traded securities and their derivatives invented mathematical models that priced their products. You knew what a Merrill Lynch or a
derivative was worth, because the investment bank told you what it was worth.
You might note a certain inherent conflict of interest here. The investment houses that were selling these products were also valuing these products. Their ability to sell more of these products was, to a great degree, dependent on those calculated prices behaving the way the models said they would. It wasn't that those privately calculated prices couldn't go down but that they had to move in predictable fashion.
Were those calculated prices real? In the absence of actual buying and selling, those prices were as real as they could be. But in the absence of public buying and selling, the question was essentially meaningless. Those prices were the only prices --until someone conducted a public sale.
And that's exactly where the hedge fund hit the fan. Like the other investment banks on the hook to the Bear Stearns hedge fund, Merrill Lynch wants its money back. Unlike other lenders, such as Goldman Sachs and
Bank of America
, however, Merrill Lynch refused to unwind its loans through private deals with
( BSC). Those deals would avoid any public sales that might damage the prices of these assets as calculated by computer models.
A plan worked out by
private-equity buyout firm that went public June 22, would have required creditors to avoid any margin calls on their loans for 12 months in exchange for a $1.5 billion, fully collateralized injection of new money from Bear Stearns itself.
Merrill Lynch instead seized the $850 million in collateral that backs its loans to the hedge fund and, on June 20, began to sell it at auction.
An auction, of all things. With lists of assets. Relatively public bids for those assets. Relatively public sale prices. My God, it almost sounds like a market.
I have my suspicion about why Merrill Lynch rejected the Blackstone plan. Waiting 12 months without recourse as a market that is clearly in trouble unwinds further isn't exactly an attractive proposition. Seeing the questionable collateral backing your loan spread over another $1.5 billion loan isn't exactly enticing either.
And then there's the once-in-a-portfolio-lifetime chance to see how far from actual market prices calculated prices might be.
Merrill's Risky Gambit
The auction is only a pale reflection of a public market, though. Merrill Lynch will get more information on prices out of the exercise than any other investment bank will. Among investment bank competitors, only Merrill Lynch will know precisely how much difference there is between the prices of these assets as carried on the books of portfolio managers throughout the global financial industry and the prices these assets might bring in an actual sale.
With the market for many of these assets under stress -- Wall Street lingo meaning "They're falling like a stone, and we can't find any buyers" -- in the recent bond market panic of mid-May to mid-June, such information would be an incredible competitive edge, certainly worth any losses Merrill Lynch might suffer in the auction of an $850 million portfolio.
But it is a dangerous game that Merrill Lynch is playing. The likelihood is that it won't be able to keep all this pricing information to itself, and what it can keep to itself for the moment will become common knowledge on Wall Street in short order. Once prices from real sales are out there, portfolio managers will be forced to mark down the value of their existing portfolios to actual sale prices. And that will set the repricing avalanche in motion.
How big and destructive could that avalanche be? Think of just this one example: The safe Treasury market took a hit of 10.5% in the four-week May panic. That's a 10.5% loss in the most liquid, accurately priced debt market in the world. Think an illiquid market with prices that only exist in computer models will do better?
What should you do? At the very least, call up the manager of every fixed-income mutual fund and ETF you own, and the manager of your pension fund, and the manager of the company that insures your home or health, and ask them about their exposure to CDOs and mortgage-backed derivatives and this avalanche. Don't be put off by their talk about investing only in the safest parts of this market. The truth is that no one knows what is safe in this market and what isn't.
Look out below!
New Developments on Past Columns
10 Global Blue Chips for 2007": On June 21,
announced that it would buy eyewear maker
( OO) for $2.1 billion in cash. The deal, Luxottica projects, will drive 2007 sales to $7.7 billion from an earlier, preacquisition projection of $6.8 billion.
The acquisition, expected to close in the second half of 2007, gives Luxottica a deep new product line in the sports and active eyewear market just in time for the Beijing Olympics. In the past two years, Luxottica has acquired Modern Sight (28 stores) in Shanghai, Ming Long (113 stores) in Guangdong and Xueliang (79 stores) in Beijing to bring its total in China to 270 stores. And on Sept. 21, 2006, the company opened a flagship LensCrafters store in Beijing, the first of a planned 90 stores in China by the end of 2007.
Why Fewer U.S. Jobs Are Going Overseas": If you've been looking for a good spot to start or add to a position in
C.H. Robinson Worldwide
, I believe the stock's pullback in June is your chance.
Investors seem to be betting that U.S. economic growth is going to be slower than expected in the second half of 2007. But so far, the data are pointing in exactly the other direction. I believe investors will wind up being surprised by the strength of the company's earnings in the second half of 2007, just as they were surprised by first-quarter earnings.
On April 24, C.H. Robinson Worldwide announced that first-quarter 2007 earnings came in at 42 cents a share, an increase of 27% from the first quarter of 2006 and 4 cents above analyst expectations. Revenue rose 8% from the first quarter of 2006, hitting $1.62 billion for the quarter, matching Wall Street projections.
Dig down, and the results are even better than the top-line numbers indicate. Thanks to falling truck freight rates -- which work to the advantage of a logistics company, such as this one, that hires trucks to move freight for customers -- and to a further shift in intermodal freight traffic to the more profitable long-haul segment from short-haul routes, the company saw a 17.7% increase in gross profit margin in its transportation business from the first quarter of 2006. That drove gross margins in this business to 20.2% from 18.3% in the first quarter of 2006.
For the company as a whole, gross profit margins climbed to 18.3% this quarter, well above the 15.5% average for the past five years.
Holding this logistics stock takes advantage of the global logistical crisis that I see slowing the trend to send jobs overseas. That idea is working better than I expected and should keep working, thanks to robust growth in the global economy outside the U.S.
As of June 26, I'm keeping my target price at $62 a share by extending the timetable to March 2008 from the prior September 2007. (Full disclosure: I own shares of C.H. Robinson Worldwide in my personal portfolio.)
At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: C.H. Robinson Worldwide and Luxottica. He did not own short positions in any stock mentioned in this column.
Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;
to send him an email.