It was Wall Street's version of hide and seek this week as some of the world's largest investment banks remained tight-lipped on the likely fall in price of some complex securities that may soon infect global debt and equity markets.
In the past week the stock market lost ground, the bond market saw prices bounce around, and investors were left with the sinking feeling that things could get worse as credit worries undermined the $1 trillion market for collateralized debt obligations (CDOs).
The losses suffered by two funds containing these complex securities, many tied to risky mortgage loans, sent Bear Stearns Cos. executives scrambling to re-finance the funds this week.
But the large and sophisticated investors in these funds did not run for the hills. Instead, they went silent.
If word of the exact nature of the losses became public, it would have forced many other funds to revalue their holdings and perhaps lose money, setting off a domino effect that could rattle markets globally.
Wall Street is now engineering a way to pretend that nearly worthless subprime bonds are maintaining their original values, said Peter Schiff, president of Euro Pacific Capital, a broker-dealer based in Darien, Connecticut.
CDOs, consisting of slices of debt securities, in the past few years have been the most popular extension of the Wall Street securitization machines that seek to spread risk among a wider array of investors.
The complex nature of the bonds that have increasingly included huge chunks of mortgage debt, makes the bonds difficult to value, increasing the risk of pricing inaccuracies, analysts said.
With delinquencies and foreclosures in the subprime mortgage market for less creditworthy borrowers at the highest in a decade, losses in subprime asset-backed securities contained in CDOs are forcing the issue of valuations.
An index of subprime mortgage bond prices made new lows this week, reflecting concerns that the worst is not yet over for the industry behind the $7 trillion market for mortgage-related bonds.
Allegations that dealers are exploiting the opaque nature of the CDO market came to a head this week as JPMorgan Chase & Co., Goldman Sachs Group Inc. and others sought to extricate themselves from investments in hedge funds managed by Bear Stearns Asset Management.
Most of the hastily arranged auctions for CDOs seized from Bear as collateral were cancelled at the last minute, fueling speculation that traders were told to avoid transactions rather than accept low prices.
There is a potential vested interest among Wall Street dealers to support the asset class, so it's hard to know how the bonds should be priced, said Derrick Wulf, who buys bonds for Dwight Asset Management in Burlington, Vermont.
Some bonds offered for sale revealed the incestuous nature of the industry. At least $500 million of CDOs for sale were managed by Bear Stearns Asset Management, according to lists obtained by Reuters. Another $81 million in CDOs were managed by New York-based Tricadia Capital, whose founder, Michael Barnes, worked at Bear Stearns for 12 years, including five as head of structured transactions.
Bear Stearns on Friday moved to address the problem of liquidity in the market by offering up to $3.2 billion in its own money to support the two funds in question. The financing would eliminate exposures of banks including Citigroup Inc. and Barclays Plc but left exposed others that have provided loans to another fund that had lost nearly a quarter of its value this year.
Stuart Rothenberg, managing director of portfolio management of CDOs at Bear Stearns Asset Management and former director at Standard & Poor's, declined to comment.
The bigger worry for Wall Street and buy-side investors is that low prices for the CDO securities could force mark downs in the value of similar securities held by others. The problem is most acute for funds that used borrowed money to ramp up investments, since the lenders make margin calls and force rapid selling of the securities.
Still, the heterogeneous nature of CDOs means investors that bid for one security may not have much idea of general results of the auctions, said Dan Castro, a managing director at GSC Group. The auctions appeared to attract bids anywhere from 90 cents to 50 cents on the dollar, he said.
The fact that (Bear Stearns is) putting up more money might indicate that the market is too illiquid and that a number of players are trapped, said Kyle Rosen, president of Rosen Capital Management, an options hedge fund in Santa Monica, California. People are spooked.
Bear Stearns fund liquidations and the potential for contagion in other markets will be scrutinized by the House Financial Services Committee on Tuesday, chairman Barney Frank said in an interview. The Securities and Exchange Commission will testify at the hearings.
The example of Bear Stearns' funds may give fresh impetus to Frank's mission to make Wall Street and investors more liable for the securities they buy, he said. Many critics of the subprime mortgage meltdown have blamed Wall Street for encouraging lenders to boost loan volumes by loosening underwriting standards.
The more people don't know what they have the more there are problems with subprime, I think it substantially depletes this argument against assignee liability, Frank said.
We are being told 'You are going to ruin this wonderful market.' Well, I would not want to be today someone who is dependent on my ability to sell subprime mortgages in the secondary market, he said.
Credit rating agencies, whose valuation models are integral to price estimates have been criticized for failing to downgrade the securities.
Dealers that work with rating companies as they structure asset-backed securities and CDOs may be making a mistake in tying the bonds' fate to future rating actions, said Josh Rosner, managing director at New York-based independent research firm Graham Fisher & Co.
Even with rating assessments, investors must take a leap of faith over the risk they take in CDOs, analysts said.
The rating agencies are downgrading securities after the fact and not providing the market with the right cues for comparability and valuation of assets, Rosner said. This is exacerbating the problems and uncertainty in situations like what we're seeing in the Bear situation.
Fitch Ratings on Friday said it may cut ratings on some CDOs, including one high-grade CDO issued just last year, due to exposure to deteriorating subprime credit.
(Additional reporting by Neil Shah, Walden Siew and Dan Wilchins in New York, Doris Frankel in Chicago and Patrick Rucker in Washington)