Wednesday, August 15, 2007

Subprime Issues Nowhere Near Done

From the WSJ:

The oft-repeated problem is that the funds, and even some companies, can't get prices for many debt securities and derivatives with direct or indirect links to loans made to homeowners with spotty credit histories. Given that, they ask, how are they supposed to mark holdings to market when there is no market?

Typically to "mark" or estimate the value of a holding, funds use market prices, quotes from broker-dealers, values tallied by third-party pricing services, internal models or some combination of all four. Sometimes funds will block redemptions of their securities in an effort to prevent having to sell into a market that they think is below reasonable values. Still, funds have an obligation to estimate the value of their holdings to reflect market realities. But, without a market, doing so can get tough, especially when markets take a dive.

How to do so is open to debate, and in some cases the methods may be pretty unpalatable for managers dealing with the turmoil now gripping markets. One answer is that everything has a price -- if it is low enough. That is tough for many managers to swallow if they think the long-term value of a holding isn't impaired. Trading at such a price is also a difficult prospect if a manager wants to avoid selling into a distressed market. The key point with BNP, for example, was the use of the word "fairly."

But if there are no buyers to be found, there may be an even worse alternative. "Then the price is zero," says Jack Ciesielski, editor of the Analyst's Accounting Observer newsletter. "If there's a bid out there, then there's a price. Take your pick."

This is one of the central problems managers are facing right now -- what is the value of some of the assets they hold in their portfolio. Because the markets are going through a correction, the value of some assets is falling. But according to the article, managers can't even get a broker to give a price for some security. That means several things;

1.) If a broker won't give you a bid on a bond, it means the market is completely frozen for some bonds.

2.) How does a manager value his portfolio if he can't get a price quote on a bond? The answer is he can't. Now if the manager isn't facing a rash of redemptions then he can ride this situation out. However,

For anyone worried hedge funds could spark another market crisis, Wednesday is a red letter day: the final chance for investors to put in demands for their money back by the end of September at many funds using standard redemption terms needing 45 days’ notice.

By Thursday, hedge funds with these terms will know exactly how much cash they must find to repay shareholders; cash they are likely to find by selling their investments. Large-scale redemptions may prompt big sell-offs; something BNP Paribas analysts say could cause “irrational” markets.

The real issue going forward is the amount of redemptions hitting funds right now. This could be similar to a run on banks. However -- and I will caution here in the strongest possible terms -- we don't know what the level of redemption requests is right now. If it is high (and again, WE DON'T KNOW WHAT THE LEVEL IS) then we're in for another round of serious problems. If it's low, then we could be able to ride this out. Again -- this is definitely a wait and see what the news says type of situation.