Humpty Dumpty had a great fall

When I use a word, It means just what I choose it to mean - Humpty Dumpty

Never have Lewis Carroll's words rung truer than in the current Bear Stearns Hedge Fund debacle. It's now been reported that two hedge funds managed by Bear Stearns are in serious trouble. The names of these two funds? Wait for it 'The High Grade Structured Credit Strategies Enhanced Leverage Fund' and 'High Grade Structured Credit Strategies Fund.' There is absolutely nothing 'High Grade' about these funds riddled as they are with high risk sub-prime mortgages.

So when Bear Stearns uses the word High Grade that's what they choose it to mean. However unlike Humpty Dumpty Bear Stearns doesn't have the luxury of living in a fantasy world, although the world of debt securitization and structured finance comes close to it. If BSC were to name their fund exactly what it is they'd have to rename it something like the 'High Risk Mortgages That Noone Else Would Touch Leverage Fund.'

The ratings agencies are in on the scam as well since they don't rate the funds according to what they are made up of. Some of the funds carry AAA ratings. The rating agencies along with the investors and banks have been seduced by the new-found sophistication of CDO's. The logic goes that because the risk is so diversified noone will get whacked too badly if things go south.

However the speed with which Merril Lynch reacted to the news by seizing $800 million of the funds assets and then auctioning some of them off to cover their exposure could only be described as panic. JP Morgan Chase, Bank of America and Goldman Sachs all closed out their positions in the fund as well. The CDO market is relatively illiquid so panic selling could see prices fall significantly.

Since we know foreclosures on sub-prime mortgages are going to to get worse before they get better we should expect some more fallout from the CDO market. An interesting point about Bank earnings is that despite moving into a worsening credit cycle they have yet to start increasing their loan loss provisions. It will be interesting to see to what extent the major banks are hit and how well they are able to absorb the losses.

My friend over at Shenandoah Capital has an interesting view on why the Bear Stearns hedge fund debacle matters.