Banks Fight to Postpone Day of Reckoning by Axel Merk

The U.S. trade deficit with the rest of the world leapfrogged in recent days: aside from goods and services, we are now importing “consensus based crisis management” from Japan. Out of fear that a cleanup of bad loans would trigger widespread defaults, Japanese banks got themselves deeper and deeper into trouble by hushing up the problems. We are talking about the crisis at Bear Sterns’ subprime hedge fund. The crisis shows that major adjustments on how the market prices risks are overdue; this may have negative implications for stocks, bonds, commodities as well as the dollar.

Bear Sterns is a leading provider of services to hedge funds; it is also one of the largest originators of subprime backed Collateralized Debt Obligations (CDOs). CDOs are what their name implies: a security backed by collateral. CDOs are created when mortgages with various risk profiles are grouped into different tranches or segments. Amongst others, Bear Sterns would create a CDO in a bundle according to a client’s specifications. Indeed, Bear Sterns would work with a rating agency, such as Moody’s, to obtain the desired rating (a practice likely to face more scrutiny as some allege that Moody's no longer acts as an independent rating agency, but as a syndicator in the offering). The explosive demand in this sector has attracted ever more creative structures. Investors should have grown concerned when dealmakers started suggesting that one can create a higher grade security by grouping together a couple of lower grade securities; it is rare that 1+1 equals 3. As these instruments have grown more complex, the clients buying these instruments often do not have a full understanding of what they buy.

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