Sub-prime spreads out: admission of a problem is the first step

After a few weeks of speculation and hope for magical solutions, Bear Stearns this morning admits that its two failed sub-prime hedge funds have “no value left”.  Admitting the truth is the first step towards resolving problems, so this morning's admission is a step in the right direction. 

Investors were told that “they will get little if any money back after “unprecedented declines” in the value of AAA rated securities used to bet on subprime mortgages.”  In an interview with the NY Times Bear Stearns CEO Jimmy Cayne called this debacle a “body blow of massive proportion.”

Here in highlights the concern some of us have voiced with ratings on these pools in the past couple of years.  One would think that a pool of assets rated AAA would have the highest possible capital security.  That is why we bother to have a rating system after all, its meant to help investors determine the low risk from high risk plays.  To discover that the “AAA pool” is now worthless should be shocking and must confirm fears that more AAA and AA debt pools will soon be revealed as a type of fraud on investors.  As we hand out the blame however, many investors must also be found guilty, once more,  of willful blindness.

We know that more of these issues will be coming to light over the next several weeks and that the unraveling will lower liquidity and widen risk spreads on assets around the world.  We have yet to know the magnitude of the spread. While this funny money has been a large support for gains in world assets, we will now see that the laws of gravity do still apply. 

As one hedge-fund consultant summed it this morning:  “right now things are starting to come unglued.”  The truth is, this moment of truth has been a long time coming.  Those who have been paying attention over the past couple of years will not be surprised.

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