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it’s official: subprime is junk

Like the stock-market before it, the real estate market of the past 5 years was propped up by excess liquidity that gave rise to the kind of irrational exhuberance famously derided by Alan Greenspan in his testimony before Congress. In the case of both markets, the end of excess liquidity meant that the market had to revert to its true mean — at least 20% lower than its high and generally much more than that. And as we all saw, neither event was pretty …

Case in point – a month ago venerable Wall Street brokerage Bear Stearns found they had no choice but to close the 2 hedge funds they managed that invested in the stock, or held the debt, of subprime lenders. Problem was, Bear Stearns had NO WAY to value their portfolio. Why? Because their bonds didn’t trade often enough to give them an accurate idea of what they were worth to a willing buyer. The market was so thin that prices varied wildly as everyone tried to avoid being the last one caught with the bonds (sound familiar?). Since Bear Stearns didn’t want to value the bonds at such a low price, they decided instead to ‘mark them to market.’ In other words the company valued the bonds based on their last 12 months’ total return as it that represented the market price. In reality, nothing could have been further from the truth because the market had collapsed (again, any of this ringing a bell?).

Standard & Poors, which rates bonds based on their ability to deliver timely, regular payment, finally stepped in and downgraded the bonds to roughly the same level as your average stock — meaning investors would be as likely to get a return investing in one of these bonds as if they put their money in stocks. They have a name for bonds with that kind of shaky promise. They’re called junk bonds and they were really popular in the ’80’s.

Does this mean Flashdancing is coming back too?

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