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Does it matter if a hedge fund managed by Bear Stearns blows up? For a part of Tuesday, it seemed to matter a lot to Wall Street, as some of its larger banks prepared to hammer out a rescue plan. As creditors who lent $6bn to the highly leveraged fund, they might have worried about the market turmoil that a fire-sale of the fund’s assets could cause. These assets include subprime mortgage-backed securities and interests in collateralised debt obligations. Wall Street banks have exposures to these markets in many ways. They lend to other hedge funds, secured on similar types of assets. They also underwrite big securitisations of such assets and may hold unsold inventory.
In the event it appears some, if not all, of the banks thought the market risk was containable and the potential deal simply not attractive enough. Merrill Lynch, for instance, is set to take bids on $850m of its collateral on Wednesday. Certainly, it is understandable why the Wall Street banks could not swallow one of the conditions of the deal: that they make no margin calls for a year. To ask them to take such a market risk – and create a dangerous precedent – was unlikely to fly. In fact, agreeing to such a dramatic condition could have induced a panic of its own, since it would have underscored how fearful the banks were of systemic risk.
We do not know how easily the market will absorb the hedge fund paper. The pricing is likely to be all over the place, given how uncertain liquidity is for some of the more esoteric securities. CDOs, in particular, are difficult to price. Pricing will be on everyone’s minds, because, if large discounts are inflicted, it will set new levels at which similar assets held by others have to be marked to market.