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Bear Stearns and Merrill Lynch Play Musical Chairs

Do you remember the game Musical Chairs? Its being played these days by big brokers Merrill Lynch and Bear Stearns. The music has stopped and Merrill appears to have stolen the chair out from under Bear. In this case, Bear started a fund of subprime mortgage paper, and Merrill loaned it money to do so. The value of the fund dropped, and Merrill seized the collateral for its loan.

The subprime mortgage market continues to have a negative impact on our financial markets. Friday saw a near 200 point decline in the Dow, and today we saw a 100 point advance disappear and turn into a loss. These ups and downs are part of the normal workings of the stock market. What is really scary is that the whole subprime market is based upon the sharing of risk.

The big brokerages have developed a complicated risk sharing arrangement through the derivatives market. It is supposed to be a system that allows them to reap extra return while swapping out the excess risk with someone else, putting them in a risk neutral position.

When we something like this musical chairs game go wrong for one of the brokers, it makes me worry about the much bigger issue of the derivatives market. What happens to J P Morgan, with $4 Trillion of derivatives exposure if the risks really aren’t all neutralized? It could throw a wrench into the nation’s financial system, sending both the stock and bond markets into significant bear markets.

Will it happen? Probably not, but the risk is there. Bear probably never thought their fund would implode or that another broker would have a part in it. Stay aware of the risks and don’t be surprised if the shared risks in the derivatives market are not as neutral as everyone assures us they are.

Mark