Previously on “As the Housing Bubble Deflates,” . . .

Yes, the subprime soap opera plays on. To recap, from my March 28 entry:

“I believe (housing in general and the subprime problems in particular) will have a broader and more negative impact on the economy than is currently reflected in the stock and bond markets.”

Then, the June 29 issue related how a couple of hedge funds were close to being shut down due to losses on bonds backed by subprime loans, but were then bailed out by their sponsor – with more borrowed money. I concluded that “. . . more and more mortgage-backed bonds will see declines in value, and more and more investors in those bonds will be looking to get out. Crisis avoided? I’d say more like challenges deferred.”

Well, the challenges weren’t deferred for long. The hedge fund sponsor announced this week that, due to continuing losses on bonds and related derivatives, the funds are now basically worthless. Even top-rated bond issues owned by conservative investors are becoming suspect. But, no one knows exactly where we are with this because, as the hedge fund sponsor stated, “. . . there isn’t much of a market for the bonds.”

It is this one aspect of the problem – the illiquidity of the assets – that was behind my initial concerns, and that convinces me that there are more problems to come.

Liquidity is important for all investors, but especially for retirees who will generally be selling assets in the months and years ahead. They must recognize that most assets’ “values” are assumed to be the prices at which similar assets most recently sold. That’s how appraisers set home values, car dealers determine used car values, and investors value stocks and bonds.

But, even in the most liquid markets, the “last trade” took place between the then most eager buyer and most agreeable seller. Lined up behind each of them are increasingly less eager buyers, and increasingly less willing sellers. So, if anything happens to make the buyers even less interested and the sellers a bit more eager to unload their holdings, prices can plummet in very short order. And, the less “depth” there is in a market – the shorter the lines of buyers and sellers – the more severe the price change.

Assets like subprime loan-backed bonds have an additional valuation problem. There often are no recent “last trades.” As a result, there are no arm’s length transactions to give guidance for the next trade, much less for the trades that might follow.

So, when a hedge fund values its portfolio, the prices used are often little more than educated guesses. And, with the lack of transparency and the pressure to perform in this business, these guesses can be little more than wishful thinking. Until the next trade.

So, stay tuned. This soap opera has many more episodes to come.