How CDOs work (from the WSJ $)
So investors often have to estimate the value of a CDO and have a lot of leeway in how they do it. That's a worry for investors in hedge funds, big buyers of CDOs. Hedge-fund managers make most of their money through performance fees. This gives them added incentive to use price estimates that work in their favor, even if they might not reflect the price at which they could actually trade the CDO.
Or it could mean that the managers themselves don't know exactly what their holdings are worth, because they are so far removed from the underlying investment. In the case of Jane's loan, that means the CDO buyer will have a tough time gauging whether she's a good risk or not. And if she defaults, it may take a while before that affects the value of the CDO, even though market conditions overall might have already changed.
Amid Financial Excess, a Revival of Austrian Economics (WSJ Economics Blog)
It notes that â€œthe prices of virtually all assets have been trending upwards, almost without interruption, since the middle of 2003.â€ While fundamental economic improvements are at the root, â€œthe market reaction to good news might have become irrationally exuberant. There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-takingâ€¦ [S]uch endogenous market processes â€¦ can, indeed must, eventually go into reverse if the fundamentals have been overpriced.â€
Apart from financial imbalances, the report argues the world economy also displays dangerous misallocations of capital. In its â€œrecent rates of credit expansion, asset price increases and massive investments in heavy industry, the Chinese economy also seems to be demonstrating very similar, disquieting symptomsâ€ to Japan in the 1980s. â€œIn the United States, it is the recent massive investment in housing that has been unwelcome from an external adjustment perspective. Housing is the ultimate non-tradable, non-fungible and long-lived good.â€ In other words, the U.S. could be stuck with a lot of houses that are hard to sell to each other and impossible to sell to foreigners, and wonâ€™t need replacement for a long time.
Now, the problems at the Bear Stearns funds -- which prompted the firm to lend one of them up to $3.2 billion in a bid to rescue it -- show how hedge funds bent on short-term gains can go astray when holding assets that can't be easily valued. That has stoked worries on Wall Street that other funds with similar types of investments will suffer losses as fund managers reassess the value of those investments. Those concerns contributed to last week's 279.22-point, or 2.1%, drop in the Dow Jones Industrial Average to 13360.26.
Many hedge funds and other institutions are paid in part on performance, so it is often in their interest to price, or "mark," their assets aggressively, attaching the highest possible value to them. The higher the value, the more compensation the fund manager receives from the fund's investors.
Moreover, hedge funds typically don't keep investors abreast of the details of day-to-day trading. As a result, any losses the funds suffer may be significant by the time investors learn of them. That can be especially true for illiquid assets, which may not show much price movement for months and then dip sharply when confronted with the one-two punch of declining fundamentals and nervous investors.
The combination of illiquidity and leverage has long been a mainstay of financial crises. In 1994, hedge funds run by Askin Capital Management sustained huge losses on leveraged bets on infrequently traded mortgage-backed securities. The collapse of Long-Term Capital Management, which roiled markets around the world in 1998, was sparked by its inability to unwind leveraged bets.