I'm with wally. Painful in that the increased leverage magnified those pesky losses and made it all that much harder to sweep those self-same losses in the illiquid "difficult to value" securities under the rug. No fund manager likes taking the punch bowl away and having to tell their happy, oblivious and, fee-paying customers that they lost money on their sure-fire strategy.
A single CDO likely owns pieces from 10 to 20 different ABS. Each ABS has may have 100 to 1500 assets meaning severity of loss estimates need to be applied to many thousands of contracts. During volatile periods the assets are not priced based on the rating Moody's/Fitch/S&P gave it 6 months ago (since everyone knows this rating is likely no longer valid). So to value the CDO correctly recent secondary market transactions have to be used instead of the simple rating agency to asset type spread matrix. It is 'difficult' to do that.
It surely is. And since the "difficulty" of valuing these things seems related to their risk, which seems related to their returns, which are a damned sight better (I hope) than what I get on my tax-exempt munis, I find myself unable to cry a big river for those poor hedge fund investors who find themselves with too many moving parts.
Somebody thought this crap was worth 2 and 20, after all. I assume you pay extortionate fees like that to get "difficult" valuations accomplished even in a volatile market. No?
Modern American print and airwave journalism has become a miasmal swamp of lazy, intellectually lazy, semi-educated, semi-literate neanderthals, self-satisfied, prima-donnas, arrogant, word / opinion pimps and whores whom God, nauseous with disgust, should strike dead with lightning every time they touch a pen, pencil, microphone, or computer keyboard.
Only the wild and crazy and FREE internet and the wild and FREE blogs save us and give us any kind of HONEST and TRUTHFUL reporting.
The more I learn about CDOs, the less I understand it. I'm still scratching my head figuring out what is the economic sense of CDOs (well, except by generating fees for various parties involved). Imagine that you manage a pension fund or an endowment and want to invest in something less boring than treasuries. Why not buy the underlying securities? Even if it is a stupid idea, at least you avoid the fees. If these assents turn sour, the CDOs based on them would do the same.
Another mystery is who buys those AAA CDOs tranches when they pay just pennies above LIBOR. If you are satisfied with just pennies above LIBOR, why not buy a diversified pool of high-quality corporate bonds or agency MBS? As a bonus you operate on a more transparent and liquid market.
I also think that this opacity is not a bug but a feature. It's done to transfer money from weak (and gullible) to strong hands.
Tanta, in the comments several posts ago MOM, mp, David Pearson and I were having a conversation on how the Hedge funds and mortgage lenders had managed to, in effect, recreate the banking environment of the late 1800's in their areas. The banking environment and volatility that existed before there was the Fed, regulation, and FDIC insurance. As I recall, there was another problem in this era that dealt with equity and corporate bonds - this was before the SEC had been created and securities were opaque and hard to value. This lack of information and volatility mean that the stock market was generally known as a fool's game where the insider's held all the cards and small investors were shilled and fleeced regularly.
In my view we have gotten complacent on the quality of our markets and securities, taking that regulation and quality for granted. I think that the lack of information and opaqueness of MBS, CDOs, CLOs, etc. have, to stretch the analogy, recreated some aspects of that late 1800's - 1920's markets and we're probably about to re-learn some old lessons.
Somebody thought this crap was worth 2 and 20, after all. I assume you pay extortionate fees like that to get "difficult" valuations accomplished even in a volatile market. No?
Tanta
Perhaps they were referring to the increased difficulty of preserving plausible deniability.
jm
Tanta wrote I find myself unable to cry a big river for those poor hedge fund investors who find themselves with too many moving parts.
You're on a roll today, O Aunt of Rationality. Somehow I think the problem is not too many moving parts, but the direction that those parts are moving - down.
While I fully enjoy rapier-like sarcasm and word-play -- and believe that it's a very appropriate and effective tool against the excerable and infamous sleeze we are surrounded with -- let's all keep in mind that the scamming and sleezing manipulation, the "gamimg the system", the sheer corruption and incompentance of all this financial-moral-depravity is destroying the lives of many who are not players in this disgusting game, and destroying a nation and a way of life and a PROMISE of so much rational improvement of this nation and of the world, and the improvement of the lives of so many humans. We are LOSING SO MUCH TIME, SO MANY OPPORTUNITIES. This debacle is going to take us backwards very, very far -- and for what? For what? So much LOST, so much HOPE lost. So much of our FUTURE, of our children's FUTURE, simply lost.
One theme I have not heard raised (which may be due to the fact that I have been away from the screen for much of the last week) is how it is that Ralphie boy came to be put in charge of a $20B pair of hedge funds. The story mentions that he had been a salesman for a long time and then had run an internal trading book for six months before being brought over to the asset management side of bear. Not exactly the career path out of central casting. Most people that actually get to invest money (the "buy" side of the business) have spent quite a few years watching and supporting other people doing the investing. The track record of people who move from the "sell" side, where Ralph was, to the buy side is pretty spotty. Sales guys on wall street are not known for their intellectual depth.
It would be one thing, if he had principal responsibility for 5 or 10 years with good results and then came over to the asset management side. But inexperience and rapid asset growth can be a deadly combination. Amaranth had some of the same issues - a relatively short span of experience, rapid asset growth and very little oversight.
It is all a sign of the times. When money gets loose, it ends up in the hands of inexperienced people.
Suppose we form a hedge fund (The Tanta & Pat Fund aka The TP Fund - joke intended), we get CR to invest $100, and we get Bear Sterns to lend us $900 at 7%. Next we buy a $1000 CDO that yields 10%. One year later, assuming the CDO is still OK, we have $100 of return from the CDO from which we deduct $63 of interest for BS, $2 for our brilliant management skills, leaving $35 to be split between CR (he gets $28) and us (we get $7). Not bad, CR got a 28% return and we made $9 with no risk!
However, the next day CR calls and says he wants his $100 back now (as in RIGHT NOW!). We call Bill Gross and he offers to take the CDO off our hands for $980. I guess ol CR wont be too happy with that since he will only get $80 back.
Why would they do that? Their money is effectively at the same risk as if they had bought the 10% deal.
Probably because the $1000 CDO bought a bunch of junk that would otherwise be sitting around on BSC's balance sheet looking a bit "illiquid." So instead of having $1000 in dodgy assets at risk, BS can turn that into a $900 "secured credit facility."
Never assume that the underlying credits didn't come off the broker's own shelf to start with.
That's diabolical. If that's what was going on with Bears Super-Duper Overenhanced Ultraleverage Extravaganza Funds (and it looks like a good guess) then they were really playing Merrill, et al, for dopes and there should be bodies in the East River soon.
what no one in Congress or compliant SEC is focusing on, is that both Bear and Carlyle have been busy trying to IPO the equity portion of these CMO and mortgage pools, equity which is obviously WORTHLESS. Bear could not even sell the collateral in the open market, there were no bids or heavily discounted bids. their Everquest IPO almost went to market, and the public would have ended up HOLDING THE BAG for guys who have been MINTING it. where is the Fed? SEC? other independent analysts? where are the Democrats? this country suks
"In my view we have gotten complacent on the quality of our markets and securities, taking that regulation and quality for granted. I think that the lack of information and opaqueness of MBS, CDOs, CLOs, etc. have, to stretch the analogy, recreated some aspects of that late 1800's - 1920's markets and we're probably about to re-learn some old lessons"
Sure, Andrew. I have exactly the same opinion.
Markets require REGULATION to operate properly and honestly.
The bad news is that "this time is different". The world has changed and Wall Street is possibly about to lose its unique place in the world with no chance to recover it.
I'm definitely sorry for New York, a city I have learned to love.
He had come up with an approach to trading those assets that people who are experts in that arena thought was a sound and interesting approach.
This sentence may not mean to, but it tells you a lot about modern reporting.
Now viewing an investment approach as "sound" is certainly fine, and not something that requires a follow-up, but "interesting" is another story.
What was interesting about his approach? I know I'd love to know. I'd probably also like to know why they found it interesting. Since they liked the approach so much, did anyone else take it? Where and how?
So many questions, but then we don't really want the answers, or at least the NYTimes doesn't, because, well, it just makes thing more complicated.
I'm all for conspiracy theories - but I doubt BS lends money at 7% to make their assets look more liquid. They do not have the same level of risk as the fund, per your example the TP fund has the $100 cushion provided by CR. That cushion is enough of a reason for them to only accept at 7% return. I have read the mortgage contracts between banks and hedge funds and I have never seen a "you must buy x$ worth of our stuff". As can be seen by the list of BS fund assets I posted on my blog several days ago, most of it is from 2006 or 2007 which means they were buying the positions at issuance and not in the secondary market (which adds no liquidity to anyone).
I don't think there are extortionate fees paid for the valuations of CDOs. The hedge fund managers all work at investment banks who have in house analysts. I don't recall my paycheck ever being larger from week to week depending on what screwed up new product I was trying to value )
Great blog you guys. I'm new here so I don't know if linkage is allowed so I'll use up some bandwith from a great piece on this subject by Kevin DePew over at minyanville dot com.
Leave it to a UK media source - The Telegraph (UK)- to summarize what is happening even as many of the major U.S. media outlets continue to follow the Containment Propaganda Campaign - more on that in Number Four - or take turns allowing their sources to position them to their advantage in the emerging blame game.
The Telegraph this morning quotes Charles Dumas, global strategist at Lombard Street Research summarizing the issue: "We don't know what the value of this debt is because the investment banks shut down the market in a cover-up so that nobody would know. There is $750bn of dubious paper out there in the form of CDOs held by banks that have a total capitalization of $850bn."
Indeed, we simply don't know, which leads us to today's Number Three.
What Is Mark-to-Model?
As Minyanville Professor John Succo wondered back in May, why is it that financial markets were (are) so sanguine in the face of what all available data suggests are rapidly deteriorating collateral values in the mortgage market?
Why aren't losses being seen? Even now, they aren't being seen.
The answer, we now know, is mark-to-model.
What does "mark-to-model" mean? Let's use something even we can understand - a sports card example.
Suppose you and I are collectors (investors) in sports cards, but not baseball cards, the "prime" sports card market. No, we collect professional golfer cards - the
"subprime" sports card market.
Why would we collect professional golfer cards? Simple, we're looking for an alpha edge - a fancy way of saying "excess return" - and with leverage, we believe we can buy these illiquid sports cards and sell them later to someone else for more money.
Ok, ok, there are a couple of problems with this scheme you can see already.
- First, the market for professional golfer cards is far, far riskier and smaller (illiquid) than the market for professional baseball player cards.
- Second, since they so rarely trade, it's difficult to value the cards on a day-to-day (even week-to-week) basis.
Ok, so back to the sports card market.
Let's say that baseball cards are "highly liquid," meaning that, like stocks or U.S. Treasuries, they trade every day.
These trades provide a way to instantaneously value our portfolio of baseball cards at any time.
To value our baseball card portfolio, we simply look up the most recent trade of, say, our 2004 Derek Jeter card and record the value. This is called "Mark-to-Market."
This "liquidity" is particularly helpful if we are using leverage (meaning, if we are using borrowed money to buy baseball cards with the hope that the borrowed money will increase our return when we decide to sell) since it allows us to closely monitor and track exposure and adjust the amou
This "liquidity" is particularly helpful if we are using leverage (meaning, if we are using borrowed money to buy baseball cards with the hope that the borrowed money will increase our return when we decide to sell) since it allows us to closely monitor and track exposure and adjust the amount of leverage we are using accordingly.
So how do we know, at any given time, what our leveraged portfolio of professional golfer cards are worth? They rarely trade, so we can't look up similar cards that have recently traded in the market.
Well, unfortunately, in our professional golfer card portfolio we can't mark-to-market because these cards trade so infrequently.
So how do we value our portfolio?
Simple, we have some mathematicians build us a model that values the cards based on how each golfer performed last year, the tournaments in which they made the cut, their overall earnings and rankings among their peers, and a rating that a separate "professional golf card agency" that follows the golfers posts.
Wait, did you say, "a model that values the cards based on how each golfer performed last year"? Yes.
But what if a professional golfer's card in our portfolio is a guy who last year ranked fourth overall in earnings and won two tournaments, but suddenly gets injured this year, fails to finish a few tournaments, and slips down to 40th in overall earnings?
Hmmm, good question. For that we would rely on that separate "professional golf card agency" we mentioned to "re-rate" this card. Then we would simply input that revised rating into our models and adjust the value accordingly.
But what if the rating agency, for a variety of reasons, chooses not to re-rate the card?
Then we have a situation where the value of the card that is being spit out by our model is in no way even close to the true market value of the card.
Wouldn't that be a problem if we suddenly feared that all the ratings of our cards were too high? Wouldn't our model be insufficient? Might we not be over-leveraged in cards that have very little real market value? Yes, yes and yes.
And that is precisely where we are right now with respect to CDOs.
The credit ratings agencies' ratings are key in the mark-to-model values, and so far very few CDOs have been re-rated in a way that reflects the surging subprime default rates.
There's an old investment saw that says "Paper losses don't exist until you sell."
That old saw is being tested in real time, right now.
First!!!!!!!!!!
scratch 'difficult', write 'painful
OK, I get it. Reality didn't correspond to their model, and it's all reality's fault!
(This is where they take their ball and go home.)
We must always remember that we don't live in the United States of America, we live in Conventional Wisdom Land.
I'm with wally. Painful in that the increased leverage magnified those pesky losses and made it all that much harder to sweep those self-same losses in the illiquid "difficult to value" securities under the rug. No fund manager likes taking the punch bowl away and having to tell their happy, oblivious and, fee-paying customers that they lost money on their sure-fire strategy.
It was not nonsense, it was a very smart move by BS. They raised capital, started a fund and unloaded the toxic waste there.
Now who got a problem? Merrill
A single CDO likely owns pieces from 10 to 20 different ABS. Each ABS has may have 100 to 1500 assets meaning severity of loss estimates need to be applied to many thousands of contracts. During volatile periods the assets are not priced based on the rating Moody's/Fitch/S&P gave it 6 months ago (since everyone knows this rating is likely no longer valid). So to value the CDO correctly recent secondary market transactions have to be used instead of the simple rating agency to asset type spread matrix. It is 'difficult' to do that.
It is 'difficult' to do that.
It surely is. And since the "difficulty" of valuing these things seems related to their risk, which seems related to their returns, which are a damned sight better (I hope) than what I get on my tax-exempt munis, I find myself unable to cry a big river for those poor hedge fund investors who find themselves with too many moving parts.
Somebody thought this crap was worth 2 and 20, after all. I assume you pay extortionate fees like that to get "difficult" valuations accomplished even in a volatile market. No?
Modern American print and airwave journalism has become a miasmal swamp of lazy, intellectually lazy, semi-educated, semi-literate neanderthals, self-satisfied, prima-donnas, arrogant, word / opinion pimps and whores whom God, nauseous with disgust, should strike dead with lightning every time they touch a pen, pencil, microphone, or computer keyboard.
Only the wild and crazy and FREE internet and the wild and FREE blogs save us and give us any kind of HONEST and TRUTHFUL reporting.
LONG LIVE FREE INTERNET!
The more I learn about CDOs, the less I understand it. I'm still scratching my head figuring out what is the economic sense of CDOs (well, except by generating fees for various parties involved). Imagine that you manage a pension fund or an endowment and want to invest in something less boring than treasuries. Why not buy the underlying securities? Even if it is a stupid idea, at least you avoid the fees. If these assents turn sour, the CDOs based on them would do the same.
Another mystery is who buys those AAA CDOs tranches when they pay just pennies above LIBOR. If you are satisfied with just pennies above LIBOR, why not buy a diversified pool of high-quality corporate bonds or agency MBS? As a bonus you operate on a more transparent and liquid market.
I also think that this opacity is not a bug but a feature. It's done to transfer money from weak (and gullible) to strong hands.
But note the wording: "... making the environment [my emphasis] for trading and valuing ... much more difficult."
Perhaps they were referring to the increased difficulty of preserving plausible deniability.
Tanta, in the comments several posts ago MOM, mp, David Pearson and I were having a conversation on how the Hedge funds and mortgage lenders had managed to, in effect, recreate the banking environment of the late 1800's in their areas. The banking environment and volatility that existed before there was the Fed, regulation, and FDIC insurance. As I recall, there was another problem in this era that dealt with equity and corporate bonds - this was before the SEC had been created and securities were opaque and hard to value. This lack of information and volatility mean that the stock market was generally known as a fool's game where the insider's held all the cards and small investors were shilled and fleeced regularly.
In my view we have gotten complacent on the quality of our markets and securities, taking that regulation and quality for granted. I think that the lack of information and opaqueness of MBS, CDOs, CLOs, etc. have, to stretch the analogy, recreated some aspects of that late 1800's - 1920's markets and we're probably about to re-learn some old lessons.
Somebody thought this crap was worth 2 and 20, after all. I assume you pay extortionate fees like that to get "difficult" valuations accomplished even in a volatile market. No?
Tanta
Perhaps they were referring to the increased difficulty of preserving plausible deniability.
jm
Yup (in my skeptical opinion)
Tanta wrote I find myself unable to cry a big river for those poor hedge fund investors who find themselves with too many moving parts.
You're on a roll today, O Aunt of Rationality. Somehow I think the problem is not too many moving parts, but the direction that those parts are moving - down.
OT:
I was always convinced there was a bubble 3 years ago...now it is confirmed we have lost our minds.
Doctor Housing Bubble Blog: Real Homes of Genius: Today we Salute you Compton. $279,900 for 768 Square Feet.
While I fully enjoy rapier-like sarcasm and word-play -- and believe that it's a very appropriate and effective tool against the excerable and infamous sleeze we are surrounded with -- let's all keep in mind that the scamming and sleezing manipulation, the "gamimg the system", the sheer corruption and incompentance of all this financial-moral-depravity is destroying the lives of many who are not players in this disgusting game, and destroying a nation and a way of life and a PROMISE of so much rational improvement of this nation and of the world, and the improvement of the lives of so many humans. We are LOSING SO MUCH TIME, SO MANY OPPORTUNITIES. This debacle is going to take us backwards very, very far -- and for what? For what? So much LOST, so much HOPE lost. So much of our FUTURE, of our children's FUTURE, simply lost.
Good thing people like to sit and contemplate the intricacies of complexity during a panic.
I guess a little more earthquake-proof financial engineering should have gone into those skyscrapers being built on a fault line.
This is exact form on destructive fantasy that is made possible with a monetary system based on no proven theoretical foundation.
One theme I have not heard raised (which may be due to the fact that I have been away from the screen for much of the last week) is how it is that Ralphie boy came to be put in charge of a $20B pair of hedge funds. The story mentions that he had been a salesman for a long time and then had run an internal trading book for six months before being brought over to the asset management side of bear. Not exactly the career path out of central casting. Most people that actually get to invest money (the "buy" side of the business) have spent quite a few years watching and supporting other people doing the investing. The track record of people who move from the "sell" side, where Ralph was, to the buy side is pretty spotty. Sales guys on wall street are not known for their intellectual depth.
It would be one thing, if he had principal responsibility for 5 or 10 years with good results and then came over to the asset management side. But inexperience and rapid asset growth can be a deadly combination. Amaranth had some of the same issues - a relatively short span of experience, rapid asset growth and very little oversight.
It is all a sign of the times. When money gets loose, it ends up in the hands of inexperienced people.
Tanta,
Just to make sure I understand this...
Suppose we form a hedge fund (The Tanta & Pat Fund aka The TP Fund - joke intended), we get CR to invest $100, and we get Bear Sterns to lend us $900 at 7%. Next we buy a $1000 CDO that yields 10%. One year later, assuming the CDO is still OK, we have $100 of return from the CDO from which we deduct $63 of interest for BS, $2 for our brilliant management skills, leaving $35 to be split between CR (he gets $28) and us (we get $7). Not bad, CR got a 28% return and we made $9 with no risk!
However, the next day CR calls and says he wants his $100 back now (as in RIGHT NOW!). We call Bill Gross and he offers to take the CDO off our hands for $980. I guess ol CR wont be too happy with that since he will only get $80 back.
Now imagine Bill Gross only offers $900. Bummer?
Now imagine Bill Gross only offers $900. Bummer?
Major bummer. We therefore tell CR that he cannot redeem his money because Bill Gross does not exist.
(This is where they take their ball and go home.)
No, this is where they take your ball and go home!
Pat-
I think the problem comes in when Bill G. offers $890.
The problem came when Bear lent $900 at 7% for somebody else to buy something that paid 10%.
Why would they do that? Their money is effectively at the same risk as if they had bought the 10% deal.
Why would they do that? Their money is effectively at the same risk as if they had bought the 10% deal.
Probably because the $1000 CDO bought a bunch of junk that would otherwise be sitting around on BSC's balance sheet looking a bit "illiquid." So instead of having $1000 in dodgy assets at risk, BS can turn that into a $900 "secured credit facility."
Never assume that the underlying credits didn't come off the broker's own shelf to start with.
That's diabolical. If that's what was going on with Bears Super-Duper Overenhanced Ultraleverage Extravaganza Funds (and it looks like a good guess) then they were really playing Merrill, et al, for dopes and there should be bodies in the East River soon.
what no one in Congress or compliant SEC is focusing on, is that both Bear and Carlyle have been busy trying to IPO the equity portion of these CMO and mortgage pools, equity which is obviously WORTHLESS. Bear could not even sell the collateral in the open market, there were no bids or heavily discounted bids. their Everquest IPO almost went to market, and the public would have ended up HOLDING THE BAG for guys who have been MINTING it. where is the Fed? SEC? other independent analysts? where are the Democrats? this country suks
well said scorpio. actually, i wish it had gone on the market; i would've shorted the hell out of it.
"In my view we have gotten complacent on the quality of our markets and securities, taking that regulation and quality for granted. I think that the lack of information and opaqueness of MBS, CDOs, CLOs, etc. have, to stretch the analogy, recreated some aspects of that late 1800's - 1920's markets and we're probably about to re-learn some old lessons"
Sure, Andrew. I have exactly the same opinion.
Markets require REGULATION to operate properly and honestly.
The bad news is that "this time is different". The world has changed and Wall Street is possibly about to lose its unique place in the world with no chance to recover it.
I'm definitely sorry for New York, a city I have learned to love.
He had come up with an approach to trading those assets that people who are experts in that arena thought was a sound and interesting approach.
This sentence may not mean to, but it tells you a lot about modern reporting.
Now viewing an investment approach as "sound" is certainly fine, and not something that requires a follow-up, but "interesting" is another story.
What was interesting about his approach? I know I'd love to know. I'd probably also like to know why they found it interesting. Since they liked the approach so much, did anyone else take it? Where and how?
So many questions, but then we don't really want the answers, or at least the NYTimes doesn't, because, well, it just makes thing more complicated.
I'm all for conspiracy theories - but I doubt BS lends money at 7% to make their assets look more liquid. They do not have the same level of risk as the fund, per your example the TP fund has the $100 cushion provided by CR. That cushion is enough of a reason for them to only accept at 7% return. I have read the mortgage contracts between banks and hedge funds and I have never seen a "you must buy x$ worth of our stuff". As can be seen by the list of BS fund assets I posted on my blog several days ago, most of it is from 2006 or 2007 which means they were buying the positions at issuance and not in the secondary market (which adds no liquidity to anyone).
I don't think there are extortionate fees paid for the valuations of CDOs. The hedge fund managers all work at investment banks who have in house analysts. I don't recall my paycheck ever being larger from week to week depending on what screwed up new product I was trying to value
)
Great blog you guys. I'm new here so I don't know if linkage is allowed so I'll use up some bandwith from a great piece on this subject by Kevin DePew over at minyanville dot com.
Leave it to a UK media source - The Telegraph (UK)- to summarize what is happening even as many of the major U.S. media outlets continue to follow the Containment Propaganda Campaign - more on that in Number Four - or take turns allowing their sources to position them to their advantage in the emerging blame game.
The Telegraph this morning quotes Charles Dumas, global strategist at Lombard Street Research summarizing the issue: "We don't know what the value of this debt is because the investment banks shut down the market in a cover-up so that nobody would know. There is $750bn of dubious paper out there in the form of CDOs held by banks that have a total capitalization of $850bn."
Indeed, we simply don't know, which leads us to today's Number Three.
As Minyanville Professor John Succo wondered back in May, why is it that financial markets were (are) so sanguine in the face of what all available data suggests are rapidly deteriorating collateral values in the mortgage market?
Why aren't losses being seen? Even now, they aren't being seen.
The answer, we now know, is mark-to-model.
What does "mark-to-model" mean? Let's use something even we can understand - a sports card example.
Suppose you and I are collectors (investors) in sports cards, but not baseball cards, the "prime" sports card market. No, we collect professional golfer cards - the
"subprime" sports card market.
Why would we collect professional golfer cards? Simple, we're looking for an alpha edge - a fancy way of saying "excess return" - and with leverage, we believe we can buy these illiquid sports cards and sell them later to someone else for more money.
Ok, ok, there are a couple of problems with this scheme you can see already.
- First, the market for professional golfer cards is far, far riskier and smaller (illiquid) than the market for professional baseball player cards.
- Second, since they so rarely trade, it's difficult to value the cards on a day-to-day (even week-to-week) basis.
Ok, so back to the sports card market.
Let's say that baseball cards are "highly liquid," meaning that, like stocks or U.S. Treasuries, they trade every day.
These trades provide a way to instantaneously value our portfolio of baseball cards at any time.
To value our baseball card portfolio, we simply look up the most recent trade of, say, our 2004 Derek Jeter card and record the value. This is called "Mark-to-Market."
This "liquidity" is particularly helpful if we are using leverage (meaning, if we are using borrowed money to buy baseball cards with the hope that the borrowed money will increase our return when we decide to sell) since it allows us to closely monitor and track exposure and adjust the amou
This "liquidity" is particularly helpful if we are using leverage (meaning, if we are using borrowed money to buy baseball cards with the hope that the borrowed money will increase our return when we decide to sell) since it allows us to closely monitor and track exposure and adjust the amount of leverage we are using accordingly.
So how do we know, at any given time, what our leveraged portfolio of professional golfer cards are worth? They rarely trade, so we can't look up similar cards that have recently traded in the market.
Well, unfortunately, in our professional golfer card portfolio we can't mark-to-market because these cards trade so infrequently.
So how do we value our portfolio?
Simple, we have some mathematicians build us a model that values the cards based on how each golfer performed last year, the tournaments in which they made the cut, their overall earnings and rankings among their peers, and a rating that a separate "professional golf card agency" that follows the golfers posts.
Wait, did you say, "a model that values the cards based on how each golfer performed last year"? Yes.
But what if a professional golfer's card in our portfolio is a guy who last year ranked fourth overall in earnings and won two tournaments, but suddenly gets injured this year, fails to finish a few tournaments, and slips down to 40th in overall earnings?
Hmmm, good question. For that we would rely on that separate "professional golf card agency" we mentioned to "re-rate" this card. Then we would simply input that revised rating into our models and adjust the value accordingly.
But what if the rating agency, for a variety of reasons, chooses not to re-rate the card?
Then we have a situation where the value of the card that is being spit out by our model is in no way even close to the true market value of the card.
Wouldn't that be a problem if we suddenly feared that all the ratings of our cards were too high? Wouldn't our model be insufficient? Might we not be over-leveraged in cards that have very little real market value? Yes, yes and yes.
And that is precisely where we are right now with respect to CDOs.
The credit ratings agencies' ratings are key in the mark-to-model values, and so far very few CDOs have been re-rated in a way that reflects the surging subprime default rates.
There's an old investment saw that says "Paper losses don't exist until you sell."
That old saw is being tested in real time, right now.