James Hamilton at Econbrowser asks the remarkably sanguine question: CDOs: what’s the big deal?
He does a nice job looking at many of the issues this topic raises. However, I still have some unanswered questions about CDOs:
Thus, I will respond to the Prof in true Socratic method by asking more questions. These raise the possibility that not only CDOs may be a big deal, but we don’t have a clue how big a deal it may be — Modest? Gargantuan? Ginormous?
Here are my 10 questions:
1. What would have happened had Bear Stearns simply let their two funds, High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leverage Fund, dissolve?
2. If CDOs are not priced to market, what are the actual values of these holdings?
3. How levered up are the funds that own the bulk of the CDOs? 10-to-1? 20-to-1? More?
4. How many Hedge funds are or have been taking quarterly or annual performance profits, based in whole or in part, on hoildings that have been marked to a theoretical value ("Mark-to-Model") versus an actual value ("Mark-to-Market")?
5. Liquidity has been a driving force behind M&A activity, share buybacks, and leveraged buyouts. Might the CDO situation somehow impact liquidity?
6. Might a liquidation in a CDO/illiquid derivative fund spread to other asset classes?
7. How widely held are the toxic CDO tranches in funds that are self-decribed as "conservative" or "risk averse?"
8. How accurate are the major ratings firms (Moodys, Standard & Poors, Fitch) assessment
of these products. Are these outfits arm’s length objective raters, or
are they merely corporate whores who play for pay?
9. After the final chapter is written on CDOs, what might the total losses on the $250 Billion in quarterly CDOs that Wall Street has created actually be? 10 Billion? 100 Billion? 1 Trillion?
10. How much will systemic confidence be impacted if there is a
series of large fund failures due to CDOs? What impact might that have
on the rest of the markets?
The big deal is that we simply know so little about these issues. Wall Street has gotten better, for the most part, about managing risk. But these CDOs are increasingly looking like unknown factors, with an unknown set of risk parameters.
Hence, that is what the big deal is . . .