I know the regulatory side of things in more than a passing fashion, but from a lower level perspective. Nuts and bolts, when the higher ups get excited about a case they have access to the commissioners and their staffs, and lots of resources, to throw at a case. But before the excitement builds there are competent professionals, but no derivative “rocket scientists” doing the digging and putting the case together in the early stages. Lots gets missed. Meanwhile, I’ve known a former IBM researcher, Ivy League PhD in physics, who went to Wall Street to do the math for the firms regarding derivatives.
My perspective was solidified by seeing this morning that a AXA money market fund in Luxembourg is down 26% today, as a result of the fund discovering that buying CDO’s wasn’t such a hot idea.
If I were a Euro-zone investor with money in a money market fund that went down 26%, I’d be coming after someone with a fire axe. Money market funds are supposed to be for ready, short-term, easily liquidated funds. If I were invested in a speculative bond fund, and it went down 25%+, hey, that’s what I get when I invest in junk debt.
But a money market fund? No way.
Options on stocks and commodities futures are derivatives too, and those are priced in open markets. This CDO situation is nothing more than a repeat of the bad old junk bond days - people who thought they knew what they were doing with credit and interest rate swaps got burned - and burned bad. Recall that Orange County, California, was burned by 5-year notes issued by Fannie, and derivatives that assumed interest rates would keep going down. Oh, and there was leverage involved.
History is repeating itself, only in a much larger magnitude.
BTW — the whole concept of the CDO was created by the same firm that was at the heart of the junk bond scandal: Drexel. History repeats yet again.
One of the problems of the CDO modeling is that they’re using Monte Carlo simulations. Well, that’s all well and nifty, but the buy side guys observing the sell-side’s simulations aren’t asking about the underlying assumptions the sell-side guys are making then they run their Monte Carlo simulations. This, as it turns out, it resulting in customers who are very under-informed about what real risk they’re buying when they buy a CDO.
I’d be more sanguine about leverage combined with mark-to-model if the SEC would impose real penalties on those firms that deliberately abuse the system. By all rights, Drexel should have been put out of business permanently, everyone in the firm should have lost their licenses, the executives all should have gone to prison for a nice, long time. The penalties should have been so severe that every other firm on the street would say “Whoa... let’s not do that.”
Either way, one or the other of the issues has to go: either mark-to-model, or leverage on mark-to-model assets. Removing either one would remove debt market blow-ups like this one, or the junk bond blow-ups of the 80’s.