At the second annual SunGard Senior Risk Managers’ Roundtable in early June, considerably more attention was focused on hedge funds than had been the case in 2006. In addition to often cited concerns about the generally opaque nature of the underlying risk, considerable discussion centered on how objective and how reliable are the current market valuations that are available.
The market standard Gaussian copula model for pricing CDOs is notoriously simplistic, requiring inconsistent correlation assumptions to match the prices of different tranches in a single CDO pool. For actively traded structures this does not raise serious doubt about fair value estimates since there are observed prices at which significant numbers of trades actually occur. But what about less liquid structures that do not have a regular two-way deal flow? This is certainly not a new problem. It has long plagued the municipal bond market in the US where many local issues only trade infrequently. In that market the usual strategy for valuation is to apply a matrix technique where observed trades for similarly rated bonds are used to estimate the fair value of ones that have not traded.
Municipal securities are relatively simple, however, compared to sub-prime mortgage pools where thin trading is also a problem. In such a space, mark-to-market versus mark-to-model becomes an important distinction. Significant volumes of highly complex illiquid securities can end up being valued based on very limited trading volume of similar issues. Modest demand shifts can have a significant impact on prices for the daily trade flows. The effect can then be magnified as these observed prices are used to value the much larger volume of outstanding issues.
One theory is that the recent troubles at two hedge funds run by Bear Sterns have been driven by this type of effect. (See CDOs: “A Triumph of Greed Over Fear” at http://www.riskcenter.com/story.php?id=14943.) A significant source of concern is the extent to which other hedge funds have similar problems in their sub-prime mortgage portfolios that have not yet emerged. It also raises doubts as to whether most hedge fund returns are genuinely based on alpha or are a sophisticated form of alternative beta driven by esoteric but identifiable market factors whose behavior has been relatively benign in recent years.
Certainly many readers out there are much closer to this unfolding issue than I am. How do you think this story will unfold in the coming days and weeks?