CDO’s and the Market: An Investor Guide

A quick downdraft Friday afternoon was linked by some to a rumor that CDO’s were being repriced to the market for the quarter end.  This would be negative not only for Bear Stearns hedge funds, but also other funds holding these assets.

The selling begat more selling, tripping some technical models, including ours.  As we noted, our intermediate term outlook moved to neutral.

The Containment Perspective

A New York Times article quoted various high-placed sources have spoken out to assure the markets that the subprime problems were "contained."

Jim Cramer, writing for RealMoney has repeatedly said the same thing.

James Hamilton at Econobrowser asks "CDOs:  what’s the big deal?"

Raising Key Questions

Barry Ritholtz responds to Hamilton by raising a number of key questions.  (Barry says that he is employing a Socratic method, but we note that Socrates, like a good cross-examiner, knew the right answer in advance.  We think that Sophocles is a better analogy!)  We look forward to some answers from Professor Hamilton.

A Helpful Expert Analysis

David Merkel, an authority with plenty of experience in these markets, offers a long and thoughtful analysis which is worth reading carefully.

David concludes as follows:

In summary, this will not be a “piece of cake,” but the losses will be
concentrated among a small set of investors.  As for the CLO market, it
will have its troubles, but not yet.  Prudent investors will avoid it,
but there may be some rallies there in the short run, away from
subprime and Alt-A.

Our Take

No one knows for sure the extent of the problem.  Markets hate uncertainty, so the reaction is immediate and dramatic.  Will asset problems spread to banks making loans to hedge funds?  If investors are reassured that this is not another event on the scale of Long-Term Capital Management, attention will turn back to earnings and interest rates — perhaps quite soon.