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Sunday, March 22, 2009

Robert Waldmann

I think the reason the CDO market is frozen is that CDO owners are not willing to sell at the market clearing price, because they would then have to mark their remaining holdings to market. This is one hypothesis.

(after the jump I will re-review others and explain why I find them unconvincing)

I'd say that people are convinced that something else must be going on, because of an earlier example of market freezing. I say frozen markets are a sign that people care a lot about the latest price and will not sell an asset at a price higher than their perception of its hold to maturity value, because they don't want the transaction to be recorded in the market to which they mark.

So, why would broker-dealers have done such a thing say the last time markets froze ?
That would be during the Long Term Capital Management meltdown/Freeze up metaphor mixer.

Why lo and behold, it is alleged that markets froze because all broker dealers were manipulating the mark to market value in this book I read "Inventing Money. subtitle includes "long term capital management" or "LTCM""

The assets were long maturity calls on European stock indices. LTCM was massively short these options. The market price of the options became absurdly huge and trading volume fell to roughly zero. LTCM collapsed. Now given the absense of actual trading, the price to which they were marked was the list price as listed by broker/dealers. All major broker dealers were LTCM counter parties. LTCM had REPO accounts so if the mark to market value LTCM's holdings at a bank fell to zero, the bank could seize the holdings including a short position on a grossly overpriced option.

So long as all broker/dealers refused to sell the options for less and no one wanted to buy them for that absurd price, they could seize a valuable LTCM position.

It was rumored that broker/dealers were secretly trading the options at lower prices.
So, it is alleged, that the market freeze up then was pure fraud.

I just know what I read in this book. I don't know if it is true. However, I think the allegation makes it unwise to use the case to prove that market's freeze up for reasons other than dishonesty about the true value of assets.

Here I argue against three other explanations of the current freeze.

Another would be adverse selection. Only the worst of the CDOs are for sale so the market price is the price of the worst of the worst. This can happen if sellers know more about the value of assets than buyers (check) and buyers have to bid on assets and let sellers accept some of the bids and reject others (huh). The second condition doesn't hold. As I've argued repeatedly below, if I had the money I could offer to buy x% of a bank's CDO book at a y% discount but only if they sold me equal proportions of the book. Adverse selection problem largely solved.

Another would be that everyone is panicked (except Geithner, Paulson and Summers). or that everyone has to deleverage. This would really have to be everyone. With frozen markets willingness to buy even a small amount of the assets at a high price would be enough that the latest market price wouldn't be the latest fire sale price.

Another would be that everyone has to deleverage. Again *everyone*.

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