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Strategies & Market Trends : The Residential Real Estate Crash Index -- Ignore unavailable to you. Want to Upgrade?

To: Asymmetric who wrote (151485)	9/28/2008 10:16:10 AM
From: neolib	Respond to of 306849

That was very informative on the mark to market issue for derivatives. I wonder how correct it is. Individually, CDOs are hard to value. Suffice it to say, legend has it that constructing the cash flow payments on the first theoretical 3-tranche CDO (the simplest type of CDO) took a Cray Inc. ( CRAY ) supercomputer 48 hours. Now try and value credit default swaps on them! Because there are so many different individual CDO securities, and because there are so many credit default swaps on so many of these CDOs, and so many swaps on individually referenced entity debts and loans, the only way to value them in a portfolio is by indexing. That's right, there are indexes, and guess what? You can trade the indexes! Markit Group Ltd. , of London, constructs and manages the CDX, ABX, CMBX and LCDX family of credit-default-swap indexes. Investopedia has a decent little tutorial . Here's the problem: If you own a portfolio of CDOs, and the only way to value them (or, at least, to develop a valuation that others are reasonably certain to respect), is by looking at them through the prism of an index of credit default swaps on them, you're at the mercy of the index. Your portfolio, your securities may not be so bad, but you may not really know based on mortgage-duration analysis and foreclosure events that you can't calculate. So you value, or mark-to-market , against the closest index. Here's the rub. What if other speculators are selling short – that is, betting in anticipation of that index going down? What if large portfolio-hedgers are selling short the index to hedge the portfolio they can't sell because no one will buy it – because no one knows what it's worth?