Since the credit crisis erupted six weeks ago, hedge funds suffering heavy losses in CDOs related to sub-prime mortgages have had a difficult time pricing these complex instruments. Last week, French bank BNP Paribas shut down three funds with exposures to the U.S. sub-prime market because it said it could not value the funds. This in turn rattled other overseas banks that were exposed to U.S. sub-prime mortgages. The issue is that hedge funds can't value these CDOs and sub-prime related credit instruments in their portfolios, because they rely on tradable prices and right now there are no bids, say sources.

"You can certainly argue that you can't value something when there is no bid for it," comments Virginia Parker, founder of Parker Global Strategies, a fund-of-funds manager in Stamford, Conn. "Some people may be trying to sell, but nobody is buying," says Parker. Parker was told a story of fund that owned Triple A paper. They thought they'd get (a bid the 80s, instead they got a bid in the 30s. That's not terribly realistic," says Parker.

Closing down the funds is a way for the hedge funds to take a pause in the midst of the liquidity crunch. "I frankly feel that you have to look at the other side of the argument. I think it's a just a way to wait for the market has gotten through this period of dislocation," says Parker. "In the end, that is probably better for the investors that BNP Paribas has taken a pause," says Parker. "Still it creates a lot of jitters in the marketplace," reflects Parker.

If investors panic over the potential losses and request redemptions, hedge funds could be forced to mark their positions and sell off assets at bargain basement prices. According to sources, there is no secondary market for CDOs right now. They are executed as over-the-counter transactions and lack price transparency.

In order to value an asset that is traded in the market, whether it's IBM stock, sub-prime mortgages or CDOs, there are three ingredients that are necessary, says Phil Stapleton, president and CEO of Conifer Securities, a San Francisco provider of middle and back-office services to corporate and independent investment managers. The three factors are price transparency, liquidity and methodology of valuation, says Stapleton. "You have to deal with liquidity when you value these things," he says. Unlike a liquid security, such as IBM stock, where there is a real-time price feed and multiple market makers that are willing to buy or sell, "sub-prime mortgages are on the opposite end of the spectrum," continues Stapleton. "When you deal with sub-primes you have a marketplace that has no price transparency, you don't know if they're going up or going down. You have a marketplace where the liquidity providers are scarce and now the last problem you have is the methodology for valuing sub-prime loans has changed," cautions Stapleton. For instance, there are some people who say they should be valued 250 basis points over treasuries. Now based on their current experience they feel they should be 450 basis points above treasuries, he illustrates.

Terry Brennan, director of alternative investments at Linedata Services, agrees, "The biggest technical problem is there's no market for these securities," noting these are thinly traded. Brennan compares the valuation of CDOs to owning a house. Though homeowners call in appraisers, "Nobody really knows what it's value is until you sell it. The only time you mark-to-market your house is when you sell it," he says. Similarly, funds are experiencing the same problem with these tranches of bonds, mortgages and credit default swaps. "Because there's no market for some of these tranches, they basically use appraisers to figure out what their value might be," he says.

"Instead of mark- to-market, they use mark-to-model," says Brennan. "But are those good financial models?" he asks. Especially in a catastrophic market like this, do those models accurately reflect the value? There's a lot of questions there," he says.

Concerns over valuations are also spreading to the top investment banks that hold CDOs and mortgage-related securities on their balance sheets. On Friday, the Wall Street Journal reported that the SEC is checking the books at top Wall Street brokerage firms and banks (including Merrill Lynch, Goldman Sachs and Citigroup) to make sure they have a consistent method for valuing sub-prime mortgages in their own inventory. Though the firms have been aggressive in marking down the value of their clients' assets – they may not have marked down their own positions, the WSJ reported.
One source says the prime brokers that lent money to hedge funds to buy structured debt may not want to value the bonds, because then they'd have to recognize the losses on their own books. "So the very people who say there is no market would take horrific losses," says the source.

Check out the other articles in the Bear CDO Series:

Management Overhaul: Questions on Risk Management

A Credit Crisis and More Bloodletting Hits Hedge
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