When CDOs kill CEOs

Up to now two CEOs of fortune 100 companies have fallen from grace because of the collapse in CDO markets and more shoes may have to drop before this crisis is over! So what is going on?!

This is my take of the situation: CDO stands for the Collateral debt obligation. We don’t need to get to the technical definition of it. So much to say that it is a financial derivative instrument. Now, since Black and Scholes published their paper in mid 70s people know how to price the derivatives. Here is finance 101. You price a derivative by calculating present value of its expected future cash flows.

Expected value of the cash flows depend on the odds you assign for the cash flows to come in (like probability that you collect the mortgage payments in this case. The better credit the mortgage payer has higher odds cashflows come in) and present value is what accounts for the time value of the money (one dollar received a year from now worth less than a dollar today).

This is one way to calculate price of a derivative. Lets call that “Mark to the model“. Basically your mathematical model tells you the price based on the assumptions you make in calculating the odds.

There is a second way to come up with price of a derivative security or anything else for that matter and that is the old fashion way based on supply and demand. Basically the price of anything depends how much you can sell it for and that automatically assumes someone is willing to buy it from you. In financial derivatives world That is called “mark to market“.

Now I explain how in the world Merrill Lynch wrote down prices of its CDOs another $4 billion in a span of two weeks! How could they miscalculate price of CDOs so gravely?!

The answer lies in the difference between “mark to model” and “mark to market”.   The former is what you math gurus are calculating with their sophisticated models and the latter is what people are actually willing to pay for it! Now while their sophisticated models are saying these CDOs are worth 60 cents for a dollar, nobody else wants them and rest of the market is only willing to pay pennies for a dollar.

That reminds me of my first encounter with Black-Scholes model in my finance class. When professor was done writing all math equations I asked him but what about the supply and demand? Where does that come into picture?!

He mumbled something to the account that, that assumption “is not necessary in this context”! I was not convinced then, heck I am not convinced now!

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