Subprime Mess: It's Not Derivatives' Fault

I'm sure it's been happening a lot in idle conversation, but it's still disheartening to see it happening in on the front page of a WSJ section: confusing illiquidity problems in the subprime market with more theoretical worries about derivatives. Here's Scott Patterson, who should know better, in his Ahead of the Tape column:

The subprime-mortgage crackup is casting a bright light on an often dark corner of Wall Street: derivatives...
A rising concern is that many derivatives are "illiquid," or don't trade very often, making it hard to value them accurately. This can pose a problem for hedge funds, which generally need to place a value on their holdings every few months or so...
A recent study by Paris risk-management firm Riskdata shows that roughly 30% of hedge funds that invest in illiquid securities smooth out returns with price estimates for these securities that are potentially self-serving, compared with just 3% for funds that invest in highly liquid securities such as stocks.

There is no indication whatsoever here that Patterson understands that the illiquid securities which are causing so much trouble in the "subprime-mortgage crackup" aren't derivatives. And in fact I'd take issue with his contention that "many derivatives are illiquid". I'm sure that some derivatives are illiquid, but as a general rule they don't even come close to the illiquidity endemic in, say, the CDO market.

CDOs are securities – not derivatives – which are very, very rarely traded. As a result, they're often "marked to model" rather than being marked to market. That seems to be the problem that Patterson's column is concerned about, and it's silly for him to be complaining about derivatives in this regard.

It's true that the troubled Bear Stearns funds did invest in some derivatives – mainly bets on the direction of the ABX.HE index of subprime bonds. Those investments rose and fell in value very transparently, and were by far the easiest part of the Bear portfolio to unwind.

So let's not start blaming illiquid derivatives for Bear Stearns' problems. Right now, illiquid derivatives are the least of anybody's problems.

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