Tuesday, November 20, 2007

Hedge Funds Pounce On CDOs

I've been hearing over the last several days of CDOs being snatched up by a number of hedge funds for approximately 40 cents on the dollar. Meanwhile the Treasuries and other high-quality bonds continue to decline in yield.

The opportunities created from such disparities abound for the leveraged bond investor. The Convergence Play was a typical favorite of John Meriwether's Long-Term Capital Management, and I would imagine he's utilizing the same technique at his new hedge fund, JWM Partners, over in Greenwich: Long the CDOs, short the Treasuries.

The reasoning behind this is fairly simple. With the flight to quality, the prices on the 2- and 5-year Treasuries become out of proportion relative to historical relations. Given the temporary weakness in the dollar, the temporary volatility in the stock market, and the otherwise temporary uncertainty in the investment arena, banks/funds are dumping the CDOs/CMOs at any price and buying however many Treasuries they can afford, driving yields down and prices ever higher.

Understanding the resilience in the stock market and its tendency to experience temporary abnormalities in price, such as we have seen since June/July, it's reasonable to believe that prices, volatility, and confidence will return to normal levels over time. Yields on the Treasuries will go up, while yields on the CDOs will come down (ie "Converging") - and the prices will be inverse - going several basis points in each direction.

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Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.