I just finished listening to Gregory Zuckerman’s The Greatest Trade Ever and highly recommend it if you’d like some insights into how John Paulson managed to make several billion dollars in a difficult market.
Much of the profit came from the rather esoteric credit default swaps he invested in. And because these are often private, over-the-counter deals, pricing can be quite difficult: unless there’s a market, how does one price them? Other players who stumbled upon the same opportunity as Paulson found it nonsensical that their holdings were holding steady in price while the housing market was tumbling. We saw this same problem with other derivatives because of their infrequent trading. And because many of the mortgage backed issues had undeserved high ratings, their pricing was even more “out of whack.”
The author discusses how Bear Stearns and Lehman’s real estate holdings were overpriced: but what prices should they have used? Granted, they could have used “fair value pricing,” but was this an option? Truly, a more conservative approach would have revealed much sooner how bad things were.
At a meeting of the European Performance Measurement Forum a few years back we learned of difficulties throughout Europe where managers knew their holdings were overpriced but from a regulatory perspective had no options available to adjust the pricing.
Bad prices mean bad performance. I’ve been hearing “GIGO” since the 1960s but it still rings true, five decades later.