Word: illiquidity
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...which could “leverage private capital on an initial scale of up to $500 billion, with the potential to expand up to $1 trillion.” Second, the plan proclaims that “private sector buyers [can] determine the price for current troubled and previously illiquid assets.” Why should private investment funds supply this capital? And why would private firms be any better at pricing these toxic securities, when the Fed has had no clear success in that endeavor over the past months...
...diverge from what was actually happening. With the cash flow from many mortgage pools dropping quickly, the derivatives based on them began to lose a tremendous part of their value. The paper became so "toxic" from a performance standpoint that the trading in the instruments locked up, making them illiquid and driving down their values even faster...
...hedge funds can trade - are not as liquid as stocks, so they do not always have a definite price on the market. Since a fund reports unrealized gains, it could easily get away with inflating profits. More specifically, the fund could use the most optimistic models to price its illiquid assets, which include mortgage-backed securities and other swaps. After all, economists disagree about how to value these assets, so the fund is not necessarily being dishonest in its assessment...
Suppose some investors decide to withdraw their money from a hedge fund. The fund must liquidate the appropriate amount of its assets to pay these investors. Say the fund holds large positions in illiquid assets. The fund cannot immediately sell these assets, except at a fatal loss, so it would sell its more liquid assets. Given that the fund is more likely to inflate its estimation of the illiquid assets, it would seem that investors who withdraw early get the better returns over that time period. Sounds a bit like a Ponzi scheme, right...
...have to liquidate part of their profits in order to pay their managers, traders and other support staff. Fund managers typically keep 20% of (unrealized) trading profits. But first they must realize that 20% by selling the liquid assets. If a fund is overestimating the value of the illiquid assets, then its manager's profit is grossly overestimated. In most cases, the profit is at least slightly overestimated because of slippage in the liquid assets. In other words, if a fund liquidated all profits, the supposed 20% taken out first would actually be larger than 20% of the total realized...