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Markets abhor the vacuum left by derivatives

By Frank Partnoy

Published: August 10 2007 03:00 | Last updated: August 10 2007 03:00

The recent collapse of two hedge funds at Bear Stearns Asset Management raises two questions few people can answer. How did they lose so much money so quickly? And where else are similar problems buried? The unsatisfying answers illustrate why markets suddenly have become so volatile.

First, it has been widely reported that the Bear Stearns hedge funds lost money on highly rated derivative securities based on subprime mortgages. Essentially, these securities, known as collateralised debt obligations (CDOs), were complex bets on how many people would repay the money they borrowed to buy homes. Although Bear Stearns has not yet admitted which versions of these derivatives it held, one can glean some characteristics from letters the funds sent to investors months ago.

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