Worries on Valuing "Repackaged Debt"

For those of you who are relatively new to the complexities involved in the pricing of collateralized debt obligations (CDOs), this Financial Times article, “Worries grow about the true value of repackaged debt,” gives a good overview. Since the article is lengthy, and the first part covers largely familiar ground, I’ve excerpted the second half.

One thing nags at me as I read this article. The assumption, which is articulated by a consultant, Christopher Whalen is that more liquidity would help pricing (in financial markets, that is close to a tautology):

The lack of a publicly quoted market for CDOs and like assets is exacerbating the liquidity problems for these assets beyond the underlying economics, for example, in subprime real estate

Now it is undeniable that more trading of CDOs would give more pricing benchmarks. Something is obviously better than nothing. But this market is a harder nut to crack than most people imagine. My belief is that a very considerable range of CDOs would need to be traded to provide enough data points to be useful. And lacking natural buyers and sellers (no one in the normal course of events sells this stuff, unless there is a problem, which means buyers are likely to be chary), it’s hard to imagine how market participants are going to get around this issue.

The reason I stress this issue is that readers might easily imagine that if a few “benchmark” CDOs were to be traded with some frequency, that would give this sector the anchors it needed for more realistic price marking for the CDOs that don’t trade. But these instruments are so arcane, so complex, and so highly differentiated on so many axes that one is likely to need to have a large number of CDOs trading to capture enough permutations to allow for realistic pricing.

Let’s consider the variations: underlying assets (they can contain any tranche of asset backed securities, other CDOs or even CDOs of CDOs, whole loans, mortgages), degree of credit enhancement (whether via overcollateralization or the use of guarantees), leverage, use of synthetics (I may have managed to miss an attribute or two, but you get the picture). As a result, the maturity of the deals vary, and the structures used to achieve the desired credit ratings are all over the map.

So even if a few of these puppies traded, I’m not sure what it tells you. You could try to infer what that means for illiquid issues, but unless you have a statistically reasonable sample trading, it’s hard to decompose why the liquid issues are priced the way they are priced. Or else you make an educated guess as to why they trade the way they trade and use a very complicated model to relate the price to the untraded paper you own. I’m sure it would be an improvement on what we have now, but my sense is that the public at large is overestimating the benefit of more active trading of a few issues. “A few issues” won’t scratch the surface of the variety and hairiness of the paper out there.

And there are a few other barriers: you can’t get the deal documents. No kidding. The Fed can’t even get them because it isn’t a “qualified investor.” (Should the Fed start a hedge fund so it can study this problem?). From “Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions,” by Joshua Rosner and Joseph Mason (pages 83-4):

At present, even financial regulators are hampered by the opacity of over-the-counter CDO and MBS markets, where only “qualified investors” may peruse the deal documents and performance reports. Currently none of the bank regulatory agencies (OCC, Federal Reserve, or FDIC) are deemed “qualified investors.” Even after that designation, however, those regulators must receive permission from each issuer to view their deal performance data and prospectus in order to monitor the sector.

So if regulators can’t get the description of the securities, market participants certainly won’t. So what good is a price if you aren’t really certain what is being traded?

In addition, the discussion in the FT article presupposes the CDOs are passive CDOs, meaning the assets are assembled and the CDO is structured before it is sold to investors. Yet many CDOs are “active” or “managed” CDOs, meaning blind pools. Blind pools that are tranched, often with leverage and often buying other CDOs or “CDO squared” (CDOs of CDOs). That means the investors pony up money before the fund (it is like a convoluted mutual fund) is formed, and the managed gets to trade it over its three to five year life. No CDO manager is going to disclose his holdings (it would put him at a competitive disadvantage) but how can you value it otherwise?

I don’t understand how anyone with an operating brain cell could have bought this stuff, and the supervising grown-ups (the regulators) seem powerless to do anything to ameliorate the situation.

From the Financial Times:

To an extent, the valuation problem for CDOs reflects the fact that the frenetic pace of innovation seen in the financial industry this decade has outpaced the development of its infrastructure. It has often been the case that when new instruments emerge in the banking world, the market is initially quite illiquid, meaning that the level of trading is low. But the murky nature of new products has rarely had broad systemic implications, because they have typically occupied a small niche.

What makes the CDO sector unusual is that it has exploded at such a breakneck pace with bankers packaging bonds, loans and other debts into ever more complex structures. Last year alone, about $1,000bn (£500bn, €745bn) in cash and derivatives CDOs was issued in Europe and the US, according to data from the Bank for International Settlements. More than one-third was composed of asset-backed securities, often including low-grade mortgages.

As this explosion has occurred, some corners of this universe have already become relatively widely traded and transparent. Every day in the London and New York markets, for example, billions of dollars worth of deals are struck involving indices of derivatives on well-known corporate bonds – making it easy to obtain prices.

However, many other such products are created by bankers directly with their clients and then simply left to sit on the books of an investor. Since such instruments typically last three to five years – and the CDO boom is so recent – many have not come to the end of their life. Nor have they been traded. Christopher Whalen of Institutional Risk Analytics, a consultancy, says: “The lack of a publicly quoted market for CDOs and like assets is exacerbating the liquidity problems for these assets beyond the underlying economics, for example, in subprime real estate.”

To compensate, investment institutions and banks use a variety of techniques to assign a value to these instruments in their accounts. In some areas, third-party data groups exist that can offer price estimates. However, the pace of innovation is so intense that it is hard for these providers to keep up with all corners of the market. So in many cases, investors are turning to alternative techniques to create prices. One tactic used by hedge funds entails asking several brokers for price quotes and taking an average. Results vary – not least because dealer banks may hold positions in these instruments themselves.

“It is very easy for hedge funds to shop around to find valuations that suit them best and then book their assets at that,” says one banker who advises hedge funds. “Going back to the bank that sold you a CDO and asking for a price is rarely likely to produce an accurate picture.”

Another approach is to estimate valuations based on the ratings the instruments receive from credit rating agencies. Yet this does not offer a fail-safe valuation method either. The rating agencies have been downgrading bonds backed by subprime mortgages in recent weeks but critics say they have been slow to act and face difficulties in analysing the market.

Christian Stracke, analyst at CreditSights, a research company, says: “With so little truly relevant historical data on the behaviour of subprime mortgages, and with such massive structural changes having occurred in the mortgage landscape in recent years, any time-series analysis approach is little more than a not-so-educated guess.”

Moreover, while ratings attempt guidance on the chance of default, they offer no indication of how market prices could behave – as the rating agencies stress. As the BIS noted in its annual report this week, ratings reflect expected credit losses rather than the “unusually high probability” of events that “could have large effects on market values”.

That means that on the rare occasions that instruments are traded, a large gap can suddenly emerge between the market price and its book value. This week Queen’s Walk Fund, a London hedge fund, admitted it had been forced to write down the value of its US subprime securities by almost 50 per cent in just a few months. That was because when it was forced to sell them, the price achieved was far lower than the value created with the models the fund had previously used – which had been supplemented with brokers’ quotes.

But unless circumstances arise that force a market trade, valuations often remain at the investment managers’ discretion. While managers say they strive to assign honest values, these are often difficult for an outside accountant to verify, since the techniques used are invariably highly complex.

Moreover, incentives do not always encourage fair valuations: hedge fund managers, for example, are typically paid a percentage of the profits they book, giving them a vested interest in reporting a high asset valuation. At best, this means that the valuations of CDOs, for example, may often lag behind any swings in broader asset classes; at worst, this ambiguity may enable hedge fund managers or investment bankers to keep posting profits – even when markets fall.

But Amitabh Arora, head of interest rate strategies at Lehman Brothers, points to a further potential impact from the Bear Stearns upheaval. “The bigger risk now is that it calls into question CDOs as a financing vehicle in the corporate credit market – I think in the next six to 12 months we will see a significant reassessment of CDOs as a financial vehicle not just in the subprime world but the corporate world too.”

Adil Abdulali, a risk manager at Protégé Partners, a fund of funds, recently studied the performance of hedge funds and discovered clear statistical indications that they tend to stage-manage their earnings [known in the industry as “smoothing” them] when they trade illiquid instruments. “Conservatively, 30 per cent of funds trading illiquid securities smooth their returns,” says Mr Abdulali.

Some bankers and policymakers argue that this is simply a teething problem that will fade as structured finance becomes more mature. History suggests that most opaque, illiquid markets eventually become more transparent when they grow large enough – and behind the scenes, the Bear Stearns hedge fund problems are prompting bankers and investment managers to re-examine their valuation techniques. “We are getting a lot of calls from worried people,” says one third-party data provider.

However, history also shows that large-scale structural dislocations – such as a serious mispricing of assets – are rarely corrected in an orderly manner. Thus the big risk now is that if thousands of banks and investment groups suddenly have to slash the value of the securities they hold, the wave of accounting losses might at best leave investors wary of purchasing all manner of complex financial instruments. At worst, it could trigger more distressed sales and a broader repricing of financial assets, not just in the subprime sector but in other illiquid markets too.

“If every CDO [manager] was forced to mark to market their subprime holdings, it would be – well, I can’t think of a strong enough word to describe what it would be,” confesses a US policymaker.

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  1. Anonymous

    People are only looking for the sale. On both sides. The buyer wants, house, car, boat, interest income, whatever and the seller wants to make a sale, mostly for the commission earned. If you have been in a real estate closing with a loan you would realize that NO One reads the loan documents. At least no one I have ever heard of or been with. To many pages of legalese. It is all about TRUST in most cases. We have to trust that what is being sold is not to different from what we think we are buying.

    So in the case of CDOs and MBSs, the pension funds and other buyers bought believing the sales person and the fact that these instruments had been sold for some time without any real problems. This trust gave way over the years to egregious behavior. Human nature. Now that there is a problem everyone goes around looking for a villain and claiming to be victims.

    I’m sure there are both. Where the real problem lies in the lack of regulatory supervision. This is what government is suppose to do IMO is to keep the playing field even and the rules transparent and eliminate those who morf the system to be a one sided win lose game.

  2. Yves Smith

    With all due respect, the buyers we are discussing in this case are the investors in CDOs or other similarly complicated paper. Investors such as pension funds (which have been buyers of CDOs) have a fiduciary responsibility, which means they have legal obligations (specifically, a duty of care and a “prudent investor” standard, which is a higher bar than the “prudent man” level). The people who make investments are paid to evaluate what they are buying. They are liable for their actions. This paper isn’t being sold to individuals who are taking risks on their own behalf. (Hedge funds are also liable, but because only “qualified investors” who are assumed to be sophisticated by virtue of meeting certain income and net worth standards) can invest in hedge funds, they are understood to be taking a greater level of risk).

    The big fixed income investors (until hedge funds joined in the game) were pension funds and insurance companies (they are still big, mind you). They have projected liabilities and they buy various assets to make sure they have the cash flow to meet their obligations. This isn’t supposed to be a rock n’ roll, swing for the fences, bunch. Historically, fixed income investors are a skeptical and dour lot.

    Now in fairness, it is apparently the public pension funds that have bought this stuff, and they are more herdlike in their behavior.

    Investors and lenders DID read documents, including indenture (those specify the terms of the covenants), and I guarantee you at at places like Pimco they still do. You know what sections are boilerplate and hone in on the ones that count. And Moody’s and Standard & Poors publish detailed summaries of the key terms of all public debt deals.

    In this case (see post http://www.nakedcapitalism.com/2007/06/bear-stearns-and-vagaries-of-models.html) many investors seemed to have derived false comfort from credit agency models (meant to measure credit quality ONLY) and used them as pricing models.

    Your comment does apply to what is called “active” or “managed” CDOs, where a manager can and does trade assets within the CDO vehicle during the life of the deal. It bears some resemblance to a mutual fund, except it lacks liquidity and transparency. It’s complete “trust me” paper. Why anyone would buy this stuff is still beyond me.

  3. trotsky

    I would suggest that it’s not merely ‘other illiquid markets’ that are in danger of a sudden ‘repricing’. many hedge funds hold both illiquid AND liquid assets such as publicly listed equities for example. when margin calls come, it is the liquid stuff that gets sold first. this is how you get the ‘mass-correlation effect’, when normally uncorrelated markets suddenly strongly correlate to the downside.

  4. Zar and Jano

    From 04 to 06 I was involved in many Subprime, ABS, ABS CDO transactions and I am sure that most of the buyers (long/short) of these risks had no idea of what the hell they were getting into. I remember a Japanese investor that did not even understand English buying at the equity tranche of an ABS CDO,…. Keep in mind most ABS market participants are bond traders at best and have no idea of the derivative nature of the business.

    There is now an active market on Subprime Correlation risk (TABX), and I am more interested in seeing how much and how well people are engaging in this product. How do you determine the default correlation of a New Century pool of loans with a Countrywide pool of loans…And yes it’s the same cash bond traders that are now using gaussian copula to trade these instruments.

  5. Yves Smith

    Zar amd Jano,

    In a way, what you say doesn’t surprise me (Gillian Tett at the Financial Times has been quoting traders who have said, in less detail that you, that a lot of the buyers are unsophisticated) but it is still pretty horrifying.

    I haven’t had direct experience in this market, but I worked actively with some derivatives players in the early days and witnessed the same phenomenon you saw: investors buying products they didn’t, and couldn’t possibly, understand. If you don’t have the higher math skills, you are certain to be taken.

    It reminds me of that old saying, “If you are playing poker, and you don’t know who the mark is, it must be you.”

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