New Credit Crunch Tactic: Barter in Lieu of Price Discovery

If this factoid about barter being used to effect distressed subprime trades (and she admits it is, at least so far, an isolated example) had come from anyone other than Gillian Tett, the captial markets editor for the Financial Times, I’d be inclined to discount it. But the fact that it is happening at all really is a stunner. In the modern world, you normally see barter for large transactions only when that parties have to operate outside the banking system, either for less than upstanding reasons or due to capital controls.

Tett uses this to segue into a discussion of how banks and investment banks have been very chary of marking down their holdings of illiquid assets, but auditors, unwilling to repeat the mistakes they made in the Enron era of being too accommodating, are taking a tough line on valuation. In particular, she focuses on the fall in the ABX indexes and what that means for pricing of subprime holdings.

From the Financial Times:

This week, a banking friend made a startling confession. In recent weeks he has been furtively unwinding some large investment portfolios linked to subprime securities.

But as he has embarked on this sordid task, he has discovered that the only effective way to get rid of these distressed assets is to avoid putting any tangible price on the trade.

Instead, he has resorted to using a tactic more normally associated with third world markets than the supposedly sophisticated arena of high finance: barter.

“Barter is the only thing that works right,” he chuckles grimly. “It is like the Dark Ages.”

I daresay this is an extreme example. But it nevertheless reveals a crucial point: namely that while this summer’s credit turmoil is already several months past, parts of the credit world remain plagued by strikingly high levels of fear and mistrust.

Indeed, in some arenas, such as mortgage-linked securities, sentiment now seems to be getting worse, not better. And that raises the prospect that we are now moving into an entire new phase of this year’s credit squeeze.

Take the ABX index, the basket of derivatives linked to subprime securities. As financial tools go, this index is far from perfect, since it is barely two years old, and tends to be thinly traded.

But right now it has the unfortunate distinction of being the only tool easily available to measure sentiment in the opaque subprime securities world. And in the past couple of weeks, the message emerging from this measure has started to look utterly dire.

Never mind the fact that the risky tranches of subprime-linked debt (the so-called BBB ABX series) have fallen 80 per cent since the start of the year; in a sense, such declines are only natural for risky assets in a credit storm.

Instead, what is really alarming is that the assets which were supposed to be ultra-safe – namely AAA and AA rated tranches of debt – have collapsed in value by 20 per cent and 50 per cent odd respectively.

This is dangerous, given that financial institutions of all stripes have been merrily leveraging up AAA and AA paper in recent years, precisely because it was supposed to be ultra-safe and thus, er, never lose value.

But the trend also has crucial significance for investment banks. Until quite recently, many Wall Street banks tended to value their subprime linked holdings using models, because they (and their auditors) knew it was hard to get prices for these opaque instruments through real market trades. But I am told that this autumn some banks’ auditors have started to crack down on this approach, particularly in the US, owing to the so-called “Enron factor”.

More specifically, the experience of living through the Enron scandals earlier this decade means that the audit industry is now terrified that it could face lawsuits if it is perceived to be too lax towards its clients. So some now appear to be demanding that their banking clients reprice their mortgage assets according to the only visible market tool – namely the ABX. It is thus little wonder that some banks have suddenly been forced to increase their writedowns in recent weeks. Indeed, I would wager that the pernicious combination of ABX and the “Enron factor” is a key reason for the recent shocks emanating from Merrill Lynch.

However, the rub is that while auditors at some Wall Street banks are becoming quasi-evangelical about the need to reprice subprime assets, there are still other, vast swathes of the financial system which have not been touched by the full blast of transparency yet. Moreover, many financiers outside the world of Wall Street banks remain very wary of rewriting their mortgage assets to current ABX price levels, due to a lingering hope that the recent ABX slump will remain temporary.

No wonder that my banking friend is now furtively resorting to barter, to unwind his clients’ investment portfolio. And no wonder that investors are currently so suspicious about the health of financial entities – and so nervous about the potential for secondary shocks. This new wave of fear is unlikely to vanish quickly. Call it, if you like, The 2007 Credit Crunch Story, Part II.

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