John Succo on Pricing CDO Mortgages

John Succo:

Minyanville : Actual prices where traders can really buy and sell is substantially lower than where investors are marking their positions. I asked a large broker firm to send over its smartest math person on Collateralized Debt Obligations (CDO) structuring.  I wanted to know what I am missing: why is the market so sanguine in the face of deteriorating collateral values in the mortgage market?  One of my firm's theses has been that, as the mortgage market deteriorates, investors holding CDO as an investment would realize losses and this would feed into other risky asset classes.  Why aren’t losses being seen when the market is clearly deteriorating?

The team that came over was headed by a very smart gentleman. He was very good at math and very straightforward. Working for a broker I was prepared for some sugar coating. I didn’t get any. The answer is simple and scary: conflict of interest. He explained that due to the many layers of today's complicated credit products, the assumptions used to dictate the pricing and outcome of CDO are extremely subjective. The process is so subjective in fact that in order to make the market work an “impartial” pricing mechanism must exist that the entire market relies upon.

Enter the credit agencies. They use their models, which are not sensitive to current or expected economic activity, but are based almost entirely on past and current default rates and cash flow to price the risk. This of course raises two issues.

First, it is questionable whether "recent" experienced losses over the last few years really represent the worst of the credit market (conservative). But even more importantly, it raises a huge conflict of interest: the credit agency's customers are the very issuers of the tranches they rate. The credit agencies, therefore, need to compete for business based at least in part on the ratings they are willing to give these tranches. As a result, they will only downgrade when forced to by experienced losses; not rising default rates, not a worsening economy, but only actual, experienced losses. Even more disturbing, they will be most reluctant to downgrade the riskiest tranches (the equity tranches) since those continue to be owned by the issuers even after the deal is sold. So even though the mortgage market has deteriorated substantially, mark-to-market losses by those holding the CDO paper have generally not been realized simply because the rating agencies have not changed their ratings for all the above reasons.

Accounting rules only require holders of the paper to mark prices according to the accepted model, not actual prices. For example, below is a chart of the actual BBB minus tranch of the mortgage-backed securities pool from November '06 to present. Actual prices where traders can really buy and sell is substantially lower than where investors are marking their positions.

The levels at which investors are carrying the paper is not reflecting underlying reality as the holders simply hold their collective breath and the rating agencies ignore a worsening environment.

I asked them what would force the rating agencies to change their ratings and the response was “it's just a matter of time if the market continues to deteriorate, for the agencies at some point will be forced by the cumulative losses to acquiesce." Because these losses have been compressed, any re-adjusting of ratings by these agencies are likely to result in a massive repricing of risk.

Comments

[panochia]

Doesn't everyone interested in Economics, already visit Minyanville?

[david]

Does anybody have a decent sense of the overall risk of a CDO mortgage meltdown? I'm a glass totally empty kind of person, and I'd be interested to hear where the downside might bottom out.

[meno]

There's conflict of interest here. But there's also a failure in modelling.

This is a bit like the Amaranth issue, where they were modelling market volatility based on an unweighted look at the last three years of the market, instead of weighting recent trends more heavily. So a large and rapid increase in volatility over a couple of months didn't cause their estimated risk to shoot up.

That's led lots of people to say that VaR measures didn't help Amaranth: actually the answer is that their VaR measures didn't help Amaranth but some more appropriate VaR measures would have.

All the sophisticated computational mathematics in the world won't help if your choice of source data and weighting of data is inappropriate.

[ken]

"...a chart of the actual BBB minus tranch of the mortgage-backed securities pool from November '06 to present. Actual prices where traders can really buy and sell is substantially lower than where investors are marking their positions."

As I understand it less than 10% of the outstanding securities in question are rates below single A.

So what relevance does his chart really have I wonder.

Looking at the other charts in the same series, the ones covering 90% of the market shows that the securities are still trading fairly close to par.

If these proportions are correct then this guy is full of hooey baloney.

[Hal]

Buffett warned about this sort of thing some years back:

http://news.bbc.co.uk/2/hi/business/2817995.stm

[Ian Whitchurch]

Ken,

Your point that "As I understand it less than 10% of the outstanding securities in question are rates below single A." is true, but irrelevant - because the article is essentially about how credit ratings agencies have stuffed up measuring the risks.

The issue under all this is that a bunch of people borrowed money to buy houses and they arent paying that money back. If the messy and expensive business of foreclosing happens, then these houses can only be sold for less than the loans are worth.

This then feeds through the system, up to where people bought a whole lot of these loans with a whole lot of borrowed money, leveraging the risk.

If you are borrowing money at 6% to lend it out at 7, then a 2% default rate puts you underwater.

At the bottom, thats whats happened.

Ian Whitchurch

Ian Whitchurch

[ken]

Ian, so his point is that he knows better than the rating agencies?

But by how much does he know better?

Should the proportions be reversed and less than 10% singe A rated or better and 90% BBB or lower?

Or are the rating agencies only off by two or three percent?

I think the rating agencies have the better argument here. Mr Succo is speculating while the agencies are waiting for hard data.

[Brasky]

Mr. Succo followed up that article by answering an email about some of the same things commented about above.

Check it out if you haven't already by clicking the link in my name.

[Ian Whitchurch]

Ken,

But there is evidence. Two of Bear Stern's CDO funds really did blow up, and a Florida Bank (BankUnited) has, and I quote,

"that non-cash interest income was 74% of all interest income before any interest costs; i.e. 74% of what we generally would define as a company’s revenues did not come in as cash but rather was tagged onto the outstanding balances of the existing loans. "

http://www.minyanville.com/articles/index.php?a=12648

The question you have raised is exactly the right question - what is the correct weighting of the bundles of mortgages held as CDOs.

And as for 'Mr Stucco is speculating', all I have to say to that is ... durrrr.

For crying out loud, he *is* speculator. Being right when the market is wrong is his *job*.

Finally, Ken, you have a potentially profitable opportunity here, if you think the rating agencies are right - vote with your wallet, and go way long on CDOs.

Ian Whitchurch

[Maynard]

Apparently the hedge fund industry has changed drastically since I first started reading about it in the wake of the LTCM crash. Now, it seems hedge funds are just glorified, unregulated investment funds. Back then, they were clever, nimble-footed outfits seeking the quick payoff from mispricing in asset markets. I would've expected a fund like LTCM, recognizing (by late last year at least) that the market was surely understating the risk in CDOs relative to other instruments, to short the hell out of 'em. Why hasn't anyone been doing this? Or have they?

[Ian Whitchurch]

Maynard,

There's a line of thinking that says CDOs are too thin a market to allow direct short-selling.

[Barry]

"Ian, so his point is that he knows better than the rating agencies?

But by how much does he know better? "

Posted by: ken

I'm always amazed by people who read a post whose core theme is 'conflict of interest', but who come away thinking that that theme was 'they're stupid'.

[ken]

'conflict of interest' on the part of the rating agencies?

Geez Barry, that story is as old as the rating agencies themselves. They have always been paid by the party with the most interest in the ratings.

If that is all he was saying then his point in beyond trivial it becomes ridiculously inane. He is lecturing the people who rely on these rating on a subject that they are fully aware of.

Is that all he is saying? It reads to me that he is saying he knows better than the rating agencies on how and when ratings ought to be revised, and that the only reason they are not following his advice is becuase they have a 'conflict of interest'.

I am completely wrong on that? He doesn't seem to concede any room for the agencies to have any legitimate rational for how they make the call on rating revisions.

[Ian Whitchurch]

Ken,

Yes, you are completely wrong on that.

Two Bear Sterns funds just went *boom*. One of them - the apparently healthier one - needed $3.2b in bailout money from Bear Stearns.

Many funds are marking assets similar to those held by these funds "to market" based on rating agencies' ratings.

Which they havent adjusted.

Meaning the funds dont have to adjust their book values.

In the corporate world, there is nothing more dangerous than a gap between reality and the accounts.

And that appears to be just whats happened.

Ian Whitchurch

[Maynard]

Ian,

"There's a line of thinking that says CDOs are too thin a market to allow direct short-selling."

So if you can't go short you should go long?

[Josh]

On the Credit Bureaus, do you know if they are using anything more sophisticated than estimated default rates based on the standard FICO (or related scores -- like Beacon from Equifax)?

The reason this is important is that FICO is built against bankruptcy. It is not built against default, either on credit line or a mortgage.

Also, the models are typically built against 24 months performance window. If you get a odds-table from Equifax today, it tells you the probablity of someone with a given score in June 2005 having a bankruptcy between June 2005 and now.

Josh

[Hal]

Found these comments on the Bloomberg site in a piece written by one of its pundits:

The efforts by Bear Stearns's creditors to extricate themselves from their investments have laid bare one of the derivatives market's dirty little secrets -- prices are mostly generated by a confidence trick.

As long as all of the participants keep a straight face when agreeing on a particular value for a security, that's the price. As soon as someone starts giggling, however, the jig is up, and the bookkeepers might have to confess to a new, lower price.