CDOs: Mark-to-Model and Donner-Party Economics
Saskia Scholtes and Gillian Tett of FT on mark-to-model:
Saskia Scholtes and Gillian Tett of FT: As head of the financial stability unit at the Banque de France, Imène Rahmouni-Rousseau travelled to America this month to look at the current turmoil in the US subprime mortgage world. Although initially that had seemed an all-American saga, Ms Rahmouni suspected that French and other European investors also held assets linked to subprime securities. So on behalf of her central bank she wanted to assess the risks. What she discovered surprised her. There was little confidence about how to value the holdings. “Pricing data are difficult to obtain,” she says. It is a discovery being shared by numerous other policymakers and investors around the world as the fallout widens from a subprime lending boom, in which US banks provided vast amounts in home loans to financially stretched borrowers who put little money down and gave no proof of income. Among the casualties have been two hedge funds run by Bear Stearns, the Wall Street investment bank.
Until recently, when late payments and defaults on these mortgages spiked higher, the problem drew little attention. This was because, through the magic of so-called structured finance, risky assets such as subprime mortgages could be packaged into attractive investment products. These elaborately constructed securities, called collateralised debt obligations (CDOs), are designed to yield juicy returns while also carrying high credit ratings. They have proved popular with hedge funds as well as with longer-term investors such as pension funds and insurance companies, many of which have bought billions of dollars of such securities in recent years – thus providing the liquidity that was then channelled into mortgage loans.
But heavy losses incurred at the two Bear Stearns hedge funds as a result of such financial haute couture have prompted fears that the CDO emperor may turn out to have no clothes. Such a revelation could threaten the value of investor portfolios around the globe – not just in the mortgage sector but in the way many sorts of company fund themselves. This is because unlike stocks listed on an exchange or US Treasury bonds, CDOs are rarely traded. Indeed, a distinct irony of the 21st-century financial world is that, while many bankers hail them as the epitome of modern capitalism, many of these new-fangled instruments have never been priced through market trading.
Instead, products such as CDOs, which are designed to be held until they mature, have often been valued in investor portfolios or on the books of investment banks according to complex mathematical models and other non-market techniques. In addition, fund managers and bankers often have broad discretion as to what kind of model they use – and thus what value is attached to their assets.
So when Wall Street creditors last week threatened fire sales of CDOs seized from the stricken Bear Stearns funds, thus creating a market price for them for the first time, they also threatened to create a wider shock for the system. Fire sales rarely realise anything close to the previously expected value of assets. But if these deals went ahead, they would provide a legitimate trading level that would challenge current portfolio valuations.
In the event, Bear Stearns’ creditors sold only a fraction of the assets put up for auction. Market participants suggest that this was in part because bids fell far below expectations, with traders increasingly reluctant to take on CDOs tainted with subprime exposure. But the crisis at Bear’s funds has left investors, brokers and regulators asking an uncomfortable question: can the pricing models that have provided the foundations for this new financial edifice really be trusted? Or will valuations turn out to be over-optimistic and result in further investor losses? “Investors are slightly more cautious, becoming more picky and asking more questions,” says Michael Ridley, co-head of high-grade debt capital markets at JPMorgan. “They want us to lift the lid off the box a bit more.”
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.
These assets do have finite lifetimes. Unless nominal asset values crash over the next five years, CMOs and CDOs held for the next five years until maturity will pay off at or close to their model value. Only those with faulty capital structures who are thus illiquid today are in trouble, and they aren't in big trouble unless the numbers of those willing, rich, liquid enough to take on the risk of holding more CDOs and CMOs and with the analytical capability to price them are small.
As long as underlying asset values don't collapse, this is a redistribution: those hedge and other funds leveraged and without liquidity lose big, and those hedge and other funds that are liquid gain big. The caravan moves on, and the returns of those who make it down the California side of Donner Pass look very impressive, with the flesh-stripped bones of the illiquid and their investors scattered near Donner Lake for future archeologists to examine.