Sunday, November 4, 2007

This Weekend’s Contemplation - The Uncertainty About CDOs Needs To Be Reduced

The problem in the markets that have debt instruments backed by mortgages is one of uncertainty. The general market does not know how big the CDO market is, who holds what, the extent of the losses, etc. Maybe it is time to come clean with some of this, if not with the general market (general public), then definitely with the Fed. Somebody needs to know where we are at. Text in bold is my emphasis. From the WSJ:

Now we're talking real money. Deutsche Bank's Mike Mayo reckons Merrill Lynch could face as much as $10 billion in additional write-downs on collateralized debt obligations, subprime-mortgage bonds and the like. That's on top of the $8.4 billion that helped trigger the ouster of former Chief Executive Stan O'Neal.

Combined with a report that some Merrill transactions might have attracted scrutiny from regulators, that sent the Thundering Herd's stock tumbling toward two-year lows. Others are suffering, too. Shares in Barclays and Citigroup, two other big players in CDOs, have suffered heavy declines in recent days, not to mention the stock of bond insurers such as Ambac Financial that also have CDO exposure.

But it's not just talk of further write-downs that is fueling the latest bout of fear and caution in the markets. The real driver is uncertainty. Financial institutions have been wary of disclosing much about their exposure to these wilting securities. And investors have developed a healthy distrust of any numbers they are given. It's a fragile, even dangerous, situation.

How did we get here? Well, Wall Street developed a voracious appetite for packaging home loans -- made to increasingly stretched borrowers -- into complex debt securities for sale to investors. When the credit crunch hit over the summer, it became clear that while bankers were adept at constructing and selling these vehicles, they weren't actually any good at valuing them. Suddenly, some mortgage bonds and CDOs were almost impossible to sell -- at least at the prices their creators thought they should be worth.

Hence Merrill's staggering losses on the instruments. They were much bigger than the firm's own experts originally expected. The discrepancy probably stemmed from the use of computer models to value them -- the only way to price them if there's no trading. A cheerier set of assumptions -- most bankers' instinctive preference -- will make models spit out higher values than a gloomier scenario.

So what's to be done?


The banks could just muddle on. But that would mean waiting another couple of months for the next update on where Wall Street firms stand. Meanwhile, credit markets could remain mired in fear and confusion. Moreover, the pain from recent shoddy mortgage lending might not be over for another year or two.


At the other extreme, the banks could simply write their subprime-related CDO holdings off altogether asTetragon, a Guernsey-based investment fund, just did -- albeit on a very small scale. Then, any value that materializes later is gravy. The trouble with this, of course, is that some institutions might look very shaky indeed if they have to write down billions, or tens of billions, more. It's hard to see how this could be done without at least the potential for a bailout, if it were needed.


The third option is for these firms to come clean. If they set out in more detail the exposures they are struggling to value, it would reduce the uncertainty of what is out there. It wouldn't necessarily mean the securities could be valued definitively, but at least investors would be able to assess the holdings, and discover which firms were using more and less conservative valuation assumptions.

That could soon bring about a market consensus valuation, which itself might help a measure of price stability return. It might even kick-start the nascent market for trading distressed mortgage bonds and CDOs, further improving liquidity.

None of these possibilities is particularly attractive, though the last could be the most practical way to start exorcising the demons. Oddly enough, having taken more heat than most and reacted a bit clumsily, Merrill might now be best placed to lead the way. There's no incumbent CEO who might want to avoid the blame. And any new boss should want to start with the assurance that all the bad news is out.

No comments:

Post a Comment