Monday, November 5, 2007

Valuing CDOs – The Problem and the Consequences

It is appears that the mathematical models used to value CDOs that are thinly traded is the primary cause of the losses at the large banks and investment banks. These are not excuses, because one has to understand to source of the problem to understand the extent of the problem. Computer models that value assets usually don’t work all that well. Been there done that. Text in bold is my emphasis. From the WSJ:

When the market for mortgage securities entered a meltdown over the summer, financial firms holding billions of dollars of hard-to-trade assets used mathematical pricing models that were heavily dependent on credit ratings. When the credit-rating firms began a massive downgrade campaign last month, firms such as Citigroup Inc. and Merrill Lynch & Co. saw the value of their holdings plummet.

Citigroup's struggles to put an exact number on its losses demonstrate just how fallible the models can be, and how serious the consequences. Last night, Citigroup said that the downgrades will result in a reduction of fourth-quarter net income of $5 billion to $7 billion. That follows a third quarter when Citigroup recorded mortgage-related write-downs of $2.2 billion, including losses on subprime securities and fixed-income trading. . . .

That made the bank highly vulnerable when, in October, ratings firms Moody's Investors Service and Standard & Poor's slashed, or put on watch for downgrade, the ratings on tens of billions of dollars in securities.

It is unlikely that Citigroup is alone. Ratings play a big role in valuation models used by many banks, investment funds and insurance companies. Meanwhile, the market for securities linked to subprime loans has deteriorated in recent weeks as defaults have confirmed some of analysts' most dire forecasts, increasing the likelihood of further ratings downgrades.

Citigroup's subprime exposure -- and source of its problems -- is found in two big buckets that together total $55 billion in its securities and banking unit, the bank said. The first bucket totals $11.7 billion, including securities tied to subprime loans that were being held, or warehoused, until they could be added to debt pools for investors. The second, totaling $43 billion, covers so-called super-senior securities.

These highly rated super-senior securities are portions of collateralized debt obligations, or CDOs. CDOs are repackaged pools of lower-rated securities backed by subprime loans into pieces with different levels of risk and return. Analysts estimate that $60 billion in such super-senior tranches are sitting on the books of banks, insurers and investment funds.

The troubles stem back to the heyday of the U.S. housing boom, when Citi became one of the biggest players in the lucrative world of CDOs backed by subprime-linked bonds. Overall, Citi was the second-largest underwriter of CDOs in 2006, doing $34 billion in deals, according to data provider Dealogic.

As a result, Citi's holdings of subprime exposures varies from the actual loans to the most highly rated slices of CDOs, the bank said. They include securities the bank had warehoused to later package into CDOs, extended to the super-senior tranches of CDOs that Citi helped create. Banks often kept the super-senior pieces of CDOs, because their low returns made them unattractive to investors despite their extremely high ratings.

When trading in the subprime-linked securities all but dried up amid this summer's credit-market turmoil, Citigroup and other banks suddenly faced the difficult task of putting a value on securities that investors no longer wanted to trade.

For lack of any market pricing, Citigroup used credit ratings as a key input in figuring out the value of the future payments it expected to receive on the securities, according to a person familiar with the bank's valuation models. For example, in valuing the payments on pieces of subprime-backed CDOs with the highest triple-A rating, the bank would look to how the market was valuing payments on corporate bonds with the same rating.

"In general, the industry-standard model for pricing CDOs is not adequate in my view, which means that there's a lot of uncertainty about what they are worth," says Darrell Duffie, a finance professor at Stanford University's business school. "They can get better models but that's not something they can do overnight."

The problem with the ratings-based approach was that it ignored a key difference between corporate bonds and subprime-backed bonds: Defaults on the latter were growing at a fast rate, which would likely lead to ratings downgrades.

The downgrades began in earnest Oct. 11 when, in a little-noticed announcement, Moody's Investors Service said it had slashed credit ratings on about 2,000 bonds backed by subprime home loans that originally carried a total value of $33.4 billion. It also flagged bigger problems ahead, saying that 502 CDOs had direct exposure to the mortgage securities that had been downgraded.

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