25 June 2007

naked capitalism

naked capitalism: "We had wanted to write about the role of models and more important, model assumptions in the ongoing Bear Stearns hedge fund debacle, and Gretchen Morgenson of the New York Times, in her story, 'When Models Misbehave,' provided some useful intelligence.

With all due respect to Morgenson, while she touches on some dimensions of the problem, she doesn't begin to capture how woefully inadequate the risk management and risk modeling processes are that are apparently standard practice on Wall Street for collateralized debt obligations, which has been a rapidly growing market in recent years. And the worst is these shortcomings have been in plain view."

Let's start with Morgenson:

First, marking illiquid securities to a model that makes certain assumptions about their future behavior is not the same thing as marking to an honest-to-goodness market of buyers and sellers...

In worst-case scenarios, such models may reflect the fantasy that a firm’s principals prefer, not the reality of a security’s likely value. And yet, investors and financial firms everywhere are relying heavily on these models and building their balance sheets accordingly — a very dangerous game, especially when it comes to complex pools of securities backed by assets like home loans.

What does this mean in cold, hard cash? On a conference call with clients on Thursday, a Credit Suisse analyst estimated that the markdowns would likely be in the billions of dollars.

That brings us to our second lesson, which is another blinding glimpse of the obvious emerging from this debacle: the rating agencies, which investors rely on to be prescient cops on the beat, are stunningly behind on downgrading mortgage-backed securities and the pools that own them. Do the math: Bear Stearns is paying $3.2 billion to shore up a fund that once had $10 billion in value, according to one investor. That’s 32 cents on the dollar.

THE portfolio wasn’t just made up of toxic stuff, either. While 60 percent of the fund was invested in residential mortgages, 40 percent was in commercial loans. Moreover, 90 percent of the fund consisted of securities with AA or AAA ratings, according to the investor.

Officials at ratings agencies have said in the past that their ratings reflect their estimates of future performance, not market pricing. So the agencies are also marking to model. And that keeps people playing the fantasy game about values, especially in hard-to-analyze collateralized debt obligations that are essentially pools of other asset-backed securities. Some $1 trillion of C.D.O.’s have been issued. (Yep, C.D.O.’s were in the troubled Bear funds.)

“The C.D.O. sector is still extremely rich versus where the underlying collateral is trading,” said Albert Sohn of Credit Suisse on the conference call. “Either subprime has to get richer or C.D.O.’s have to get cheaper.”

I hate to sound like I am picking on Morgenson, who is a fine journalist, but market arcana is not her beat. There is enough wrong with this piece so as to make it somewhat misleading, and almost all of it is in the direction of making the situation sound better than it is.

Morgenson is right that marking to model is problematic, but she only skims the surface of how detached from reality the CDO assumptions, developed by the ratings agencies, are. This post from Minyanville give a much clearer picture:

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.

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