Feature Stories | Jul 04 2007
By Greg Peel
The collapse of US energy giant Enron in 2002 exposed a tangled web of corporate fraud, insider trading, influence peddling, obstruction of justice, and tax evasion. But it also exposed the remarkable fact that Enron was allowed to get away with a method of asset valuation that captured future earnings today. While this is exactly the means the market uses to value listed stocks, the balance sheets of listed companies do not account for what hasn’t yet been earned. That is why a company with earnings potential, as well as earnings in the bank, trades at a premium to its book value.
Enron nevertheless was permitted to use this future earnings model to evaluate asset prices and thus to book profits. So complex were some of Enron’s derivative transactions and company consolidations that it seemed no one was in much of a position to argue. Enron was thus left to revalue its own assets by its own method. It is no great surprise that massive profits duly booked never actually existed. It was inevitable that Enron would ultimately collapse.
There is no suggestion that the US sub-prime mortgage crisis is about to expose a similar web of fraud and deceit. However, there is a not-so-vague connection between the fact that Enron was left to value its own assets, and the valuation methods used for positions in collateralised debt obligations (CDOs). CDOs might be grouped under one asset class on a nominal basis, but the truth is that rarely are two CDOs exactly the same. Indeed they are more akin to snowflakes. Under SEC regulation CDO positions are required to be “marked to market”, but in reality there is virtually no particular opportunity to do so.
If you buy shares in a company for $5.00 and they fall to $4.00, you might be the sort of investor who likes to kid himself they’ll no doubt return to $5.00 and as such don’t yet consider you have made a loss. If forced by accounting standards, however, to mark the value of your asset to market at the end of an accounting period, then the inevitable must be faced. The price of your shares is a known value by virtue of its homogenous, transparent trade on the stock market. You have lost $1.00 in value whether you like it or not, irrespective of whether you have sold the shares.
BHP Billiton and Rio Tinto might be often considered in the same breath, given they are very similarly large diversified mining companies. But that’s where the similarity ends. Both boast differing portfolios of mining operations across the commodity spectrum, with some degree of homogeneity but also sufficient diversification to ensure that they trade at different share prices and sometimes even move in different directions. They might be in the same sector, but really they are an apple and an orange.
CDOs are assets which package up various debt instruments and rearrange them into three tranches of risk level from AAA to BBB or less. The lower the rating of the tranche, the higher the yield. Sub-prime mortgages are popular constituents of the third tranche of many CDOs. But virtually every CDO created is unique in its composition. Indeed some CDOs even include investments in other CDOs. They are highly complex instruments for which even their creators have difficulty in the mathematics behind finding a price.
But find a price they must, both at initial sale and at the end of a given accounting period, according to SEC requirements. The buyer is obliged to do the same. CDO positions are supposed to be marked to market. The problem, however, is that a “market” doesn’t necessarily exist. As assets, CDOs were created to be bought and then held to maturity – typically three to five years. Unlike shares or corporate bonds, for example, they were not designed specifically to change hands, and thus hardly ever do. There is no listed market for CDOs, hence no publicly listed price. If ever they do change hands no one legally has to know about it.
Marked to market? What market?
In order to satisfy SEC requirements investors in CDOs, such as hedge funds, find different ways to price their assets at the end of an accounting period. Most popularly they are “marked to model”. This implies that relevant variables are plugged into a complex computer algorithm that then spits out a supposedly appropriate price. While some asset holders may simply implement their own modelling, others more keen to satisfy the spirit of the SEC regulation will canvass other CDO holders, brokers, or even the original issuer in order to arrive at some sort of market consensus on price. While laudable in intent, the problem with this methodology is that it would be hard to find anyone who doesn’t have a vested interest in the assets being revalued at the best possible price. The risk is that CDOs will always be on the books at a value that never really comes close to the price that may be achieved if sold. Exacerbating the situation is that fund managers tend to be remunerated based on their performance over an accounting period. If no one has a particular means of verifying the value of a particular CDO, why would a fund manager be inclined to mark down their value?
Which brings us to the Enron connection. For some strange reason, largely related to the complexity of the assets created, Enron was able to use its own accounting models to value the company. Not only did Enron err on the side of overstating value, it quite simply booked vast profits that never existed. Suffice to say, Enron is no longer with us.
Late last month the head of financial stability at France’s central bank travelled to the US to assess the sub-prime mortgage situation first hand, the Financial Times reports. While it seemed that the sub-prime crisis might be a US-only phenomenon, Imene Rahmouni-Rousseau suspected, rightly, that there may be links to European investors. Thus on behalf of the Banque de France she wanted to get a handle on the risks involved. What she found was “Pricing data are difficult to obtain”.
But June did actually provide a real opportunity to put a price on CDOs when two Bear Stearns hedge funds found themselves in difficulty and the funds’ lenders, such as Merrill Lynch, went looking for buyers of the assets. What Merrills found might be considered the shocking truth.
The FT’s Saskia Scholtes and Gillian Tett noted last week:
“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 [US]$1,000 billion 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.”
Last week a London-based hedge fund called the Queen’s Walk Fund admitted it had written down the value of its US sub-prime securities by 50% in just a few months because when it was forced to sell them the price achieved was far less than its models had assumed. Queen’s Walk had used broker quotes to arrive at a valuation.
Last Wednesday Merrill Lynch reputedly attempted to sell US$850 million of collateral assets seized from the Bear Stearns hedge funds but managed only to sell US$100 million. Nobody outside the deal knows what price was achieved. However, rumours have it that both Lehman Bros and Credit Suisse held similar auctions before Bear Stearns stepped in to provide at least a partial bail-out of its funds and, again, achieved only half the face value.
Bloomberg suggests that there are US$1 trillion in CDOs in the market of which some US$800 billion are backed by sub-prime mortgages. These assets are not just held by risk tolerant hedge funds, but by banks, insurance companies and pension funds.
The implication is thus that US$800 billion of securities in the market are really only worth US$400 billion today, and that’s before any major selling is attempted. Given that the sub-prime pricing effect is likely to precipitate up the scale into the more highly rated securities within CDOs, US$1 trillion must be cut down to size. And that’s just the CDOs. A re-rating of all debt instruments on the lower end of the credit rating scale must surely be a strong possibility.
So why hasn’t this happened? The Bear Stearns crisis is now two weeks old, yet despite an initial scare other asset markets, such as the US stock market, appear to have shrugged off the problem.
The answer lies very much in a matter of time.
While all this talk of hedge funds, CDOs and asset pricing models seems like some parallel universe of high finance to the average Joe, it is the average Joe who is largely the root of the problem (albeit with plenty of encouragement).
The US housing market has been in a severe state of recession for many months. In fact, according to the US National Association of Realtors, the national median home sale price is poised for its first annual drop since the Great Depression. But boom times preceded the housing slump, as is always the case. In such an environment, average Joe saw an opportunity to buy a bigger, better house than had previously believed be could afford. And mortgage lenders, awash with liquidity and stinging from a need to write more and more business, were happy to lend Joe the money despite the fact he had a pretty poor credit record. Joe signed up for a sub-prime mortgage.
It was always going to be a struggle for Joe to meet the interest payments, even though he had a full-time job. But he was safe in the knowledge that were he forced to sell, he would no doubt sell at a better price. Unfortunately Joe’s luck run out. And when he did attempt to sell his home, he couldn’t even get the price he paid for it. He could no longer make the mortgage payments, but he couldn’t afford to sell either.
It is standard practice in the US that a homeowner may be delinquent on mortgage payments for three months before foreclosure proceedings begin, notes Bloomberg’s Mark Pittman. Even then a foreclosure will be slowed down if the borrower files for bankruptcy or appeals against eviction. Only when the house has been sold do mortgage lenders actually write down the value. The holders of securitised mortgages (such as CDOs) will only see a loss if the price achieved on sale is less than the collateral behind the security.
Hence, there is a good deal of time between Joe missing a mortgage payment and sub-prime security holders seeing a devaluation. Even then, the extent of the fall in value of the security will not be truly known until it is sold. Or perhaps until a hedge fund somewhere goes under when the CDOs it’s holding are hit by mass delinquency.
Pittman reports Lehman Bros Holdings Inc – the biggest underwriter of mortgage bonds – sold US$2.43 billion of Structures Asset Investment Loan Trust bonds to investors a year ago. In January, a US$18 million portion of the bonds rated BBB (sub-prime) fell to 43 cents in the dollar from 98 cents. More than 15% of the mortgages in the securities are at least 60 days delinquent and 8% are in foreclosure. Ratings agencies Moody’s and Standard & Poors both say they are considering downgrading the debt.
Which brings us to the next problem.
In order to to sell CDO’s to investors, particularly balanced investors such as pension funds, issuers need to have their instruments rated by an acknowledged agency such as Moody’s, S&P or Fitch. Despite the sub-prime mortgage crisis, which actually began in February, few ratings downgrades have yet occurred. The problem is that ratings agencies don’t operate like that.
Ratings agencies are not in the business of pre-empting changes in circumstance that would affect changes in the rating of a financial instrument. They respond only after the fact. Hence there will be no major de-rating in the mortgage security market until foreclosure sales show that the collateral backing the securities has declined sufficiently in value to create actual, rather than anecdotal, losses. In other words, Moody’s S&P and Fitch will not move until Joe’s house has been sold at a loss. Between them, the agencies rate US$6.65 trillion of mortgage-backed debt across the scale from sub-prime to prime.
The mortgage market wheels take a very long time to turn.
Were the ratings agencies to be forced to begin marking down the ratings on various securities, investment vehicles such as pension funds will be duty bound by their own constitutions to reduce exposure. Masses of losses will ensue. And the longer it takes the worse the situation will likely become.
Pittman notes a total of 11% of the loan collateral for all sub-prime mortgage bonds had payments at least 90 days late, were in foreclosure or had the underlying property seized, according to a June 1 report by Friedman, Billings, Ramsey Group Inc., a securities firm in Arlington, Virginia. In May 2005, that amount was 5.4 %. Hence investors may be holding riskier mortgage-backed securities than their ratings indicate. And they may have borrowed money in order to invest in the first place.
What’s more, creators of CDOs aren’t obliged to disclose the contents of their holdings to the SEC and may even change the make up after those securities are sold.
There are just too many unknowns in the CDO market. The biggest unknown is price. And the rest of the debt market is beginning to respond. In the past two weeks at least US$3 billion of planned corporate bond sales have been cancelled. US Treasuries have again found favour following a violent sell-off (when the ten-year yield jumped over 5%) as worried investors are shifting into safe haven debt. Mortgage bonds represent the world’s biggest debt market.
Credit Suisse’s Rob Dubitsky notes the three ratings agencies have to date downgraded only 1.3% of BBB mortgage bonds. He suggests 80% of the balance will eventually follow. “We’re talking about massive, massive downgrades here”.
Rob Peebles, of PrudentBear.com, describes sub-prime mortgage securities as “pigs with lipstick”. As we speak, there is many a hedge fund manager out there trying to offload what are ostensibly pigs, but hoping to get more than what a pig is really worth. To do this they are applying lipstick, because clearly a pig with lipstick must be worth more. But I’ll leave the last word to the FT’s Scholtes and Tett:
“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 sub-prime sector but in other illiquid markets too.
“”If every CDO [manager] was forced to mark to market their sub-prime holdings, it would be. … Well, I can’t think of a strong enough word to describe what it would be,’ confesses a US policymaker.”
