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The SEVEN "Values" of Toxic Assets FAQ

Interest-Rates / Credit Crisis 2009 Mar 28, 2009 - 06:34 PM GMT

By: Andrew_Butter

Interest-Rates Best Financial Markets Analysis ArticleThe Hiesenburg Uncertainty Principle says the more you know about the weight of something the less you know about how fast it's moving. A toxic asset follows the same principle, which is presumably why investment banks used to hire rocket scientists.


Background:

A toxic asset is a mortgaged backed security (MBS) or a Collateralized Debt Obligation (CDO) that went "toxic", the new politically correct word is "legacy".

They are not much different from loans (or a bunch of loans) except the loans (mortgages mainly) were packaged into "securities" which are standardized so you can trade them; part of that process is that they are "rated" which means that a rating agency calculates the risk of default, typically from AAA (infinitesimally likely - supposedly) to BBB (very unlikely). A CDO is a lot of MBS's packaged the same way all over again like feeding cattle remains back to cattle with the implicit risk of BSE.

The way that you turn a bunch of 100% LTV (loan to value) sub-prime mortgages into AAA is a "waterfall" is created so all the payments from all the loans go to service say 70% of the MBS (that's called the senior tranche) before they can be paid out to the BBB tranche, that's where the word "structured" comes in. So if 30% of the "deadbeats" default then the BBB tranche is toast but the AAA tranche is OK.

Pretty simple, just a bunch of loans all packaged up so you can buy them and sell them easily. But why bother?

First reason, you could get a higher interest payment on a AAA MBS or CDO than on an equivalent AAA US Treasury, but that's not the only reason they were so popular (although perhaps it was a good reason to smell a rat - too good to be true is sadly, often just that).

There was a demand for credit in the private sector that needed supply, but there were limits on capital to underwrite the demand. But because they could be traded a MBS or a COD could be used almost like cash or US Treasuries when calculating capital adequacy, re-packaging the loans into "instruments" provided a mechanism to meet the demand for credit without a commensurate increase in capital.

A loan you make to someone is considered an asset on the balance sheet, because you believe that some time in the future that money will be paid back. But it's not liquid, so if all your depositors turn up one day and ask for their money back, you can't go out to the people that you lent money to and say, "Sorry mate I want my money back or I'll break your legs (it's not legal)".

With a MBS or a CDO you can theoretically go out in the market and sell them, like Treasuries or Gold, so their value in determining capital adequacy is much more.

Which means you can lend more money for a certain amount of capital, and so long as you get paid back more than you loan you can make a higher return on capital; that was the incentive.

What's complicated is that these "instruments" can have SEVEN values (all at the same time).

1: What you paid for it if you bought one ( Book ). This if often how assets are valued when "held for investment", and some of that can be "off balance sheet" since you don't know how much you will get for your investment when you come to sell it - it's like at the time of the audit the wheel is still spinning (and sometimes you don't want to know).

2: What someone might pay for it today ( Fair Value by mark-to-market (always) or Market Value under International Valuation Standards (IVS) (so long as the market was working (the technical word is not in "disequilibrium"), i.e. sometimes).

3: What someone says they might pay today in principle ( mark-to-quote , that sounds stupid but it's how the toxic assets sold by AIG under the Maiden Lane Program of TARP were valued, (Maiden Lane by the way is a street in Washington, and in case you care AIG got screwed).

4: What someone would pay whenever there are buyers in the market ( other-than-market-value worked out under International Valuation Standards). This value is EXACTLY the same as (2) when the market is working.

An important point is that when the market is NOT working the other-than-market-value can be a lot more (in a slump like now) or a lot less (in a bubble like in 2006), than mark-to-market. Which is why IVS as a method of valuation is counter-cyclical (although it is not used) and the methods of valuation under US GAAP and IFRS are pro-cyclical (which explains how we got in the mess in the first place and why it's taking so much time to get out of it).

The big advantage of using mark-to-market (2) is it's cheap and quick. But a bond market is not like a stock market and most transactions are (were) over the counter (OTC), and transactions are infrequent, so you have to rely on people who research the market for prices (like housing for example), and so it was always debatable how reliable the "market" actually was.

But working out "other-than-market-value" is expensive and it takes time because every component needs to be based on market-derived data. Doing a proper "other-than-market" valuation of a CDO is extraordinarily complicated (therefore expensive).

5: What you could get if all the borrowers jingle-mailed and you took hold of the collateral; that's the "Value" part of the LTV that the ratings agency uses to work out the rating; typically for AAA you need the LTV to be 70% if it goes up they down-grade your MBS or your CDO which means it gets to be worth a lot less.

Rating agencies also specify the Debt Service Coverage Ratio (DSCR) threshold, so if for example borrowers start paying late this can also affect the rating. LTV and DSCR are monitored by the service provider that looks after the administration of the loans, and they report what's going on to the rating agency.

6: What the owner of the bond thinks it ought to be worth based on his model - ( mark to model; theoretically this should be the same as (4) and when the market is working (2) except that it is an internal model not an external independent valuation).

7: As a normal loan would be valued; hold-to-maturity this is book less an assessment of "impairment", (an estimate of how much of the loan plus interest will eventually get paid).

The "problem" is that ALL seven values are correct, but they can easily be completely different, so the value can change completely depending on the purpose of the valuation.

The "problem" facing (many) banks now is (mainly) the way that capital adequacy is calculated.

Working out capital adequacy is complex, there are rules set by banking regulators and auditors check that you followed the rules (and they got rules too and in general if they are smarting from a recent mistake (like for example signing of a bank as a going concern when three months later it turned out it wasn't), they tend to apply the rules rather "un-creatively").

Like I said, capital adequacy is an important number for a bank because the more you can loan with less capital the better your returns on capital, so long as the loans don't go bad.

That's why there is this confusion about mark-to-market.

If you value your toxic assets as held-to-maturity (7) or other-than-market-value (4) then theoretically you might be solvent, i.e. your assets are more than your liabilities. But if you value them mark-to-market (2) when the market is stalled, then theoretically you are insolvent (assets are less than liabilities - which means that legally you are not allowed to do business), but if you don't value them mark-to-market you can't say they are liquid so your capital adequacy is shot, which also means that you are not allowed to do business. It's called being between a rock and a hard place.

And when people who have loaned you money or depositors find out that you are at risk of not being allowed to do business, they start a mad scramble to get their money back. And when the market finds that out they, sell you short.

What just happened?

Housing prices went down and so a (relatively small) proportion of home-owners defaulted, so the BBB tranche of MBS and CDO's that contained those, became worthless.

This was compounded by the fact that the fall in house prices and the effect that this had on the financial system, caused the economy to tank, which increased the numbers of loans that defaulted in double negative feedback loop (http://www.marketoracle.co.uk/Article6811.html).

But that wasn't the main problem.

Until everyone was (is) clear about how many of those AAA bonds will default (the BBB tranches are toast already), no one wanted to own one, so the market dried up completely.

So suddenly the banks were technically either insolvent or their capital adequacy was shot (generally not both, once both are shot it's game over).

The solution (apart from doing the "Fail" part of "Too Big To Fail"), was either the government (a) buys those toxic assets at their "hold to maturity" value (i.e. exchanging them for something liquid - i.e. cash), or (b) injects capital into the banks.

The initial idea under TARP was to do (a), but there was a problem, the government was a bit wary of buying something for say 80 cents on the dollar (a reasonable fire-sale discount for a AAA which theoretically might have been worth 100 cents if valued like a loan), but that was trading in the market-place at 20 cents on the dollar.

Governments traditionally pay too much for everything, for example $30,000 for screwdrivers, and $700 billion and counting to find out there were no WMB in Iraq (I could have told them that for free), or according to the latest "spin", to take out Saddam Hussein (I would have done that for free too).

But it was cheaper to just put in capital, plus it was more popular in that (a) it gave the government some control and (b) even more popular it gave the government a stick to beat the bad boys with (witness AIG).

And there is no doubt that some of them have been VERY BAD BOYS, although as with all forms of collective punishment, the bad boys were typically not the ones who got spanked in the end - those were the ones left with the thankless task of trying to clear up the mess left behind from the bad boys (and girls too (but mainly boys)).

Which is why as Tyler Durden pointed out USA is now on track to having one chimpanzee and a janitor in charge of an ex-CIS nuclear power station located in Lower Manhattan, that was perhaps not smart, it certainly dwarfs the threat from Iran .

Geithner's Plan

Giethner's plan is like TARP except that (a) it is trying to get over the issue of what is paid by bringing in "professionals" and (b) it realizes that there are limits to how much money you can print to throw at this problem.

As some people pointed out in September (for example http://www.marketoracle.co.uk/Article6451.html), the government simply does not have the capability to price those bonds. Sure you can hire a consultant, but that's expensive, slow, and not foolproof, it was obvious from the start that the TARP plan to buy up those assets was never going to happen, and it didn't.

To put a proper price on a toxic asset someone (preferably at least two someone's), needs to work out for each one, most of the seven values. Then someone who knows what he is doing needs to decide, OK this is the price that I am prepared to pay. The market is not some magic casino where price is "discovered" out of thin air, behind every decision someone who knows has done a valuation, and price is discovered when a lot of someone's agree on the valuation, which is what has to happen before there is a transaction.

The only way to get that done cleanly and transparently is to bring in people who do that sort of thing every day of the week, like PIMCO, and the only way to bring people like that to the table is a carrot (sticks don't work).

So in that regard, Secretary Geithner's plan makes complete sense. But the problem is simply will the banks sell at the price anyone wants to buy?

Fortunately the best part of the plan is that it might not happen at all!

The virtue of forebearance

If you owe someone $100,000 then you got a problem, if you owe them $100 Million, they got a problem.

A bad time to get bad-tempered and aggressive with people who owe you money, is when they haven't got any. A little bit of "forebearance" at such times can go a long way (and quite often gets you to the front of the line when (if) they make it out of their hole).

The "New Deal" wasn't what fixed the Great Depression, it was more of a social program to help the destitute (and avoid riots); a better example of a successful Keynes style strategy was the Golden Years of Germany (1923 to 1929).

The Great Depression was healed (finally) by "foreberance", so was the South American induced banking crisis, the S&L and the Asian crisis.

I suspect that's what the "Stress Tests" are all about. What those will do is provide a mechanism for the banks to de-facto "suspend" mark-to-market rules insofar as they apply to assessing capital adequacy, with the guarantee against default being provided instead by the government (which is de facto what is happening now anyway).

Fix that and value will look after itself, not before.

By Andrew Butter

Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( hbutter@eim.ae ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.

© 2009 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

Andrew Butter Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


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