[DEBATE] : The tea-leaf approach to pricing securities By Floyd Norris/Friday,
Riaz K. Tayob
riazt at iafrica.com
Sat Nov 10 11:07:05 GMT 2007
The tea-leaf approach to pricing securities By Floyd Norris/Friday,
November 9, 2007
NEW YORK: Mark-to-market accounting is one of those ideas that sounds
brilliant until you try to do it when there is no market. That's where
mark-to-model comes in: Companies say things are worth what they ought
to be worth.
But as Wall Street's credit crunch has worsened, even mark-to-model
seems to be too generous a term. Mark-to-muddle may be closer to reality.
Consider Citigroup, which says it may report a loss of $8 billion to $11
billion on a portfolio of $43 billion in "super-senior" securities from
those esoteric things called collateralized debt obligations, or CDOs.
Those are securities that Citi evidently saw as being of little or no
concern only months ago. Now up to a quarter of their value may be gone.
Is that number too high or too low? Who can know? There is no market for
these securities, and not nearly enough public information available to
create one. The only companies in a position to really understand the
paper are the ones that manufactured it - that is to say, Citi and
perhaps some of its competitors. None of them want any more of the
paper, so there are no informed buyers around.
Without a market, where did those numbers come from? Citi has disclosed
something about that, and it sounds every bit as reliable as reading tea
First, you should understand the securities themselves. The underlying
source of payment is subprime mortgages, and that is a market where the
outlook keeps getting worse. But these securities are "super-senior" and
will not suffer unless losses grow to extreme levels that wipe out the
value of junior securities backed by the same loans. The losses are not
that high yet, or even close to that level, but fear is rising.
So how can we estimate what the market price would be if there were a
market? First, Citigroup thought it needed to estimate how much money
the securities would eventually bring in. To make that estimate, it had
to guess what would happen to housing prices. Then it had to decide how
risky the forecast was and pick an interest rate at which to discount
the estimates. The riskier it is, the higher the rate it should choose
and the bigger the loss it should take.
The only actual market price Citigroup looked to came from what are
called the ABX indexes, which do trade. Investors can use them to buy
protection from defaults on mortgage-backed securities, and they are
trading as if real estate prices are likely to plunge and defaults soar.
Is that a reasonable estimate, or a reflection of panic? Or both?
There is a temptation to think the bank's write-offs are too high, given
that they were announced just as Chuck Prince was being forced to walk
the plank and step down as chief executive. Taking a big hit when the
old guy leaves is a traditional way to make the new guy's tenure look
better. But there is no way to be sure.
This is no way to run a financial system. It is obvious that no one -
not boards or chief executives or Wall Street analysts - appreciated how
big the risks were that were producing the extraordinary returns that
Wall Street enjoyed until the music stopped.
Now the boards are firing the chief executives, and the analysts have
flipped from Polyannas to Cassandras.
For companies, that can get downright agonizing. This week Ambac, which
has written insurance to protect investors in some CDOs, fired back. It
said a report by Ken Zerbe, a Morgan Stanley analyst, was too
pessimistic. The report's flavor was captured in its title, "On the
Knife's Edge: Can the Financial Guaranty Industry Survive?" His answer:
maybe. Zerbe acknowledged that he had been too optimistic in the past.
One of Ambac's complaints was that Zerbe did not give it enough credit
for having insured not just paper based on the mortgages going bad - the
ones written in 2006 and 2007 - but on the earlier pools that have shown
Unfortunately, even as the chief executive of another financial insurer,
Dominic Frederico of Assured Guaranty, was complaining about "the
hysteria of the market," analysts were studying the latest reports of
subprime mortgage pools and finding significant increases in
delinquencies and foreclosures from 2004 and 2005 loans. Perhaps the
difference is not that those loans were better, only that the problems
took longer to surface.
Since the end of May, financial stocks are down 20 percent or more,
while most other stocks have held their own. At some point, financial
stock valuations will fall so far that prices are ridiculously low.
Maybe that has already happened, but it takes a lot of nerve to place
that wager when it is so clear that the companies themselves are only
beginning to understand the foolish risks they took. © 2007 The
International Herald Tribune
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