[DEBATE] : The tea-leaf approach to pricing securities By Floyd Norris/Friday,

[Riaz K. Tayob]

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 
leaves.

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 
fewer problems.

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