Toxic Assets: The Challenge

For more than two years we have watched all sources of information in the discussion about the valuation of illiquid assets.

Unlike most of the people participating in this debate, we did not start with an opinion. We arrived at conclusions after examining data.

Analyzing the Arguments

The key question is whether the distress sale prices of illiquid securities are meaningful. One body of opinion holds that many of these assets are "performing." The cash flows continue, even though some asset holders are selling at distressed prices.

There are many substantive examples. Here is a recent illustration from Bankstocks.com:

One Alt-A MBS expert, Thomas Patrick, chairman of New Vernon Capital and a former Merrill Lynch vice chairman, calls mark-to-market accounting a 'swamp' in this environment, an 'accounting fiction' better reflecting the 'financial desperation of sellers than the value of the securities sold.'

In 3,700 mortgage securitizations he examined, Patrick found that of $1.4 trillion in Alt-A mortgages, $948 billion were current on interest and principal, while $452 billion were delinquent more than 30 days. Further, banks carried the performing mortgages at an average 50% of par. Patrick observes that if owned directly as loans, the banks would carry the mortgages closer to par. He concludes that the mark-to-market fiction has created enormous financial difficulties.

There is something seriously wrong with a method that applies one valuation to a loan and another to a securitized loan.

From the perspective of these analysts, the required regulatory capital of these companies has been dramatically reduced without any basis in reality. The regulation affects the overall capacity for lending.

But let us consider the alternative viewpoint.

Many commentators applaud mark-to-market prices. I have only seen one actual piece of analysis -- one example of a security -- where the marks were challenged. Watch this for yourself. Those taking this viewpoint state confidently that the "toxic assets", and they ALWAYS use that term, are worthless. This is not a fair response to those who have examined the various pieces of complex securities and done a discounted cash flow analysis.

Conclusion: This is Important

M2M did not cause the economic problem, but it was an accelerant. At "A Dash" we try to be descriptive rather than prescriptive. On November 5th we made an exception, with our "open letter" to the President. We explained why fixing this problem was the single most important thing he could do.

Almost everyone disagreed at the time, preferring direct investments in financial institutions. Three months later we can see that solution for what it was -- a stopgap. If we would solve this troubled asset problem, whether through price discovery or by suspending M2M, the government could get out of the banking business. We need market-based incentives rather than Rep. Frank and his committee setting rules governing business decisions. This means that we need an accurate measure of regulatory capital. Without stabilizing this problem, how can we expect fresh private investment in these institutions? They also will not get deposits with many pundits saying that the banks are insolvent.

Several experts on TV have been saying that the toxic asset question is no longer crucial. They are so wrong.

Comments

[bartpr]

massive forclosures are anticipated on the alt a and option arms in the coming two years. who would anyone know the estimated foreclosure rate accurately enough to make any judgelent cal on the value. it is all fiction.
some have said the fr will be 80%plus. at this rate these mbs are near zero.

2009 Feb 13 01:17 PM

[Aristophanes]

M2M is a constant. Deriding it is blaming the messenger. It only accelerates bad news by revealing that a deflationary spiral in value can, well, accelerate. Patrick's analysis is a stopped time rendition: it accounts for no further devaluation as the market deteriorates. He's brought cake to a party that ended a week ago.

If the assets are not worthless, then YOU buy them. The spread between bid/ask on these items disproves Patrick. Others have crunched the same numbers and seen hidden risk because of the way they are structured. The ridiculous assumptions of mortgage holder income viability threatens the long term valuation. Future risk assessment says that a great deal more people will default. The massive recession says so. Do you want to guess how many and where? These bundled assets are geographically everywhere.

As these assets are, wrapped in bundles so tight that even Geithner says they are "complex contracts" (and Paulson before said that stated "contracts will not be broken"), then they are inscrutable black boxes. That is by design, not accident.

To break these black boxes open you will have to break contracts. Period. Someone will have to pick winners and losers. At this point, M2M is not the issue, nor is any market mechanism, because what you have is now the negative value of a broken contract and all the repercussions and further legal liabilities. therein. This is precisely why the real estate and financial industries are lobbying so hard against bankruptcy cramdowns. A bankruptcy judge would be a M2M analyst of precisely the kind that properly values the real worth of the asset, on a local scale, fixated on the timeline of the purchaser and their relationship with the lender. It would be a real world, real value, real time analysis with legal precedent. It would destroy the interest first prerogative of the mortgage industry for a decade as bankruptcy-derived valuations spread through the real property sector in the absence of market valuations.

So unless the financial wizards are willing to pry apart their contract items, the assets are essentially worthless. Only a massive taxpayer subsidy can value them when the markets refuse to. Hence the "stress test". And even then there is no indication that Geithner's clean-up crew have the tools necessary to analyse these assets in a proper balance sheet accounting. Again, by design. The industry is taking a "buy them all at our price levels or we'll hold the system hostage" approach. This is far beyond M2M accounting specs.

If assets remain in the black box, all sanctity of these ridiculous contracts preserved, then all the malfeasance that went into liar loans, Alt-A, ARM, Jumbos, etc. will stay hidden as well, because there is no ral appeal process in a foreclosure unlike the courts. Exposure might well lead to further civil legal proceedings by bond holders, and likely a few criminal ones as well if state regulators get their information. This is a further deterrent to the banks seeking market measures in their current form. This is a private equity form of "executive privilege". There are criminal policies that will be uncovered.

These assets are everything to the credit jam. They need to be banned. Black box securitization and the legal sanctuary of contract law are being used to smother the market valuation. Not M2M accounting standards. Blaming the latter is a diversion and not worth the energy complaining about.

If I was a local lender in a thrift mortgage business, I would consider buying some of the local assets; all broken into bits I could reasonably evaluate and price tem, including a face-to-face with the mortgage holder to see how we can square things. But this contractual sanctity and Wall St.'s hostage mentality prevent any market valuation all the way from Geithner's office down to Main St. Again, by design.

2009 Feb 13 01:37 PM

[Tom Armistead]

Appreciate your factual approach to this issue. I hold Allstate and Hartford, both of which have substantial amounts of MBS in their portfolios. They have done careful cash flow analyses and concluded that the value of the securities is greater than mark to market. Mark to market under today's conditins is mark to insanity.

I advocate preparing balance sheets based on discounted cash flow, with mark to market reserved for a footnote. Its relevance would be in assessing liquidity risk. Regulatory capital and stress testing have to explicitly rely on cash flow valuations, otherwise they simply exacerbate the cycle, forcing solvent instituions into bankruptcy and/or fire sales.

2009 Feb 13 01:47 PM

[One Eyed Guide]

The reason that there is not more challenge to the M2M valuations is that the financial firms make the decision to mark to market if the asset is thinly traded. In addition, there is some question as to how many assets are actually covered by M2M as only securities being held for immediate sale have to be M2M. Based on published reports, some banks deem their MBS's as long term securities outside of M2M which allows different valuations.

A clearing house for derivatives/MBS's would seem to be the only long term solution as suspending M2M would probably have minimal effect on asset valuations, particularly if banks are currently doing voluntary M2M valuations below cash flow valuations. A liquid market clearing house should quickly bring depressed assets back to real world valuations.

Of course, if assets are still overvalued as some claim, a clear house would result in rapid nationalization of insolvent banks.

We'll see.

2009 Feb 13 01:51 PM

[dlaw]

I'm sorry, the idea that M2M is to blame here is perfectly ridiculous and the author offers a prima fascie case as to why this is so.

Consider: "In 3,700 mortgage securitizations he examined, Patrick found that of $1.4 trillion in Alt-A mortgages, $948 billion were current on interest and principal, while $452 billion were delinquent more than 30 days."

Please note the "A" in "Alt-A". The underlying loans were marketed as "near-prime" and I guarantee you that the securities had the vast majority of their tranches rated AA or better. Based on their performance, we can say without any fear of meaningful contradiction that these ***securitizations*** were fraudulent. There was no event which caused this incredibly high deliquency rate - a rate multiples of what the securitzer predicted and overwhelming the supposed protections structured into the securities.

Rather, the only reasonable conclusion is that these delinquency rates are, in fact, something of which any responsible financier could have made a far, far more accurate prediction, given true and meaningful information. Either this information was not made available and/or not sought - thus a deception through omission and therefore constructive fraud - or this information was altered to appear other than it was - a deception through outright fraud.

It seems to me that given the enormous disparity between the promised performance and the actual performance, a buy would have to be a lunatic not to demand a vast discount, given the burden of financial risk, potential management and legal costs and replacing fraudulent analytics with real analytics.

What's more, the exact same process which created the securities in the first place could - with government help if necessary - be used to re-analyze, re-rate and re-securitize them so that they could be booked at something much closer to their real value. What is not reasonable or even rational is to suggest that one should ignore the obvious misconduct that created these bonds and simply accept the word of the very people responsible for that misconduct as to their value.

If the market is incorrect, then banks should re-analyze the bonds and prove their value. If they are not willing to do this, the logical conclusion is that they are trying to commit the same fraud twice.

2009 Feb 13 02:27 PM

[Larrysyr]

I don't recall complaints about mark-to-market when the market price was rising. Either we believe the markets are efficient or we don't.

I see some problems with the discounted cash flow model.

First is that the assumptions in the model could be wrong.

Second is that the only fair way to suspend mark-to-market would be to force financial institutions into holding these securities to maturity. If they are allowed to sell prior to maturity, then the value is what the market will pay. No one is proposing this because the financial markets need the liquidity provided by open market transactions.

Mark-to-market did not cause this crisis. Overpaying for assets and underestimating risk had more to do with it.

Let those who made the mistakes bear the brunt of the losses.

2009 Feb 13 02:34 PM

[PROXIMO]

Excellent post Aristophanes. I am printing a copy of your comment for my files, as I frequently do with SA authors' posts, but very rarely with readers' posts.


On Feb 13 01:37 PM Aristophanes wrote:

> M2M is a constant. Deriding it is blaming the messenger. It only
> accelerates bad news by revealing that a deflationary spiral in value
> can, well, accelerate. Patrick's analysis is a stopped time rendition:
> it accounts for no further devaluation as the market deteriorates.
> He's brought cake to a party that ended a week ago.
>
> If the assets are not worthless, then YOU buy them. The spread between
> bid/ask on these items disproves Patrick. Others have crunched the
> same numbers and seen hidden risk because of the way they are structured.
> The ridiculous assumptions of mortgage holder income viability threatens
> the long term valuation. Future risk assessment says that a great
> deal more people will default. The massive recession says so. Do
> you want to guess how many and where? These bundled assets are geographically
> everywhere.
>
> As these assets are, wrapped in bundles so tight that even Geithner
> says they are "complex contracts" (and Paulson before said that stated
> "contracts will not be broken"), then they are inscrutable black
> boxes. That is by design, not accident.
>
> To break these black boxes open you will have to break contracts.
> Period. Someone will have to pick winners and losers. At this point,
> M2M is not the issue, nor is any market mechanism, because what you
> have is now the negative value of a broken contract and all the repercussions
> and further legal liabilities. therein. This is precisely why the
> real estate and financial industries are lobbying so hard against
> bankruptcy cramdowns. A bankruptcy judge would be a M2M analyst of
> precisely the kind that properly values the real worth of the asset,
> on a local scale, fixated on the timeline of the purchaser and their
> relationship with the lender. It would be a real world, real value,
> real time analysis with legal precedent. It would destroy the interest
> first prerogative of the mortgage industry for a decade as bankruptcy-derived
> valuations spread through the real property sector in the absence
> of market valuations.
>
> So unless the financial wizards are willing to pry apart their contract
> items, the assets are essentially worthless. Only a massive taxpayer
> subsidy can value them when the markets refuse to. Hence the "stress
> test". And even then there is no indication that Geithner's clean-up
> crew have the tools necessary to analyse these assets in a proper
> balance sheet accounting. Again, by design. The industry is taking
> a "buy them all at our price levels or we'll hold the system hostage"
> approach. This is far beyond M2M accounting specs.
>
> If assets remain in the black box, all sanctity of these ridiculous
> contracts preserved, then all the malfeasance that went into liar
> loans, Alt-A, ARM, Jumbos, etc. will stay hidden as well, because
> there is no ral appeal process in a foreclosure unlike the courts.
> Exposure might well lead to further civil legal proceedings by bond
> holders, and likely a few criminal ones as well if state regulators
> get their information. This is a further deterrent to the banks seeking
> market measures in their current form. This is a private equity form
> of "executive privilege". There are criminal policies that will be
> uncovered.
>
> These assets are everything to the credit jam. They need to be banned.
> Black box securitization and the legal sanctuary of contract law
> are being used to smother the market valuation. Not M2M accounting
> standards. Blaming the latter is a diversion and not worth the energy
> complaining about.
>
> If I was a local lender in a thrift mortgage business, I would consider
> buying some of the local assets; all broken into bits I could reasonably
> evaluate and price tem, including a face-to-face with the mortgage
> holder to see how we can square things. But this contractual sanctity
> and Wall St.'s hostage mentality prevent any market valuation all
> the way from Geithner's office down to Main St. Again, by design.

2009 Feb 13 02:52 PM

[Aristophanes]

Thanks Proximo.

The behaviour we are witnessing—this circling the wagon until the cavalry (taxpayer) comes—is not really about the mechanisms to price the assets. It's about the fundamental, underlying business model. It's a colossal failure. It's right up there with 18th century tulips.

There are careerists in these banks who know nothing about banking outside these complex derivative models. They have every incentive to drive the system into the ground by adding layers of intermediaries and compartmentalizing every micro-asset, rolling them and cutting them into tranches, so they get their cut from the cash flow. Take away their business model and you hurt their money. So this behaviour is counterproductive. They want the current badness gone at taxpayer expense, but the model to continue. That should not happen. Not hrough market discipline—look where that got us—but by outright legislation.

Securitization is a horrible risk model. All M2M does is measure how bad it can get on the low end when the holders of these "troubled assets" have to put them on the balance sheet. Even if you took M2M off the books, we'd all still know their hidden risk exists. Warren Buffet knew it without even referring to M2M accounting. Securitized assets like CDO's and CDS's are inscrutable black boxes, designed to thwart contract breakage in the event of de-leveraging. Paired with CDS's, they are poison pills. The measures of counter-party risk they create is otherworldly in scope. The sheer workforce necessary to re-value them is daunting. No wonder Geithner is trying to buy time.

They are so toxic, they inhibit markets by their very structure. It's not that people cannot identify the underlying mortgages and then re-price them. It's that the process takes so long in a downturn by the time you've reassessed, you're of by a factor enough to cause further hidden risk. They are a moving target. They are the economic equivalent of the Heisenberg Uncertainty Principle. Does anyone really think that a gang of computer geeks in L.A. pricing mortgage bonds really knows what's going on in real estate in 5,000 different locations at the same time, in real time? Yet these things are supposed to trade OTC with little effort based on three letters of grading, that then gets transferred throughout the product lifecycle. Only when they are crisp, new mortgages all fresh and clean are they somewhat understandable. After that, who knows?

The contractual shield is so impervious they cannot be re-negotiated without a small threat of lawsuits from bondholders, but almost certainly a credit default claim. If a market goes up they seem incredibly strong in their diversity; should the market go down even a pip they are dangerously brittle ad the domino of interlocked default claims spikes threatening reserves.

Worse, they lend themselves to ratings abuse. By diversifying, the risk was supposedly lessened. Not so. The opposite, in fact. All it takes is a single segment of a tranche to be valued incorrectly to set off market doubt about the rest. That can then trigger a CDS call, further blasting the other ratings down, and so on. Finally, if there is an actual real estate downturn (they happened before securitization) they gum up the whole system because they are a measure of real estate, considered the underpinning of household wealth (and are politically loaded as we are now seeing). Remember we were told not to worry, that real estate was "local"? A downturn in Florida was not necessarily bad for Seattle? IN fact, it might be good for Seatlle? These securities turned that notion on its head, cut the head off, and buried the various body parts in unmarked graves. Real estate is local, but these aset vehicles make that impossible. Now Chinese creditors of these things will have to be paid with taxpayer dollars in a preferential manner (Fannie and Freddie's unwinding is doing just that). All for some guy's shack 40 miles out of Ft. Lauderdale being mortgaged at $400k, when his income was $20k per year. Now all that is there is an alligator; and the same guy is renting down the street in a cloned shack for 1/5th the original mortgage payment. And because Florida guy was foreclosed on, some guy in Seattle who is a 70 year-old retired, ex-Navy fellow, is having his daughter move home because she lost her job in the economic fallout. And she's bringing 3 kids. All trying to get by on his fixed income.

Ban them. Ban securitized mortgages and their insurance partners. They are an asset class almost unknown outside the US and are, frankly, unnecessary. They have tied up so much capital that other industries are now starved for liquidity causing a horrendous series of tragedies in the labour market, setting of geoploitical tremors, making a dangerous trade imbalance catastrophic. Break them up and ban them. Break contracts and ban, ban, ban.

2009 Feb 13 11:54 PM

[ccerenz2]

Mark to Market is not a constant. It was implemented a few short years ago. If it had been implemented in the last century, our banks probably would have gone bust at least 10 times. It is an idealistic approach and what we are seeing idealism crash into reality.
In and of itself, the idea sound good on the surface, but it doesn't work during difficult/depressed markets because it causes artificial downward pressure on asset prices.
It's time we get realistic and realize that until this ideal is abolished, the system will continue to need life support.


On Feb 13 01:37 PM Aristophanes wrote:

> M2M is a constant. Deriding it is blaming the messenger. It only
> accelerates bad news by revealing that a deflationary spiral in value
> can, well, accelerate. Patrick's analysis is a stopped time rendition:
> it accounts for no further devaluation as the market deteriorates.
> He's brought cake to a party that ended a week ago.
>
> If the assets are not worthless, then YOU buy them. The spread between
> bid/ask on these items disproves Patrick. Others have crunched the
> same numbers and seen hidden risk because of the way they are structured.
> The ridiculous assumptions of mortgage holder income viability threatens
> the long term valuation. Future risk assessment says that a great
> deal more people will default. The massive recession says so. Do
> you want to guess how many and where? These bundled assets are geographically
> everywhere.
>
> As these assets are, wrapped in bundles so tight that even Geithner
> says they are "complex contracts" (and Paulson before said that stated
> "contracts will not be broken"), then they are inscrutable black
> boxes. That is by design, not accident.
>
> To break these black boxes open you will have to break contracts.
> Period. Someone will have to pick winners and losers. At this point,
> M2M is not the issue, nor is any market mechanism, because what you
> have is now the negative value of a broken contract and all the repercussions
> and further legal liabilities. therein. This is precisely why the
> real estate and financial industries are lobbying so hard against
> bankruptcy cramdowns. A bankruptcy judge would be a M2M analyst of
> precisely the kind that properly values the real worth of the asset,
> on a local scale, fixated on the timeline of the purchaser and their
> relationship with the lender. It would be a real world, real value,
> real time analysis with legal precedent. It would destroy the interest
> first prerogative of the mortgage industry for a decade as bankruptcy-derived
> valuations spread through the real property sector in the absence
> of market valuations.
>
> So unless the financial wizards are willing to pry apart their contract
> items, the assets are essentially worthless. Only a massive taxpayer
> subsidy can value them when the markets refuse to. Hence the "stress
> test". And even then there is no indication that Geithner's clean-up
> crew have the tools necessary to analyse these assets in a proper
> balance sheet accounting. Again, by design. The industry is taking
> a "buy them all at our price levels or we'll hold the system hostage"
> approach. This is far beyond M2M accounting specs.
>
> If assets remain in the black box, all sanctity of these ridiculous
> contracts preserved, then all the malfeasance that went into liar
> loans, Alt-A, ARM, Jumbos, etc. will stay hidden as well, because
> there is no ral appeal process in a foreclosure unlike the courts.
> Exposure might well lead to further civil legal proceedings by bond
> holders, and likely a few criminal ones as well if state regulators
> get their information. This is a further deterrent to the banks seeking
> market measures in their current form. This is a private equity form
> of "executive privilege". There are criminal policies that will be
> uncovered.
>
> These assets are everything to the credit jam. They need to be banned.
> Black box securitization and the legal sanctuary of contract law
> are being used to smother the market valuation. Not M2M accounting
> standards. Blaming the latter is a diversion and not worth the energy
> complaining about.
>
> If I was a local lender in a thrift mortgage business, I would consider
> buying some of the local assets; all broken into bits I could reasonably
> evaluate and price tem, including a face-to-face with the mortgage
> holder to see how we can square things. But this contractual sanctity
> and Wall St.'s hostage mentality prevent any market valuation all
> the way from Geithner's office down to Main St. Again, by design.

2009 Feb 14 04:49 PM

[Aristophanes]

M2M is a constant because it exists as a measure anyway. A century ago there were no detailed computerized real time trading systems that ruthlessly track a bid/ask spread across the globe. M2M has been around for a long time, but only recently was it made regulatory. Even if companies were not required to implement it, analysts would. OTC is all about comparison shopping on that premise. M2M is just a way of regulating that market—which should have been regulated it the first place!

All M2M does is it brings accounting up the speed of the transactions. Now that banks find they don't like the prices they're being offered and the pace of the de-leveraging (ah, the 1987 crash—the good old days), they don't like the method of accounting? They would prefer to sell the quickly, but if they cannot, they don't want to account for them quickly in a manner that shows shareholders and bondholders where the market value lies? I know I want that data. Bank apologists want M2M removed and short selling banned because it creates "artificial" devaluation? That's not how markets work. They're devalued because these idiots put them in a black box and gave them a trip A rating!

Banks etc. should not have put themselves in the predicament where they would have to sell complex assets to dry off leverage in such a rapid manner. The market locked up because of the quality of the product—nothing else. The banks that are caught with this paper deserve their positions because of terrible risk management. Heads should roll for this.

How else but market valuation are we supposed to price a securitized mortgage vehicle? Turn it into a futures contract? What if the FDIC has to take over a bank holding these vehicles (as they are doing)? How do they price these assets? A bunch of academics peering into them and using a crystal ball to see the future of 5,000 local real estate markets in each tranche? Then they proclaim that the Phoenix real estate market will actually be x value and Indianapolis y in z years from now? That's not gonna work.

It's precisely because of the designed inscrutability of these toxic assets that M2M is even more necessary than ever. It shines a light on their toxic sludge and identifies the mess properly. Keep M2M; it's quick and necessary and gives investors real time accounting. Ban mortgage securitization; that's the darkness.

2009 Feb 15 12:13 AM