Where Will Treasury Find Its Model?

Steve Hsu has some ideas on how Treasury's reverse auction might work; a new paper from NERA also considers the practicalities. The big question, of course, is how on earth one goes about valuing unique and hard-to-understand MBSs, CDOs, CDOs of CDSs, CDO-squareds, and other such exotica.

The NERA paper gives an idea of how it might be done, if it can be done at all. You start by finding relatively simple pass-through securities which are amenable to a standard reverse auction. Then you extrapolate:

Holding an auction may not be feasible if ownership of a distinctive and therefore unbundleable asset is too concentrated. For these non-auctioned assets, financial or statistical analysis may be used to estimate the value. This would involve calibrating pricing models to the newly available market data generated by auctions, to estimate the contribution to value of the various asset characteristics. Applying the estimated models to the non-auctioned assets would then yield a predicted price for each asset.

Is this realistic? I asked Marcia Mayer, one of the authors of the NERA paper, and she responded:

Indeed, pricing of multi-sector CDOs (which contain tranches of other CDOs) and CDO2s poses difficult modeling challenges. Prices for these securities have historically been model-based, but those model-generated results were benchmarked against recent transactions in similar securities. Since the summer of 2007, model-based values, even using assumptions adjusted for rising delinquencies and defaults, became increasingly difficult to validate in the face of the drying up of the liquidity in CDOs and other component securities. The auctions would generate publicly-reported transactions in component securities, which would greatly facilitate the pricing process. We recommend that the auctions begin with simpler products and move toward more complex products. For assets that are narrowly held and too idiosyncratic to bundle, prices obtained at auction for simpler assets--and their implications for discount rates, default rates, prepayment rates, etc.--could be used to estimate fair values.

In other words, if you have prices for simpler assets, and you have a workable model, then you can end up with decent prices for more complex assets. And the auction should generate nice transparent prices for the simpler assets.

But where is the workable model going to come from? One of the defining characteristics of this financial crisis has been the collapse of models which worked up until 2007 or so, and then failed, with devastating effects.

There are couple of people who seem to have built models which worked quite well: John Paulson and Andrew Lahde, for starters. Do you think they might be persuaded to give those models to Treasury, now that they don't need them any more?

Comments

[JasonC:]

Here is a new way a reverse auction might work - populist idiots listen to fools and throw the world into reverse, and everything is worth zero the day after tomorrow because only today exists. After we have liquidated all assets at zero, we can trade ammunition in a new form of barter, at very high velocities.

2008 Sep 29 05:52 PM

[Jan VanDenB...:]

Disaggregate the MBSs and all their derivitive products.

Pass a law which would unbundle these packages of bonds down to their constituent mortgages, then distribute the underlying mortgages to the current owners of these products on a prorata basis using guesses at the value of their current holdings based on these wacky models.

All current holders of these products -- a specified list of troubled bonds compiled by Treasury -- would be given a week to report exactly what they have to Treasury, so the ownership of everything would be of record.

The underlying mortgages are easily valued using standard software for calculating the discounted present value of a Deed of Trust discounted. Missed payments take a specified nick from the value of the DoT. Mortgages near or in foreclosure can be valued at the independently appraised value of the underlying real estate. (Hire 3 local real estate appraisers, get three values and average them.)

Even the sickest real estate in the sickest parts of California and Florida is selling to vultures. It has a price.

The total of the discounted present value of the constituent mortgages and foreclosed-on real estate in the entire bond tranche is the value of the bond tranche and all its derivitives.

The underlying mortgages in each bond should be ranked by quality (determined by payment history) and distributed to the holders of the various "slices" of the bundle based on the risk level of the crap they bought.

The bozos who bought "equity slices," for instance, should get the stuff now in foreclosure.

As for the most exotic products, something which cannot be valued is essentially worthless and should be treated accordingly. Those who produce and buy this garbage should deal with the consequences of their own actions.

Unbundling would release significant increases in value, possibly enough to re-capitalize most holders of the products.

Those who end up with the mortgages in foreclosure should simply foreclose and market the underlying real estate as soon as possible.

Re-do corporate books with these new values. THEN, Paulsen can use taxpayer money to buy newly-issued stock in those banks which are still short of capital and too big to fail, at current stock prices (without releasing the results of the revaluation). Taxpayers would almost certainly make money over 5 years.

Remember, the point of this exercise is to preserve the flow of loans to Main Street. Investment banks and hedge funds don't make loans, so let them fail.

Even at 8% unemployment, something like 95% of US mortgage payments will continue to be made. The vast majority of US mortgages are still solid.

The problem is the way Wall Street has bundled the bonds and then sliced up the bundles to make these toxic products.

The individual Deeds of Trust or Mortgages inside these ugly wraps are going to continue to produce payment income in the vast majority of cases, even in a depression.

You're getting your monthly payment. You will continue to. Your rate of return is competitive with any other investment. There is no problem with this asset.

It is the packaging, slapped on by Wall Street, which is destroying the value of these DoTs.

Wall Street has created a mess, building something they don't understand and which doesn't work.

Looking forward, let's not package mortgages. They are too diverse and need closer management.

Jan VanDenBerg

2008 Sep 30 01:32 PM