Saturday, September 27, 2008

CDOs, auctions and price discovery

How is Treasury going to buy up CDOs and other mortgage backed securities? What is the price discovery mechanism? I've heard discussion of a reverse auction process, in which the government offers a price and owners of the assets decide whether to accept the bid.

But this makes the problem sound much easier than it is. There are no simple or uniform categories for these securities -- no two are exactly alike. I imagine Treasury is going to have to do a lot of homework before each auction, perhaps aided by some sophisticated professionals (Bill Gross of PIMCO recently offered his team's services). Data on each security is available from ratings agencies like S&P and Moody's but presumably one would supplement this with additional information. After some initial analysis Treasury could set a conservative bound (i.e., using pessimistic estimates of future default rates and home prices) on the value of each security in units of the original face value (this one is worth at least 25 cents on the dollar, this is one, 45 cents, etc.). Then, they can publish a list of securities in a particular value category (without, of course, giving out the actual value estimate) and conduct a reverse auction covering all the assets on the list.

If they can get the assets below the value estimate, great for taxpayers like you and me. If banks (hedge funds? pension funds? foreign banks? who is really holding all this stuff?) won't sell at prices below the bound, and the auction heads above that price, Treasury should start demanding warrants or equity stakes on some sliding scale. In other words, the bid keeps getting higher, but at some point Treasury starts asking for not only the particular CDO but some additional warrants or stock. (This could also be done on a sliding scale from the beginning of the auction -- Treasury gets an additional x percent of the bid in warrants, where x increases with price.) The equity stake is compensation for the government for having to having to overpay for the security. At this price there is an (expected) flow of funds from taxpayers to recapitalize the seller, but at least we are getting equity in return. It is claimed that there is a range of values (roughly 20 percent of current market prices) over which the seller would be getting more at auction than the market is currently offering, but the government is still getting a good deal on the asset (expects to make money even under conservative assumptions).

Will it work? Who knows, but at least it may restore some confidence to credit markets.

Here are some old posts that really get into the nitty gritty of what is inside a typical CDO. You'll see that I've been covering credit securities since 2005 :-)

anatomy of a cdo

deep inside the subprime crisis

mackenzie on the credit crisis

gaussian copula and credit derivatives

Here's a recent NYTimes article that gives a peek into the complexity of structured finance.

NYTimes: ...Consider the Bear Stearns Alt-A Trust 2006-7, a $1.3 billion drop in the sea of risky loans. Here’s how it worked:

As the credit bubble grew in 2006, Bear Stearns, then one of the leading mortgage traders on Wall Street, bought 2,871 mortgages from lenders like the Countrywide Financial Corporation.

The mortgages, with an average size of about $450,000, were Alt-A loans — the kind often referred to as liar loans, because lenders made them without the usual documentation to verify borrowers’ incomes or savings. Nearly 60 percent of the loans were made in California, Florida and Arizona, where home prices rose — and subsequently fell — faster than almost anywhere else in the country.

Bear Stearns bundled the loans into 37 different kinds of bonds, ranked by varying levels of risk, for sale to investment banks, hedge funds and insurance companies.

If any of the mortgages went bad — and, it turned out, many did — the bonds at the bottom of the pecking order would suffer losses first, followed by the next lowest, and so on up the chain. By one measure, the Bear Stearns Alt-A Trust 2006-7 has performed well: It has suffered losses of about 1.6 percent. Of those loans, 778 have been paid off or moved through the foreclosure process.

But by many other measures, it’s a toxic portfolio. Of the 2,093 loans that remain, 23 percent are delinquent or in foreclosure, according to Bloomberg News data. Initially rated triple-A, the most senior of the securities were downgraded to near junk bond status last week. Valuing mortgage bonds, even the safest variety, requires guesstimates: How many homeowners will fall behind on their mortgages? If the bank forecloses, what will the homes sell for? Investments like the Bear Stearns securities are almost certain to lose value as long as home prices keep falling.

“Under the current circumstances it’s likely that you are going to take a loss on these loans,” said Chandrajit Bhattacharya, a mortgage strategist at Credit Suisse, the investment bank.

The Bear Stearns bonds are just one example of the kind of assets the government could buy, and they are by no means the most complicated of the lot. Wall Street took bonds like those of Bear Stearns and bundled and rebundled them into even trickier investments known as collateralized debt obligations, or C.D.O.’s

“No two pieces of paper are the same,” said Mr. Feltus of Pioneer Investments.

On Wall Street, many of these C.D.O.’s have been selling for pennies on the dollar, if they are selling at all. In July, Merrill Lynch, struggling to bolster its finances, sold $31 billion of tricky mortgage-linked investments for 22 cents on the dollar. Last November, Citadel, a large hedge fund in Chicago, bought $3 billion of mortgage securities and other investments for 27 cents on the dollar.

But Citigroup, the financial giant, values similar investments on its books at 61 cents on the dollar. Citigroup says its C.D.O.’s are relatively high quality because they were created before lending standards weakened in 2006.

A big challenge for Treasury officials will be deciding whether to buy the troubled investments near the values at which the banks hold them on their books. That would help minimize losses for financial institutions. Driving a hard bargain, however, would protect taxpayers.

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