SeekerBlog

Editor’s note: Linda Lowell is a 20-year-plus veteran of MBS and ABS research at a handful of Wall Street firms. She is currently principal of OffStreet Research LLC.

Lowell provides some very useful insider perspective on the FASB FAS 157 amendments and on the liquidity and pricing of the “toxic assets” – a term she refuses to use. There is much more a real market in the RMBS, CMBS, CDOs etc. than many people think. She concludes this Housing Wire piece with this:

Inactive markets not the real issue

I didn’t come here to praise FASB, however, but to bury the notion that the devalued and disgraced RMBS securities on banks balance sheets are illiquid. Nor should the observable market prices be described as “fire sale” or “distressed sales.”

Not that there have not been fire sales. There were some very large and visible fire sales last year as the biggest “sinners” in structured products (a blanket term that includes fairly vanilla non-agency RMBS and CMBS as well as CDO, CDO’s backed by CDS, CDS and so on) shed assets on their way to bankruptcy or acquisition (Merrill’s infamous 22-cents-on-the-dollar sale will come instantly to mind for many).

That those fire sales took place has provided a smoke screen, as it were, for banks and their enablers in Congress, free-enterprise, free-market “think tanks” and industry groups, and the media, to claim these markets are inactive.

The other mythos this crew hides behind is the notion that these riskier-than-first-thought assets are too complex to easily value (please notice that I am not going to say “troubled,” “toxic” or, no not never, “legacy” with regard to this batch of soiled laundry).

First, there is plenty of pricing information on triple-A private RMBS and CMBS. They may not trade where banks holding lots of this paper at a loss wish they traded, but they do trade. Let’s get something clear, too — they NEVER traded with the kind of depth or frequency that Treasury, agency debt or Ginnie, Fannie and Freddie MBS do. Each bond is unique enough that it has to be manually evaluated — anything from a simple cash flow calculator that uses market conventions for prepayments and defaults – or elaborate option pricing models that take into account hundreds of different interest rate, credit performance and prepayment scenarios. The cash flow calculators are ubiquitous — the sophisticated tools are available at a market price.

They trade less frequently because significant sources of demand have been eliminated. Except for the big trading books at the big banks, banks have eliminated themselves as potential buyers on the re-trade. They also cannot sell held-to-maturity triple-As unless they are downgraded, they can’t realize much in the way of losses on available-for-sale triple-As. Ditto for insurance companies, though the rising tide may let them wriggle out of some clunkers.

What’s left is the subset of investors who are marked-to-market. Ergo they have experienced their losses. This would include money managers of various kinds of funds (mutual to pension) using what we call “real money” and leveraged investors — the hedge funds and private equity managers. This segment of the market can and does trade this paper. It has been slow, but their activity has been significant enough for trading desks on both sides of the trade to track market levels, make offers and attempt to buy paper from known holders.

Most pertinently, sources on trading desks tell me they make “on the market” bids to banks for their paper and banks won’t sell. These same sources will explain that hedge funds are still the buyer on the margin, and prices have adjusted to reflect the hedge funds’ required yield –- typically 25 percent.

However, hedge funds used to achieve that yield by leveraging securities that traded at much higher prices, back when triple-A was assumed to mean risk-free (not a waiting game or playing chicken with a falling housing market). Now hedge funds’ traditional sources of leverage are gone. Security pricing has adjusted to reflect this loss of leverage.

To summarize: there are lots of tools for assessing the cash flow value, even for adjusting for credit, prepayment and interest rate risk. So market pricing would incorporate those factors, transactions will incorporate a “market view” of those risks. Those prices are further adjusted to satisfy the risk appetites of hedge funds that no longer can easily leverage to their required returns. There is necessarily a liquidity premium as well, but it is not sized on the assumption that only a fire sale will entice a buyer. It is sized given the fact that the securities must be manually examined and the field of buyers has shrunk.

The PPIP/TALF-expansion announced last week caused spreads to tighten and speculative buyers to build positions. It also triggered research from every major bond house left standing that (1) provided current market levels for the affected sectors –- either generically or for specific bond examples –- and (2) modeled expectations of price improvements when TALF and PPIP reintroduce leverage for secondary RMBS (originally rated triple-A) and triple-A CMBS.

For one thing, an illiquid market would not be graced with so much professional research. Nor would an illiquid market adapt so rapidly to the hope of new buyers (rather than the fact). In fact, if PPIP/TALF do nothing else, they should at last stop institutions that made bad investments (and, in the case of SIV, ABCP assets come home to roost, bad funding decisions) from hiding behind claims the assets are too complex to value and anyway their market prices don’t capture their true long term worth.