The Demise of "Mark to Model" and Related

[TJ_98370]

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......The level of losses industrywide is sure to raise questions about how values were assigned in the first place. Banks generally look at prices in the market first. But when no market price is available, they turn to internal computer models. The practice is similar at hedge funds, though in some instances, banks give pricing out to hedge funds, allowing price levels to trickle through in nebulous asset classes like mortgage bonds.

Now, bank executives are increasingly scrutinizing their employees and trying to catch them if they are too optimistic — or downright dishonest — about valuations.....

.......Marking the book, as the industry calls the pricing process, has become one of the more controversial topics among finance executives, even in instances where no fraud has been alleged. On Thursday, the chief financial officer of Citigroup said the company would use internal models to price mortgage bundles known as collateralized debt obligations rather than use the dismally low market prices as the only factor. On the other end of the spectrum, firms like Goldman Sachs say that market prices should be the driving factor in pricing.

Different computers models often use different data and produce different valuations. Investors have complained recently that Wachovia and Washington Mutual are modeling values with a housing price index that is more optimistic than the index used by their competitors.

"There's almost a definitional issue of what you mean by value," said Rick Antle, an accounting professor at the Yale School of Management. "You're really kind of behind the eight ball.".....

......Investors are increasingly complaining that banks have become too opaque about the assets they own and the trades that make — or lose — them money.....
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[rose-colored-coolaid]

It's interesting to consider just what the fall out will be in the mark to model world. The problem is that we haven't really learned anything. Prior to this mess, everybody knew mark to model had potential to be error prone, but what's new about that? Ask the people who had BSC stocks if something market to market can be wrong.

Also, I don't see anything you can readily replace mark to model with, other than better models.

What I do see as potentially happening is changes in regulation such that mark to model assets cannot be leveraged as highly or some such thing.

[TJ_98370]

As the article suggests, one of the biggest problems with "mark to model" is a lack of transparency as to the methods used to determine value. Standardization and regulation should help and maybe ratings of these type securities should also take into consideration or indicate how values were determined.

I understand that "mark to model" may be necessary when there is no market data. However, the Citigroup executive referenced in the article pretty much says that he is going to use values generated by his computer model because he doesn't like the market values. What!?! I'm not the brightest bulb in the knife drawer, but I'm pretty sure that when computer models trump reality there are going to be problems eventually.

[rose-colored-coolaid]

[TJ_98370]

....If you did have a model that was always better than reality, you could easily leverage each of its choices and make yourself billions.....

RCC- How can you have a model "better" than reality? I don't know if you were serious with that comment. Maybe I got it wrong, but I thought models, with assumed variables, and assumed values for variables, are only used in an attempt to simulate reality because certain data, significant to the subject of interest, is unknown or incomplete.

Moody's job is to rate the quality of the debt, the probablity that the debt will actually be repaid. My perception of the problem is that Mr. over-clever investment banker "gamed" the system so severely that the actual amount of risk was obscured and the ratings agencies were clueless. Either that or the ratings agencies just went along with the game.

[rose-colored-coolaid]

[TJ_98370]

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As these type "discoveries" continue, there will be an eventual severe backlash to "mark to model" and a push for more transparency of ratings methodology, methinks.



Already under intense scrutiny for its role in the credit crisis, the Moody's Corporation said Tuesday that some employees had violated its code of conduct in rating complex European securities......

.......The news comes as policy makers around the world are looking into how Moody's and its competitors, Standard & Poor's and Fitch Ratings, gave high ratings to mortgage and related securities that turned out to be far riskier than their ratings would have implied and have cost the financial system hundreds of billons of dollars. The companies are the subject of several investigations in the United States and Europe.

Critics have asserted that Moody's and its peers succumbed to pressures from investment banks that were packaging complex and risky debt during the credit boom earlier this decade. The rating firms are paid mainly by issuers of securities, and receive a relatively small percentage of their revenue from investors.

The attorney general of Connecticut, Richard Blumenthal, who has been investigating the rating firms, said Moody's admission of incorrect debt obligation ratings was "just the tip of the iceberg." His office is looking at how the firms dealt with investment banks, rated municipal bonds, and handled errors and mistakes.

"This company has far-reaching problems well beyond this one incident," he said on Tuesday. "This action fails to address those problems.".....

......Moody's said an investigation conducted by its law firm, Sullivan & Cromwell, had not determined that employees changed the methodology for rating the securities to mask errors in computer models, as was suggested by a report in The Financial Times in May. But it blamed employees in charge of monitoring and adjusting ratings for considering "factors inappropriate to the rating process" after the errors were discovered......
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[TJ_98370]

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A startling revelation, to be sure.......
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Moody's Investors Service and Standard & Poor's must be clearer and more detailed in their ratings of asset-backed securities and the risks of underlying collateral, the Bank for International Settlements said today.

The firms need to make rating documentation more accessible for investors and be more transparent about how they assess bonds that package mortgages and other debt, according to a report from the Committee on the Global Financial System, which meets under the auspices of the BIS in Basel, Switzerland.....

......Ratings companies are under pressure from governments and regulators to improve practices which may have contributed to the lending squeeze and economic slowdown.

The firms ``should enhance the information underlying'' their grading of asset-backed securities, the BIS committee said in the report. ``Better information on the key risk factors'' of the ratings is needed, and the companies ``should take system- wide risk into account.''

The limited historical information used in ratings firms' models made the losses worse and the companies also miscalculated the risk of mortgage sellers relaxing their underwriting standards at around the same time, according to the BIS report.....

......The BIS report is part of an attempt by governments and regulators to give greater scrutiny to the role and practices of credit-rating companies in securitizations.....
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[jon]

[TJ_98370]

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jon – I couldn't agree with you more.
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My point being that I think it is close to impossible to ensure accountability and accuracy with mark to model. I believe the best that can be done is implementation of standards and transparency as to how values of MBS's are derived and rated. Also, it's ludicrous that some bank managers will opt for model values, even when market value data is readily available, just because they don't like the current market values!
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It's obvious now that the funding made available for the housing bubble was a result of investors throwing money at MBS's. When it became known how risk was obscured by modeling and the ratings agencies were slapping AAA ratings on junk, the funding dried up. We aren't going to see easy credit for mortgages again, maybe forever. Many investors got burnt, they are very unhappy, and they are making themselves heard thru lawsuits and accusations of criminal activity. I believe a fundamental change is forthcoming with respect to how MBS's are valued, rated, and regulated and I would not be surprised if the practice of mark to model does not survive.
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[TJ_98370]

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......Automated risk-based models, on which the entire market relied, replaced portions of traditional underwriting and credit evaluation, and only in retrospect is it now clear that these models did not perform as predicted........
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[TJ_98370]

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The author proposes an interesting fix to the secondary mortgage market where the loan originator does not transfer all risk to investors. Hmmmmm.
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The deconstruction of the financial services industry this past year has been something to behold. Unfortunately, the responses have been shortsighted, the equivalent of putting a band-aid on a gunshot wound. The blunt fact is that we're in the midst of a major structural shift in the financial world: Yesterday's business model has been invalidated.

Securitization as it has been practiced will not be the dominant means of financing it has been for the past decade and a half. And it has been truly dominant.....

......the next step for finance in the Western world is to create a system that marries the discipline of portfolio lending with the asset-liability management and transparency benefits of securitization. As in the portfolio-lending model, the originator will be left to hold the loan. The bond-buying community will provide financing to the originating lender by purchasing the securitized debt that is backed by the loans originated.....
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[TJ_98370]

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A rather long but informative article about how the financial services industry has significant capitalization issues because of "disguising risk" and is not likely to recover to the levels of profitability enjoyed over the last decade. We may be seeing a return to the George Bailey style of banking. The article also provides support for those who believe we are entering a deflationary period due to the big investment banks recapitalizing and reducing overall liquidity.


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[Robroy]

[TJ_98370]

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Robroy. I think the jury is still out as to whether we are experiencing an inflationary / deflationary economy.

My intent for this thread was to establish an awareness that "business as usual" as we have seen it for the last decade for the mortgage industry is over. I am probably wasting my time by preaching to the choir of readers of the Seattle Bubble, as most are probably already very aware. The easy financing is gone, maybe forever. While posters on the blog rage about the "real" value of Ballard properties and such, what does all that mean if the financing paradigm is undergoing major change?





.....'Strong holding company oversight is essential, and thus, in my view, the Congress should consider requiring consolidated supervision of those firms and providing the regulator the authority to set standards for capital, liquidity holdings, and risk management,' he said.....
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