The Demise of "Mark to Model" and Related
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In Bear Stearns Case, Question of an Asset's Value
......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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In Bear Stearns Case, Question of an Asset's Value
......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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Comments
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.
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.
Couldn't agree more. If you did have a model that was always better than reality, you could easily leverage each of its choices and make yourself billions. Any time the model and the market disagree you've got to tip your had to the market.
That said, I don't see how you share your model. If you are Moody's or someone, your model is your secret sauce. This would be like legislating that Coke share their secret recipe. I would be on board any solution that gets rid of mark to model, but I just don't see what that would be.
To me, this all comes back to the fact that most of the plays that have gotten into trouble have been leveraged as well. In my mind, leverage has been the essential problem in the dotcom, housing, and credit bubbles. Maybe there's an approach that could reduce available leverage to make all these other flaws more manageable.
RCC- How can you have a model "better" than reality?
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.
No, you got it right...I just wrote it wrong. What I really meant to say was "a model that was always better than the market..."
There is reality, both present and future. Given the present, both the market and the models attempt to predict the future. Agreed? So my argument was, if you had a model which predicted the future more accurately than the market did, you would be able to make transactions first and you would always be right. Therefore, you would leverage those positions to do exceptionally well.
Regarding what happened with the ratings agencies, I was under the impression that they were gamed and went along with things to a certain degree. Weren't there some articles last winter about how the agencies just kind of accepted the models of the funds or banks or whoever, even when some of the rating agencies' analysts had strong suspicions about those models. Maybe I'm making that up, but I thought I read a couple articles in that vein.
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.
Moody's Says Workers Rated Some Securities Incorrectly
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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A startling revelation, to be sure.......
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S&P, Moody's Must Be Clearer on Asset-Backed Ratings
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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Mark to model has some benefits, since it allows a wider array of investments to be made available, and thus allows risk to be distributed more efficiently. But there has to be safeguards that the models are appropriate, implemented correctly, and the parameters used are not being fudged. Mark to market has the obvious benefit that someone else is staking their money on the correctness of their bid. If only that same level of accountability could be built into mark to model.
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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InyMac - Seattle Bubble Post
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IndyMac: We Were Not Greedy and Stupid
......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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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 Future of Securitization
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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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.
Voodoo Banking
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http://seekingalpha.com/article/84432-c ... flationist
Mish, I was a true believer in the "hyperinflation is coming" theory for quite some time. However, I have since changed my mind. Here's why: I own a computer business and I used to pay techs $15-20/hr. I now have people willing to work for $8-$10/hr. While the nice guy inside is saying "pay people well" the businessman is saying "market conditions demand paying people what the market will support."
Recently I have had to offer price discounts to obtain new business. Some contracts I picked up were for around 1/3 of my standard fees. I have cut costs to the point where they can be cut no further if I am to maintain my debt obligations. I am now at the point where my options are to work more hours for less money or "exploit" the labor market. Considering that I am already working 80-90 hour, there was no choice.
I just interviewed a single man nearing retirement age with a young daughter a couple years older than mine. He is not only willing, but trying to hide the fact that he's DESPERATE to work for $8-10/hr. I might be able to afford to pay him $12/hr today, but with what's coming over the horizon, wisdom dictates paying him $8 and using the difference to lessen debt obligations as quickly as possible. That would lower my costs for when the available business gets even tighter, leaving me in a stronger position to bid and win, and helping make sure he'll still have a job in 12+ months.
As it seems to me, high debt load, plus rising product prices, plus deflation's hit is painfully powerful. I'm confident from reading your articles that it's only going to get worse.
RS
Just as this economic slump will certainly increase domestic violence and divorce, the depression ended with the greatest war of all time. Countries can act badly, just like people. This could get very interesting.
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?
Video: Ben Bernanke on Financial Markets
Fed's Bernanke asks Congress to consider more regulatory authority over markets
.....'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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Could it be that investors have caught on to the fictional valuations and risk ratings?
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CDO volumes take big hammering
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Global issuance of the complex debt securities at the heart of the credit bubble has collapsed in the wake of thousands of ratings downgrades this year, cutting huge revenues from the biggest investment banks.
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The volume of collateralised debt obligations, which pool together bonds, loans and other debt, sold in the first half of this year is equivalent to just 10 per cent of the volume in the first half of 2007, according to the latest data from Dealogic and Total Securitization......
........Investors have deserted all kinds of complex products since last summer, but CDOs have suffered disproportionately as waves of downgrades have hit these deals. Analysts at Morgan Stanley said on Thursday that more than 10,000 ratings downgrades had been handed out by the ratings agencies so far this year.
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With Fannie and Freddie in trouble and funding from the secondary mortgage market drying up, it is going to get significantly more difficult to get a mortgage loan, methinks. Fewer buyers qualifying for loans means downward pressure on real estate prices, right?
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Merrill Lynch is liquidating their CDO's because investors have caught on to their fictionalized mark to model values!
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"Until the true value and the mark to model converge it's going to be difficult for investors to have confidence in anything Wall Street management says,'' – Julian Mann, a mortgage and asset-backed bond manager at First Pacific Advisors LLC in Los Angeles.
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Merrill's CDO Sale `Suggests Endgame,' Analysts Say (Update2)
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July 29 (Bloomberg) -- Merrill Lynch & Co.'s decision to liquidate $30.6 billion of collateralized debt obligations at a fifth of their face value ``suggests the endgame'' for CDO risk at financial companies, Bank of America Corp. analysts said.
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The sale reduces uncertainty for brokers, banks and bond insurers, analysts led by Jeffrey Rosenberg in New York said......
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...``Selling off the portfolio at levels below marks creates initial losses but relieves future uncertainty,'' Rosenberg wrote.....
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.....Merrill agreed to sell $30.6 billion of CDOs -- the mortgage-related securities that have caused most of the firm's losses -- for $6.7 billion and provide financing for about 75 percent of the purchase price. The financing for the sale to Dallas-based private-equity firm Lone Star Funds is secured only by the assets being sold, meaning Merrill would absorb any losses on the CDOs beyond $1.68 billion....
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.......Merrill providing financing for the deal ``suggests that the true value of the assets is quite a bit less,'' said Julian Mann, a mortgage and asset-backed bond manager at First Pacific Advisors LLC in Los Angeles, which manages $11 billion.
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``Until the true value and the mark to model converge it's going to be difficult for investors to have confidence in anything Wall Street management says,'' he said....
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End-game? These distressed sales of CDOs by a handful of investment banks is a drop in the bucket. Over $1 trillion of CDOs have been sold in recent years. Are the majority of these CDO owners going to write them down to 20 cents on the dollar (or more) like Merrill? I haven't heard much about the broader holders of these assets taking massive write-downs yet. When we start seeing that $800 to $1000 billion of CDOs have been sold at 80% discounts, then we might be able to say that an end-game is in sight.
Just where all these CDOs are sitting is what I'd like to know. Are there some pension funds somewhere with hundreds of billions worth of CDOs that they are still marking to model?
Good point Sniglet. The point that I was trying to make is that investors are not buying CDO's anymore because of the way they were valued and rated. So what are the banks going to do? I have no crystal ball, but writing them down to 20 cents to the dollar would not surprise me. If memory serves, Indymac went down because they had $10 billion worth of MBS's that no one would buy.
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Yes. I think that is exactly what is happening. Scary thought, yes?
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Everyone "in the game" was doing very well from 2003-2006. Where is the incentive to blow the whistle when you are living high off the hog? During this time the whole financial industry (branch lenders and field appraisers to major Wallstreet banks/firms) were recording "record profits". In addition, there were huge bonuses for the "captains of industry" who were knowingly or not, running their "ships" onto the rocks. I guess the "fog of greed" was a bit thick to see what was just ahead?
The "feeding frenzy" was all based on smoke and mirrors. The whole financial model is rotten from top to bottom. How does one apply a fix to any part of a completely rotten structure? Seems the only true fix is dynamite.
And once we have all our problems "fixed", won't it then be just a matter of time until the next crop of young, eager, and greedy Harvard MBAs start figuring out how to retire by 30....again?
Until WE as a species cure OURSELVES of greed, lying, and corruption, then we will be doomed to repeat.
Ridiculous. Everyone knows you "fix" rottenness with amputation before the gangrene claims the persons life. Dynamiting a limb would definitely be overkill.
Where the analogy breaks down is that the farmer is not going to actually "die". He will be drastically changed though - kinda like the world was changed by the time the financial and political fallout from the great depression had mostly died down in 1945.
There are now a LOT of one armed people losing their homes.
Uh...so in your analogy the farmer is named Optimus Prime?
I was building on your gangrene analogy. Yours is better in that it happens more gradually. Mine is better in that only the person to which the arm is attached can perform the surgery, which is what makes it so unlikely.
It's gonna hurt.
Bad.
Yeah, but you get an ARM in return so it all works out.