The world’s financial system depends on the credit standing of borrowers and the ability of lenders to value their loans as assets. If there is doubt about the ability of the borrower to repay, or of the value of the assets of the banking system then all the doubtful loans need to be discounted. In practice, investors do not want to be involved in holding doubtful assets. The discount on a doubtful loan will always need to be greater than a strict measurement of the risk involved. If there is a 10% risk of default, the discount is likely to be a multiple of 10 per cent.
In the subprime mortgage market, Bear Stearns (NYSE: BSC) have been learning the historic truth the hard way. Wall Street is trying to put a value on their C.D.O. packages, and that is proving very difficult. There is only one real valuation for any security. That is the price that a third party will pay in the open market. There is almost always a vulture fund willing to offer some fraction of the expected value, but there are very few banks who want to take the reputational risk of acquiring a portfolio of mezzanine structured C.D.O.s based on subprime mortgages. The banks wonder how they would explain them to their own shareholders and customers. If one has had the good fortune to avoid an elephant trap, one will not build one’s own elephant trap in order to pick up an extra dollar.
As the Financial Times observes, there is a theoretical valuation for subprime packages, based on the capitalisation of future income flows, but these future income flows are themselves highly speculative. “A C.D.O.’s value is not only driven by the probability of default of specific securities but is also influenced by the degree of correlation between all these securities – and who really knows what that will be in a crisis?” These words are always one of the truths of investment. Who really knows what any valuation will be in a crisis?
Ben Bernanke, the Chairman of the United States Federal Reserve will have been as reluctant as any of his predecessors to rock the U.S. bond market. Yet he gave testimony last week to Congress which caused the yield on ten year Treasury notes to fall by two basis points. The unease spread to the stock market. Mr. Bernanke had admitted that concerns about the subprime market had resulted in a “flight to quality” spreading beyond the subprime market itself. The Fed still considers financial conditions to be “generally favourable”, but Mr. Bernanke said that conditions in the subprime mortgage sector had “deteriorated significantly” – strong language for a Chairman of the Fed. The F.T. quotes him as noting “increased concerns about credit risk on some other types of financial instruments.”
The trouble is that these instruments have become hard, if not impossible, to value. Many bankers do not understand these packages. They do not want to hold them or add them to funds with which they are connected. There is a real lesson here. If you cannot value an asset, and no-one wants to buy it, it does not have a value. Bear Stearns have come up with the value of two of its hedge funds. One has lost 91 per cent of value in a year; the other has lost 100 per cent. They were invested in repackaged mortgage backed securities.
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