Structured finance: mark to bottom?
What’s the price of something that nobody’s buying?
For those of you who think the question about as Zen as the sound of one hand clapping, now imagine that billions of dollars – yep, billions – ride on the answer, for reasons that will come into focus real soon now in the subprime and structured finance arena, as recently reported in Crain’s New York Business:
Next week [that is, this week – Ed.], Bear Stearns will start to quantify the damage done by the summer credit crisis when it becomes the first big brokerage firm to report third-quarter results.
Profits at battered Bear are expected to slump by 30%, the firm’s first decline for the period since 2001. Bear’s misery will have company. Analysts also expect Merrill Lynch and Morgan Stanley to report drops in quarterly earnings.
The cause? Not selling the positions, but their revaluation, because investment banks – large firms that trade assets for their own account – have to mark those positions to market. Assets they have acquired, whose value has fluctuated, must be reported at a market price.
Other firms may do better for now, but with the market for stock and bond offerings and corporate mergers all but dead, Standard & Poor’s warns that investment banks’ revenues could fall nearly 50% in the second half of the year.
What if there is no market price, because the assets are particular, and after the recent collapses of apparently strong subprime lenders, liquidity has completely fled from this marketplace?
Ignore all official signs!
No credit, therefore no buyers; no buyers, therefore no sellers; and no sellers, no market price.
This is a terrible shock for traders who are used to infinitely elastic liquidity – a price always existing for every commodity at every time.
All securities firms will be faced in coming months with big write-downs of debt and acquisitions that are suddenly worth much less than they were just a few weeks ago. Such markdowns could result in billions worth of losses later this year.
Once a quarter, unrealized trades have to be valued, so the inventory is repriced. That can lead to markdowns.
All brainless analysts must go
“The credit crisis may be easing, but the economic impact has yet to begin,” says Alan Brochstein, principal at research firm AB Analytical Services and a former trader at Credit Suisse First Boston. “This could get really painful for Wall Street.”
Our liabilities got ahead of our assets
Painful, and contentious. If the price of something that’s not selling is a total non sequitur, what is the value of something no one’s buying?
It can’t be zero – the goods aren’t worthless. It must be some positive number. Which number?
In accounting and appraisal practice, assets are expected to be marked to fair market value. If there are trades, those trades are presumptively (flag that word!) proof of fair market value, but what if no trades? We need a definition. There are dozens of definitions, but they all work something like this:
Each of the seven components is there for a reason.
1. Highest price. Not an average, much less a bargain, but the highest price. So it only takes a few eager bidders – even only one – to set the peak, and therefore the fair market value.
2. Cash. If the seller receives paper – takeback loans, securities, goods in kind – these might have a value different from (usually less than) par:
Says the developer’s son, “Dad, dad, I sold our dog for $10,000!”
“That’s great, junior. You’re really learning our business.”
“Well, I didn’t want to have capital gain, so I took two $5,000 cats in exchange.”
– Old real estate developer joke.
$5,000 apiece?
The non-par element must be ‘reduced to cash,’ as the saying goes.
3. Willing buyer. Some buyers are under duress – scarcity crises or otherwise. The buyer is supposed to be motivated solely by serenely indifferent economics.
4. Willing seller. Some sellers, such as those facing foreclosure of a suddenly accelerated loan, may have to sell even if they don’t want to. Such pressure clouds their judgment and reduces their effectiveness in seeking or obtaining the best price.
5. Arm’s length. Sales among family, or affiliated companies, could have elements of transfer pricing – deliberately setting the price above or below market as a means of disguising a gift flowing from one to the other. (See expatriating capital, money laundering, international tax evasion, and other delights.)
Totally fair, see?
6. No undue compulsion. Some owners have to sell because a clock is ticking against them. When in 1803 Napoleon sold the
For you, I’ll sell it cheap.
So he took the best price he could get.
Only three mil, but you have to act now
7. Ample time. Anyone scalping tickets to tonight’s baseball game knows you get to the ballpark early, before the game starts, since the ticket’s value drops rapidly to zero as the game goes on.
When there are trades, they are presumed evidence of fair market value unless disqualified by one of the factors just listed. What if there are no trades, or no recent trades, or no trades of things comparable to the assets in question? Now need someone’s opinion. The opinion of someone expert in the assets.
Someone assays the ore and pronounces on its quality. Who?
An expert, of course
Someone expert, and someone independent.
Ultimately, the decision for valuing the assets lies with the investment banks’ accounting firms.
Sarbanes-Oxley has raised the stakes for accountants. Not only must they be independent, they must scrutinize and challenge management’s judgments.
Market watchers say there is an enormous tug-of-war under way, with bankers arguing that a market panic is no time to write down the value of distressed assets that could recover when things get calmer. Such an argument, however, is likely to fall on deaf ears.
“Accountants arrive at fair value by looking at what an asset could fetch today, not at some point in the future,” says Douglas Carmichael, an accounting professor at
Now all that sophisticated engineering and complication represents its own barrier: there is a lot of this stuff, and if the market of bid-ask is closed for business, each one has to be valued … by somebody.
I’m not telling the price
Punk Ziegel & Co. analyst Dick Bove says that the five biggest brokers, plus Citigroup, J.P. Morgan Chase and Bank of America, collectively hold $4.1 trillion of what accountants call Level 2 assets. These assets, which include such instruments as collateralized debt obligations or subprime-mortgage securities, can’t easily be valued because market prices aren’t readily available.
The accountants thus find themselves thrown back upon the tender mercies of the same investment bankers whom they are auditing:
As a result, the assets could be subject to steep revisions because, in Wall Street lingo, they are often “marked to model.” That means bankers and traders guess their value by using in-house tools.
Our analysts use sophisticated in-house tools
In addition, the big Wall Street institutions hold $330 billion of even-harder-to-price Level 3 assets. These securities, such as interest-rate swaps or long-term derivatives, rarely change hands and few similar instruments exist for comparison. Often, they’re priced based on trades that took place weeks or months ago, and some observers sarcastically say they’re valued through a process known as “marked to make-believe.”
This is a hard job even with an infinite time-out and access to all data theoretically available. Anyone who’s ever sold a single-family house – in this context, a very simple asset that is close to a commodity – knows there are tensions between when you sell, how quickly you sell, what else is on the market, where you set the price initially, and how good your broker is.
“This is a meaningful problem,” Mr. Bove says. “There’s a great deal of latitude in valuing these assets, and I’m looking for proof that they are worth what brokerage executives say.”
How meaningful? Giga-meaningful:
Goldman Sachs risks a $3.1 billion write-down of the value of subprime mortgages and loans made to finance deals such as leveraged buyouts, says CreditSights analyst David Hendler. That loss would wipe out nearly a quarter of Goldman’s expected 2007 earnings per share. The toll could be even steeper at Lehman Brothers. CreditSights reckons that firm faces $2.8 billion in write-downs, which would wipe out nearly half of its projected earnings
It gets better (or worse): banks must also reprice the value of companies they bought:
In addition to their bond and loan portfolios, Morgan Stanley and Merrill Lynch also face write-downs related to their ill-timed acquisitions of subprime mortgage lenders. Morgan paid $700 million last year to acquire Saxon Capital, while Merrill acquired First Franklin earlier this year for an even heftier $1.3 billion. Clearly, neither lender is worth those prices now.
That’s the thing about trades; you can’t give them back.
Can I back up now?
“These firms are black boxes,” Mr. Brochstein says. “No one knows what their balance sheets really look like.”
Will the banks have to mark their positions to bottom? Billions in earnings, and multi-billions in shareholder value, ride on the outcome.
Amounts firms may have to revise, in billions of dollars (firm, followed by their potential write-downs and their 2006 profit).
Goldman Sachs $3.1 $9.4
Lehman Brothers $2.8 $4.0
Morgan Stanley $1.7 $7.5
Merrill Lynch $0.7 $7.3
Bear Stearns $0.7 $2.1
That’s a lot of shekels … and a little bird tells me there may be lots more.
Big writeoffs coming in the fourth quarter!
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