Can Wall Street be trusted to value risky CDOs?

Can Wall Street be trusted to value risky CDOs?
Sat Jul 14, 2007 9:33AM EDT
By Neil Shah - Analysis

NEW YORK (Reuters) - The complex models that Wall Street uses to analyze risky investments in subprime mortgages may be as suspect as some of the securities themselves.

With a surge in defaults on subprime home loans jolting credit rating agencies and two Bear Stearns hedge funds in recent weeks, some fear that these models may overlook swift market downturns or corrupt loan data. That could spell further turmoil for credit markets.
The worry is that well-heeled hedge funds, Wall Street proprietary trading desks and ratings agencies may be too optimistic when analyzing or valuing exotic mortgage investments. As a consequence, future drops in market prices may be more severe and possibly trigger panic selling by sophisticated investors.

"These models end up breaking down rather dramatically during abnormal times," said Andrew Lo, a finance professor at Massachusetts Institute of Technology. "And, of course, those are exactly the times that we should and need to worry about."

Ratings companies like Moody's Investors Service use computer models to help predict losses on thinly traded debt investments called collateralized debt obligations, or CDOs, that are often tied to pools of high-risk home loans. The models help the agencies determine what rating a security merits.

Because securities in the $1 trillion CDO market trade infrequently, it is difficult for hedge funds and other investors to mark their values to recent sale prices, called "marking to market."

Hedge funds instead use mathematical models of their own to estimate and report the value of their CDO holdings to investors -- a practice known as "marking to model."

Recent troubles at hedge funds run by Bear Stearns (BSC.N: Quote, Profile, Research), Braddock Financial Corp. and United Capital Markets have highlighted the problems inherent in that approach. Even so, fund managers are resisting market views on the value of subprime assets and continuing to "mark to model," claiming declines represent short-term volatility.

"'Mark to model' is a joke," said Janet Tavakoli, president of Tavakoli Structured Finance, a Chicago consulting firm. "What you need to do now is vet the underlying collateral" in CDOs instead of just modeling, which wasn't done earlier, she said. "It's grubby, roll-up-your-sleeves kind of work."

Some hedge funds may now have to report losses on CDOs, while pension funds and insurance companies may dump other securities if these are dropped by raters to "junk" status.

UNREALISTIC ASSUMPTIONS
While models may be necessary to analyze investments of such complexity and have worked well under normal conditions, they may break down quickly in times of crisis, MIT's Lo said.

Many popular hedge fund models ignore the possibility of a sudden withdrawal of liquidity, while ratings agencies may make overly abstract or unrealistic modeling assumptions and rely on the quality of the data assembled by Wall Street banks.

This week, Moody's and its rivals Standard & Poor's and Fitch Ratings slashed ratings on billions of subprime-related bonds, including CDOs, rattling global financial markets.

Josh Rosner, managing director at investment research firm Graham Fisher & Co., points to a recent S&P statement that the loan performance data it uses has called into question the accuracy of some of the data initially provided to them.

"I find it troubling that the rating agencies are only now publicly recognizing this," Rosner said.

The potential for self-serving pricing by hedge funds is a "serious concern," MIT's Lo said. "There needs to be more independence in pricing and valuation."

Bear Stearns on May 15 said that the riskier of its two hedge funds was down 6.5 percent for April, but then revised that figure to down almost 19 percent a few weeks later.

A logical choice for independent CDO pricing might be rating agencies, but this may be difficult in practice, Lo said.

"If the ratings agency ends up coming up with a really, really good pricing model, the individual responsible for developing those models will very quickly be hired by the hedge funds," Lo said.

The ratings agencies are themselves facing mounting complaints that they have been too slow and opaque in their tackling of the subprime crisis. Some say the agencies ignore key credit risks and cash in by doling out top-notch ratings to subprime-related CDOs.

In the wake of troubles at Bear's hedge funds, the chairman of the House Financial Services Committee said on Wednesday that he would hold a hearing on the role of credit-rating agencies in the fall.

S&P spokesman Adam Tempkin said the agency is very transparent. "We make all of our technical papers completely available to anybody that wants them. They explain every aspect of the models we use."

Noel Kirnon, senior managing director at Moody's, said, "The performance of our ratings overall suggest we're doing a pretty good job."

"The ratings aren't the output of a model," said Fitch managing director Kevin Kendra. "Ratings are the output of a credit committee."

BLAME IT ON THE INVESTORS
But many say investors in lightly regulated hedge funds or risky CDO securities knew what they were doing.

"Nobody made anybody else put their money into a hedge fund," said Mark Adelson, head of structured finance research at Nomura Securities International in New York.

Fear of a broad-based selloff in CDOs may also be overblown since some bondholders would be loathe to sell at fire-sale prices and also because any sudden sales would bring in other hedge funds hungry for bargains.

"Not all hedge funds are crying today," said Arturo Cifuentes, managing director at R.W. Pressprich and former global head of CDO research at Wachovia. "For some hedge funds, this is a great opportunity."