The “Toxic Assets” Challenge

For more than two years we have watched all sources of information in the discussion about the valuation of illiquid assets.

Unlike most of the people participating in this debate, we did not start with an opinion.  We arrived at conclusions after examining data.

Analyzing the Arguments

The key question is whether the distress sale prices of illiquid securities are meaningful.  One body of opinion holds that many of these assets are "performing."  The cash flows continue, even though some asset holders are selling at distressed prices.

There are many substantive examples.  Here is a recent illustration from

One Alt-A MBS expert, Thomas Patrick, chairman of New Vernon Capital and a former Merrill Lynch vice chairman, calls mark-to-market accounting a “swamp”
in this environment, an “accounting fiction” better reflecting the
“financial desperation of sellers than the value of the securities

3,700 mortgage securitizations he examined, Patrick found that of $1.4
trillion in Alt-A mortgages, $948 billion were current on interest and
principal, while $452 billion were delinquent more than 30 days.  
Further, banks carried the performing mortgages at an average
50% of par.  Patrick observes that if owned directly as loans, the
banks would carry the mortgages closer to par.  He concludes that the
mark-to-market fiction has created enormous financial difficulti

There is something seriously wrong with a method that applies one valuation to a loan and another to a securitized loan.

From the perspective of these analysts, the required regulatory capital of these companies has been dramatically reduced without any basis in reality.  The regulation affects the overall capacity for lending.

But let us consider the alternative viewpoint.

Many commentators applaud mark-to-market prices.  I have only seen one actual piece of analysis — one example of a security — where the marks were challenged.  Watch this for yourself.  Those taking this viewpoint state confidently that the "toxic assets", and they ALWAYS use that term, are worthless.  This is not a fair response to those who have examined the various pieces of complex securities and done a discounted cash flow analysis.

Conclusion:  This is Important

M2M did not cause the economic problem, but it was an accelerant.  At "A Dash" we try to be  descriptive rather than prescriptive. On
November 5th we made an exception, with our "open letter"
to the President. We explained why fixing this problem was the
single most important thing he could do.

Almost everyone disagreed at the time, preferring direct investments in financial
institutions. Three months later we can see that solution for what it
was — a stopgap.  If we
would solve this troubled asset problem, whether through price
discovery or by suspending M2M, the government could get out of the
banking business. We need market-based incentives rather than Rep.
Frank and his committee setting
rules governing business decisions. This means that we need an accurate
measure of regulatory capital. Without stabilizing this problem, how
can we expect fresh private investment in these institutions? They also
will not get
deposits with many pundits saying that the banks are insolvent.

Several experts on TV have been saying that the toxic asset question is no longer crucial. They are so wrong.

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  • martin chow February 13, 2009  

    There are many methodologies used to value assets depending on the purpose of the valuation. In real estate, there are at least 3, including the prevailing market price – the price in comparison to similar properites that sold recently in the surrounding area for a comparable property, and valuation based on discounted cash flows. In bankruptcy cases, there is valuation of a company based on the liquidation scenario of the company at a distressed sale price and the going-concern valuation based on an estimate of value of the company if were to remain a viable company. No one method is all inclusive.

  • Patrick February 13, 2009  

    There is something seriously wrong with a method that applies one valuation to a loan and another to a securitized loan.
    But does the bank get something from that? For instance, smaller regulated capital requirements. I’m not a banker, but there has to be a reason it was set up that way to begin with. And seeing how these guys operate, they were probably exploiting a loophole.

  • Patrick February 13, 2009  

    This data from a Financial Times piece today kind of vindicates the M2M crowd:

  • El Gerente February 13, 2009  

    Martin, the third method is reconstruction valuation, the ratio of which to prevailing market price helps determine profitability of subdividing.
    Even with the SAME method of valuation, different investors have different prices, because they desire different rates of cash flow, have better or worse terms of borrow, or can commit more initial capital. So it goes beyond simple choice of method and into details below that. Continue the real estate example with tax benefit or equity buildup assumptions and we see that valuation is impossible from a strictly objectivist viewpoint.
    Like in stock market – price is NOT an agreed upon value. I buy because I think it worth more than I pay, you sell to me because you think it worth less, we don’t agree on value.
    Mark to market is mark to model, with the model being a price at which something sold. It is a model none the less.
    Buffett would probably say that market price is irrational at times and a poorer model than many, which is why he buys value. His model might be said to be better than mark to market.

  • barry February 14, 2009  

    I believe that Mr. Patrick makes reference to the fact that CDO tranches are trading at 50%. These tranches are often ‘leveraged’ with respect ot losses. The M2M price is probably much more accurate than pricing them at par.
    Interesting to note that Mr. Patrick feels that he bears no responsibility for the loading ML balance sheet with this toxic waste or helping distribute toxic waste around the street.
    Reminds of a drug pusher who then complains about the rising crime rate.

  • Jeff Miller February 15, 2009  

    I appreciate the thoughtful comments on this article. I do wish that some of the M2M opponents would actually analyze some securities.
    Meanwhile, I suspect there will be a day when the rules will change. When it happens, it will create a massive change in perceived valuation, giving us some time.
    We shall see.
    Thanks again,

  • Jeff Miller February 15, 2009  

    Patrick — I read the FT article. I am open to your explanation. It discusses the “default” of a complex security, involving many underlying loans. The article makes no sense to me, so feel free to explain.
    Those analyzing these securities go into detail, talking about complete failure in subprime, for example. There is a recovery rate even for these loans. I have yet to see one where everything failed.
    What am I missing?