“I know nothing!” pleaded Manuel, the crazed waiter in Fawlty Towers. It is becoming clear that this may be the only reasonable response to valuing the detritus created by the structured credit bubble. It is worth pausing for a moment and dwelling on Merrill Lynch’s warning on Wednesday. The $6.9bn write-off of AAA rated collateralised debt obligations represents a 31 per cent cut in their face value. Within that, so called “CDO-squared” instruments were written down by 57 per cent. These are value changes that one might expect from the very riskiest forms of equity – penny stocks or biotech – not “super-senior” debt.
Valuation problems reflect the lack of reliable market prices, but also inherent subjectivity. A recent Bank of England model posits that, with a roughly 10 percentage point change in expected default and recovery rates, the value of an AA rated tranche of residential mortgage-backed securities (RMBS) could range between 68 and 100 cents on the dollar. Factor in other variables like early repayments and the repackaging to create CDOs, and a taxi driver’s intuition may well be as good as a bulge bracket bank’s model.
Rating agencies’ systematically over-optimistic ratings add to the confusion. If the economy weakens, the snapshot assumptions in the calculations may have to change. The effort by Citigroup and others to persuade their peers to pool exposure into a “super SIV” bail-out vehicle is predicated on a degree of certainty. Merrill’s results are a reminder that this may not exist.
Markets are grown up enough to deal with the idea that estimates of losses are necessarily subjective. But the sum of announced write-offs by individual banks is just too far off top-down estimates for comfort. This week the Bank of England estimated $100bn of global losses on RMBS and noted that only a “relatively small fraction” had been disclosed. The “missing” losses do not threaten the system’s capital adequacy. But they are enough to bring down individual institutions and until they are revealed the dysfunction and mistrust prevalent in wholesale debt markets will not go away.
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