Shopping for Toxic Assets at the "Zombie Bank". Final Chapter of the Credit Crunch?

By: Andrew_Butter

Timothy Geithner's new plan is to raise $2.5 trillion or so from the private sector to co-invest with him buying Toxic Assets. That sounds risky; but perhaps the flight to safety is over-priced these days? If so then "safety" is "risky".

But there are a few things I don't understand. Not least that the last time I looked, the main problem with buying those assets was finding anyone who wanted to sell some.

I mean he's talking about is a Fire Sale isn't he?

So what did I miss?

Shortly after the “collapse” a friend of mine sat in on a meeting where an ex-Lehman banker was pitching his services. Someone asked him, “so what went wrong”…this is what he said:

"Once upon a time someone started making tins of sardines. Soon there was a huge demand for those tins from all over the world, people were buying them and selling them like crazy. Then someone opened one".

That raised a laugh, someone said; “Ah he can make tins of sardines for us”.

The problem which Hank Paulson didn't understand before he went out shopping for that stuff - (with $350 billion in his back pocket...and he came back with two banks and an insurance company (not the same thing mate)); and which Timothy Geithner appears to be getting his head around in slow motion on Primetime...

Is that there are two things you need to know when you go shopping for second-hand mortgaged backed securities:

1. What's in the tin?
2. Is what's in the tin worth more than the price that's being offered?

To figure that out you got to open the tins, every one.

Meanwhile:

At Davos Professor Nouriel Roubini announced that all the big banks in USA are insolvent “zombie banks”.

What's unsettling is that no one contradicted him; and he's not the only one with that notion ( Geithners Bank Bailout Plan Gibberish "Not Ready for Prime Time").

Presumably if "only" half of his estimated $3.6 trillion hit on the "shadow banks" will be taken by US banks, then the balance is lying in the vaults of European and notably UK banks, so they must be zombie banks too?

Perhaps he's right? He's been right before...

But until there is a law that mandates valuations of bank assets used to assess capital adequacy (and insolvency), that are not, as characterized by International Valuation Standards as "fundamentally flawed and bound to be misleading”...

...who knows?

OK the latest fudges to US GAAP and IFRS might help to dress up the funeral parlor, but if anyone believed those machinations why is there this pervading suspicion that there are still a lot of "assets" that are well...not assets, floating around ( Fair-Value and Mark to Market...The Most Expensive Scam in History?).

Perhaps that could explain why no one wants to sell them?

I suspect that right now many Toxic Assets on the balance sheets are either (a) marked to the market before it completely stalled (July/August 2008 - i.e. a sort of mark-to-market/book value hybrid, or laughably "marked to quote") or (b) selectively held completely at book value (what was paid in the first place), or (c) valued according to the same internal rocket-science models that let the problem happen in the first place (held to maturity).

In which case the moment anyone starts selling that stuff "at a reasonable price" (my words...Fire-Sale to you!), mark-to-market, and everyone will be insolvent.

Mmm...best to keep it all under wraps!!

Either there is some monkey business going on (it wouldn't be the first time), or it looks suspiciously like the banks themselves haven't got a clue if they are insolvent or not, and neither do the regulators.

If so, then with all due respect, if THEY don't know, then how the heck does Nouriel Roubini know?

Until someone actually starts to open the tins and do some proper valuations (call it due diligence if you like - same thing), no one is going to have a clue about what is really going on. And I don't care if Professor Roubini says he has X-Ray eyes. The only way you can see what's in the tins is to open them up.

Rule of Thumb:

I'm a pretty simple guy and it's long time since I worked on mortgaged backed securities, and anyway those were all CMBS. But from what I remember, and unless they changed the rules, the way it worked was like this.

1: The "story-teller" (me), came up with a projection of the net cash flow going out twenty years or so (ha...ha!!). That was all about "telling a story" that everyone believed, the trick was to put in a "carefully considered" downturn just after the critical period and then spin a yarn about how the thing would come back to a long-term trend.

2: Then we did a valuation of the collateral, pretty straightforward; basically a sales comparison (mark to market), which we dressed up by validating that from an income capitalization and a depreciated replacement cost.

3: Then we got numbers on the thresholds for Debt Service Coverage Ratio (DSCR) and the Loan to Value (LTV) from the rating agency, and worked out a repayment schedule to maximize the number of AAA you get out of the waterfall (that's the process whereby the AAA gets any money coming in first, then the BBB etc).

4: Then you dream up some standard deviations for your assumptions and run a Monte Carlo analysis to check the default probability.

5: Go through a number of iterations, write some impressive narrative that no one ever reads, bind it up and send it off to get rated. Meanwhile the lawyer writes a 400-page stream of consciousness to justify his fee, and bingo, you are set to go!!

I do remember two things. First it was a long process, so if anyone is going to take a damaged MBS and package it up again (properly) to something that makes sense, it will take time, you can't hurry those things and get them right.

The second thing is that I was basically on the "credit" or "risk" side of the fence (the bad guy with no "vision"), and from time to time the sales people and "relationship managers" would come round and try and get me to be a "little less conservative".

Boy they were good!

They were always so friendly and polite, they remembered the names of my wife, my children and my dog, never pulled rank, never made like they were putting me under pressure, I almost believed they were going to be my best friends for life.

But this is the thing. No one ever, ever tried to get me to change my line on the value that went into the LTV. All they were ever interested in was pumping up the net income stream.

That's because that the DSCR was always the thing that determined how much investment grade you could distill out of the pot (i.e. AAA), and that was where the real money was because there was a world shortage for that stuff. Which explains why eventually people started stuffing junk into those tins, the temptation was simply too high. The LTV was just academic; that was the "pound of flesh" that would never get called, and got forgotten in ANNEX 43.

Rule of Thumb for valuing a MBS worst case , all you really need to know is the LTV.

This is pretty rough and ready:

I compared valuations of AAA mortgaged-backed securities on the Markit ABX HE Index with the S&P Case Shiller Index , putting the house price Index at 100% at it's peak in August 2006. OK that's a mix of MBS's not all are RMBS, but it's a benchmark.

I also put in:

1: The point at which Professor Roubini says that the house price index will bottom (by end 2009 and 44% peak to trough worst case).

2: The point at which I say housing will bottom (40% peak to trough by end 2010: (http://www.marketoracle.co.uk/Article8126.html)). This assumes that 2009 nominal GDP growth is slightly negative but long term interest rates stay low (I'm not sure about that one though).



The "wiggles" in the AAA line going forwards are "creative license".

Looking at the chart, you can see that until Lehman blew the AAA index was broadly leading the house price index, presumably as traders priced in the possible effect of future falls.

You can see that the Bear Sterns bust had an effect, but strangely the Lehman bust didn't do much, until the TARP funds got approved. Perhaps it took a while for everyone to get their heads around Lehman?

Or perhaps anyone holding those things got spooked by the idea that Hank Paulson would start to do a mad reverse auctions and somehow force through sales? That was a "skin of the teeth moment", and if indeed that was all thanks to Gordon Brown then perhaps he did "save the world"?

Anyway, now we are at about 55% peak to trough on the AAA stuff which looks pretty sensible. i.e. conservatively but not over conservatively priced, given the circumstances.

What I think:

Looking at that chart, what I think is this:

1: Under the current rules and regulations even after some quite generous fudging, some perhaps all of the big banks could indeed be technically insolvent, as Professor Roubini says they are.

2: But if they can hang on and particularly if the rules get changed to make more sense (too long to explain in this article), they will pull through; and we will not see another major banking collapse.

3: Unless someone does something really stupid, like try and force people holding AAA mortgaged backed securities to sell at a price that they don't want to sell at, then the market for that class of assets looks at first inspection pretty correctly priced and the direction that it will go (on my chart) is to join up with the S&P Case-Shiller line in about a year.

4: It's probably worth thinking about putting on gas masks and setting about opening up some tins of sardines, particularly if Timothy Geithner manages to spook the market in which case there will be nice trough to buy into; and he seems to be doing a good job on that score.

5: By end 2010 the AAA on this chart will be trading at about 60% of what they were at the end of 2006. So unless the government sweetens the deal by facilitating purchases with gearing, there is not windfall money to be made here (and it's easy to slip up if you don't know what you are doing).

6: But equally Treasuries look over valued, so does the stock market (I say by about 25% ( http://www.marketoracle.co.uk/Article8293.html ) so the least risky thing might well be to take a punt with a few bob and go shopping with Timothy Geithner.

7. On a personal note, I have problem with government or central banks doing anything more about a financial crisis other than (a) fudging the effects of idiotic mark-to-market accounting which helped cause the bubble and has exacerbated the fallout, and (b) providing liquidity in case of runs.

As far as I'm concerned if a bank is really insolvent it should be put into administration immediately. Re-capitalizing it just prolongs the agony and poisons the market place, and don't worry about the CDS story, the Lehman things got squared away without too much fuss.

I most certainly don't agree that government should provide credit so a few can make windfall profits cleaning up the mess government helped create.

I have a concern about the Stimulus Package. As far as I am aware the evidence that a Keynes inspired New Deal ended the Great Depression is about as strong as the evidence that there were WMB in Iraq . Two other things happened (a) after about eight years mark-to-market was neutralized and (b) the US went to war. My suggestion of out those two options is that (a) is the more sensible choice.

But I acknowledge that so long as there are Toxic Assets on banks balance sheets there will be uncertainty.

One proactive thing that government could do is as follows.

•  Deploy and pay for truly independent "eyeball" valuation of the Toxic Assets held by banks. By "eyeball" I mean no more than three man-days per valuation, a competent analyst can get within 15% ninety-five percent of the time in that time (and do two for each to compare).

•  As per International Valuation Standards (IVS) the logic of the valuation opinion should be explicitly explained in plain English and the "Purpose of the Valuation" should be explicitly to work out the value "If the market was working", this is what IVS calls " Other than Market Value".

•  Get the banks to use those valuations to work out if they are insolvent not, if under those valuations (rather than idiotic mark-to-market or fuzzy logic accounting), if they are, think hard about closing them down.

•  Offer to buy the assets at 5% or 10% below the valuation (preferably bringing the private sector along), but give the banks the option of buying them back at a later date at the price that was paid plus a small margin. With luck a market would start for those options that could help re-start the main markets.

By Andrew Butter

Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( hbutter@eim.ae ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.

© 2009 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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