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[TTHQ Staff]

BEING STREET SMART
___________________

Sy Harding

PRICING THOSE DEBT-BACKED SECURITIES. October 12, 2007.

An academic study released a few days ago caught my eye. It said some hedge funds are still not marking down their holdings in mortgage-backed securities as mortgage defaults rise, and the value of those securities decline. The study claims they are doing so deliberately, in order to show more profits than they are actually making, or in the worst case scenario, to hide losses.

Perhaps so. There certainly are huge incentives for hedge-fund managers to be slow in marking down holdings. Hedge funds typically charge so-called ‘2 and 20’ fees. That is, the investors in the fund pay a 2% fee for the management of the fund, plus 20% of any profits the fund makes for its investors. The resulting bonuses for managers run well up in the $millions a year when a fund is making a profit. Not only do those bonuses disappear when a fund reports a loss, but some percentage of its investors will want out. A number of hedge-funds that have reported losses have had to close down completely as a result.

It’s not just hedge funds that have the problem, but major banks, brokerage firms, pension plans, and other institutions holding large amounts of those types of securities. In the last few weeks a number of major banks, including CitiGroup, Credit Suisse, and Deutsche Bank have warned they will be writing down several billion dollars of losses from the decline in value of mortgage-backed securities. Several brokerage firms, including Merrill Lynch, Goldman Sachs, and Morgan Stanley, have done likewise.

No one knows whether they have marked them down enough. Wall Street analysts say the write-downs are excessive and some portion of them will come back as extra profit when they are reversed in future quarters. Skeptics say more write-downs will be needed continuously going forward. More than a $trillion of adjustable rate mortgages, which were also sold off as mortgage-backed securities, will be reset to higher rates over the next year, some percentage of which will also experience defaults.

The problem is not just the huge losses on the securities, but that there is no satisfactory means of valuing the holdings so investors can know the size of the problem. The securities were bought, and leveraged with big loans, to hold for the long-term, for the high yield income they produce. That plan worked well as long as home prices moved up, ‘creative financing’ made low monthly payments possible, home-buyers made their mortgage payments, there were few defaults among the underlying mortgages, and no one wanted to sell the mortgage-backed securities. Unfortunately, with the implosion of the housing market all of those necessary support mechanisms went away.

With no normal market for the securities, hedge funds and financial firms are using a variety of methods to value their portfolios. The potential for mis-pricing, either intentional or unintentional, has the SEC looking into how mutual funds and other holders of hard-to-value’ holdings are arriving at their prices.

The pricing methods vary widely. If the academic study mentioned above is accurate, some apparently are simply not marking the values down. Some firms remove themselves from the equation by basing prices on the estimates of ‘third-parties’, brokers or rating services. Many say they are ‘marking to model’. That is, they establish some model or formula based on interest yield or other factors that determine what the securities should be worth. Warren Buffett calls it ‘marking to myth’.

Buffett suggests that before publishing the value of their portfolios, firms should have to sell 5% of the hard-to-price securities in order to gauge their true value in the marketplace. He doesn’t say where they would find buyers.

Apparently some hedge-funds have devised a version of that suggestion. They are creating a market by conducting sales of some of the securities among themselves to establish ‘market prices’, as in “I’ll buy a dozen apples from you for $100 if you’ll buy a dozen oranges from me for $100.”

It’s also rumored that some financial firms have avoided write-downs by selling the unwanted securities to hedge funds at an agreed upon price, with a further agreement that allows the hedge fund to sell them back to the firm later.

With these types of activities going on, and lawsuits already underway by pension plans and other large investors claiming they were misled by banks and brokerage firms into thinking they were in low-risk investments, I doubt we have heard the last of the problems from the financial arena.



Sy Harding is president of Asset Management Research Corp., publishes the Street Smart Report newsletter, and a free daily Internet blog at www.SyHardingblog.com. He also authored the 1999 book Riding The Bear – How To Prosper In the Coming Bear Market.