IMF Survey: Credit Market Turmoil Makes Valuation Key

IMF News, January 15, 2008

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Authors: Manmohan Singh, Mustafa Saiyid IMF Monetary, Capital Markets Department January
Published: January 15, 2008

Market participants commonly use three valuation techniques:
- mark-to-market: use of quoted prices for actively traded, identical assets.
- mark-to-matrix: estimating a credit spread of a less actively traded asset relative to a more actively traded instrument.
- mark-to-model: assigning prices based on statistical inference for the least liquid assets, including real estate, private equity, and complex structured securities such as certain tranches of collateralized debt obligations (CDOs).

Following the collapse of the U.S. subprime mortgage market in mid-2007, liquidity for certain structured securities was dramatically reduced.
The absence of market quotes forced heavier reliance on mark-to-model rather than mark-to-matrix techniques.
Some structured securities (notably most CDOs) were inherently illiquid at issuance because:
- each debt tranche had different levels of credit enhancement and varied collateral composition and quality.
- the size of the global asset-backed CDO market is no more than about $400 billion, whereas the subprime market is about $1 trillion.
Illiquidity was compounded by a lack of transparency about exposure to underlying nonprime mortgage loans and uncertainty about ratings.

Agencies downgraded structured securities by 3-4 notches on average during 2007.
A four notch downgrade example: from AAA to A+.
More than 3,000 downgrades occurred in October 2007 alone.
Agencies revised assumptions on:
- the speed at which loan delinquencies translated into foreclosures,
- recovery amounts as U.S. home prices declined,
- correlation between assets making up collateral for structured securities.
Modeling implications:
- Higher assumed correlation increases the likelihood of losses on senior debt tranches; lower assumed correlation tends to impact equity tranches.
- Ratings uncertainty increases exponentially with a linear increase in the size of the underlying portfolio of assets.
- Analogy: when hidden risks (mines) are clumped (high correlation) a ship may avoid many mines; when scattered (low correlation) the ship may hit a single mine—illustrating nonintuitive effects on equity tranches.

Some holders marked portfolios using favorable bilateral quotes or used off-balance-sheet vehicles that effectively allowed them to trade with themselves, yielding prices higher than potential fire-sale prices.
Recent moves to bring off-balance-sheet structures on balance sheet are not at explicit "transfer prices," so associated capital charges may not fully reflect potential losses.
The market resembled a monopsony for subprime products—dominated by a few buyers—creating incentives for financial institutions to maintain relationships rather than face market losses.
Analytical work modeled on conservative assumptions suggests potential losses may be higher and further capital injections are likely.
Some market participants (e.g., a few U.S. hedge funds) wrote off the value of all junior notes issued by their structured vehicles.
Most U.S. banks had not yet marked assets to genuine transaction prices or to proxy ABX indices.
Distressed or vulture funds were expecting large price declines in January and February following the bonus season.
There is an 18-month lag from end-2008 (or mid-2010) when such resets lead to delinquencies that result in cash flow problems.
In some jurisdictions (example: Japan), institutions commonly do not mark all assets to market because they hold them to maturity.

Central banks in mature markets conducted liquidity injections that temporarily improved trading in some structured securities.
These liquidity operations helped stabilize markets for some structured products; asset-backed commercial paper was declining in outstanding stock at a rate of $50 billion per week during late August and early September.
Nonbanks (institutional investors, pension and insurance funds, hedge funds) do not benefit from such liquidity injections but regulations allow them "more room to maneuver" when pricing such assets on their books.

Market participants should periodically transact a portion of their holdings of complex structured securities to obtain valid market quotes.
Policymakers should encourage investors to reduce reliance on ratings as measures of risk for structured securities.
From a structural perspective, policymakers should create incentives for market participants to transact on exchanges rather than over-the-counter operations.

Source: IMF Survey: Credit Market Turmoil Makes Valuation Key (January 15, 2008).