Bear Stearns' REO Listing - A Tip of the Iceberg

This is just a quick update on the continuing saga at Bear Stearns. EMC Mortgage Corporation, a wholly owned subsidiary of Bears Stearns, seems to be swimming in REOs.

You can get the file yourself by subscribing to EMC Mortgage Corporation's Properties For Sale report or you can look at a Totaled Excel File Extract of Bear Stearns' REOs that I asked Bart at NowAndFutures to host. The choice is yours.

Bart totaled the original 178 PDF for the benefit of all of us and came to a total of $779 million. Of course that is the "book value" off all that stuff. We do not know what it is really worth on the open market or what the value supposedly was six months ago. But this is just a piece of the tip of the iceberg.

The Mark to Market Iceberg

John Succo on Minyanville is writing Bear Stearns Fund Reveals Tip of the CDO Iceberg

Earlier this year I was struggling to figure out exactly what I was missing with respect to Collateralized Debt Obligations (CDO) structuring. Specifically, I wanted to know why is the market so sanguine in the face of deteriorating collateral values in the mortgage market? One of my firm's theses has been that as the mortgage market deteriorates, investors holding CDO as an investment would realize losses and this would feed into other risky asset classes. Why aren't losses being seen when the market is so clearly deteriorating?

So I asked a large broker firm to send over its smartest math person on CDO structuring. The team that came over was headed by a very smart gentleman. He was very good at math and very straightforward. Working for a broker, I was prepared for some sugar coating. I didn't get any.

The answer is simple and scary: conflict of interest.

He explained that due to the many layers of today's complicated credit products, the assumptions used to dictate the pricing and outcome of CDO are extremely subjective. The process is so subjective, in fact, that in order to make the market work, an "impartial" pricing mechanism must exist that the entire market can rely upon. Enter the credit agencies. They use their models, which are not sensitive to current or expected economic activity, but are based almost entirely on past and current default rates and cash flow to price the risk. This, of course, raises two issues.

First, it is questionable whether "recent" experienced losses over the last few years really represent the worst of the credit market (conservative). But, even more importantly, it raises a huge conflict of interest: the credit agency's customers are the very issuers of the tranches they rate. The credit agencies, therefore, need to compete for business based in part on the ratings they are willing to give these tranches. As a result, they will only downgrade when forced to by experienced losses; not by rising default rates, not a worsening economy, but only actual, experienced losses. Even more disturbing, they will be most reluctant to downgrade the riskiest tranches (the equity tranches), since those continue to be owned by the issuers even after the deal is sold.

So even though the mortgage market has deteriorated substantially, mark-to-market losses by those holding the CDO paper have generally not been realized, simply because the rating agencies have not changed their ratings for all of the above reasons. Accounting rules only require holders of the paper to mark prices according to the accepted model, not actual prices.

I asked them what would force the rating agencies to change their ratings. The response was, "it's just a matter of time. If the market continues to deteriorate, the agencies at some point will be forced by the cumulative losses to acquiesce." Because these losses have been compressed, any re-adjusting of ratings by these agencies is likely to result in a massive repricing of risk. We may be there now.

Three Words: Mark to Market

Kevin Depew was also talking about Mark to Market in Thursday's Five Things.
Three Words: Mark to Market
Read them. Learn them. Know them.

• CDO's are so illiquid - meaning they trade so infrequently - there is no market to mark them to.
• OK, then how are they valued?
• With models that the major credit agencies use based on past and current default rates and cash flow.
• Wait a minute, if the models are based on past and current defaults, what happens if there is a sudden surge in defaults... like we are experiencing right now?
• Nothing.
• And doesn't this raise conflict of interest questions between the credit agencies and their customers?
• Yes.
• In fact, this is an issue Minyanville Professor John Succo wrote about more than a month ago and again today.
• The bottom line is that even though the mortgage market has deteriorated substantially, mark-to-market losses by those holding the CDO paper have generally not been realized because accounting rules only require holders of the paper to mark prices according to the accepted model, not actual prices.
• The bottom line is that even though the mortgage market has deteriorated substantially, mark-to-market losses by those holding the CDO paper have generally not been realized because accounting rules only require holders of the paper to mark prices according to the accepted model, not actual prices.

There is much more to kevin's post including charts of BBB rated tranches. Thanks John and Bart and Kevin. I'm happy to pass on what people need to know.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/