CDO Valuations: Separating Fact From Fiction
When Merrill Lynch - one of the world’s largest brokerage houses - announced plans to sell $31 billion of collateralized debt obligations (CDOs), it put a price tag on the sale at $6.7 billion. Less than two weeks earlier, the Merrill Lynch CDOs had been valued at $11.1 billion.
The value inconsistency of the Merrill Lynch CDOs is troubling on several fronts, a fact that investors are all too aware of. Not only does it create controversy regarding the accuracy of the Merrill Lynch balance sheets but also begs the question of whether the write downs haunting Wall Street will ever be put to rest.
The Merrill Lynch CDO sale was a pivotal moment for the financial world - one that is sending a loud and clear message that the problems plaguing CDOs and other mortgage-backed securities is not liquidity in the market but rather how the underlying assets are being valued by investment firms.
A July 30 article in the Wall Street Journal highlights the increasing difficulty that investors face in deciphering fact from fiction when it comes to the valuations of CDOs touted by Wall Street. “Are executives basing valuations on realistic market prices, rather than a rosy, ‘trust us – these will be good money’ view,†says the story.
Valuing complex, asset-backed securities like CDOs is a tricky and oftentimes convoluted process. That’s because investment firms employ their own statistical models, not market prices, to assign value. And that can spell trouble - in this case, trouble comes in the form of write downs. Investment banks and securities firms have posted nearly $500 billion in losses and write downs after the subprime crisis unfolded last year.
Since then, dozens of Wall Street’s biggest players have dug themselves into the proverbial CDO hole based on the simple fact they failed to acknowledge the true scale of their CDO exposure. Others overvalued their CDO assets so they could prolong the period of time before they eventually had to take the losses onto their books. And still others have simply chosen to believe the market for CDOs will eventually return to normal.
That hasn’t happened, as evidenced by the Merrill Lynch CDO sale, July 29, and its subsequent write down of $5.7 billion. Some analysts predict other financial firms will soon follow Merrill’s lead and rid themselves of their own toxic CDO holdings to free up their balance sheets once and for all. When all is said and done, the extra losses could potentially double the write downs that financial institutions have taken thus far.
The Wall Street Journal article cites the example of Citigroup, which at the end of the second quarter had nearly $30 billion in gross CDO holdings, of which $9.8 billion was hedged. According to the article, a portion of the bank’s net holdings are valued in line with Merrill’s recently announced CDO sales price. But about $14.4 billion are asset-backed commercial paper CDOs valued at approximately 62 cents on the dollar.
Citigroup stands behind the higher value, saying it hasn’t suffered cash-flow losses on the holdings and that they are high quality. However, in a report issued July 30, a Morgan Stanley analyst harshly criticized Citigroup’s pricey valuation, stating the bank may need to reduce the value of the CDOs by an additional 21%.
The same scenario is being played out at Bank of America, which has $11 billion in CDOs backed by subprime mortgages. Of that amount, $5.1 billion are CDOs made up of other CDOs. These are called “CDOs squared,†and are considered the most toxic of debt products. Nonetheless, Bank of America has valued these “CDOs squared†at 35 cents on the dollar, which is far more than what Merrill Lynch received for its higher-grade and better-quality CDOs.
Again, is it any wonder investors are growing more and more leery every time Wall Street talks?
Our affiliation of securities lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage-related investment losses.Â
