In late 2007, I was unemployed, but had a line on a job with a minority broker-dealer who would allow me to work from home, something that I needed for family reasons at that point. The fellow who would eventually be my boss called me and said he had a client that needed valuation help with some trust preferred CDOs that they owned.
Wait, let’s unpack that:
- CDO — Collateralized Debt Obligation. Take a bunch of debts, throw them into a trust, and then sell participations which vary with respect to credit risk. Risky classes get high returns if there are few losses, and lose it all if there are many losses.
- Trust preferred securities are a type of junior debt. For more information look here.
I got to work, and within four days, I had a working model, which I mentioned here. It was:
Yarra Square Partners returned 19.5% net in 2020, outperforming its benchmark, the S&P 500, which returned 18.4% throughout the year. According to a copy of the firm's fourth-quarter and full-year letter to investors, which ValueWalk has been able to review, 2020 was a year of two halves for the investment manager. Q1 2021 hedge fund Read More
- A knockoff of the KMV model, using equity market-oriented variables to price credit.
- Uncorrelated reduced discrepancy point sets for the random number generator.
- A regime-switching boom-bust cycle for credit
- Differing default intensities for trust preferred securities vs. CMBS vs. senior unsecured notes.
It was a total scrounge job, begging, borrowing, and grabbing resources to create a significant model. I was really proud of it.
But will the client like the answer? My job was to tell the truth. The client had bought tranches originally rated single-A from three deals originated by one originator. There had been losses in the collateral, and the rating agencies had downgraded the formerly BBB tranches, but had not touched the single-A tranches yet. The junk classes were wiped out.
Thus they were shocked when I told them their securities were worth $20 per $100 of par. They had them marked in the $80s.
Bank: “$20?! how can they be worth $20. Moody’s tells us they are worth $85!”
Me: “Then sell them to Moody’s. By the way, you do know what the last trade on these bonds was?”
B: “$5, but that was a tax-related sale.”
Me: “Yes, but it shows the desperation, and from what I have heard, Bear Stearns is having a hard time unloading it above $5. Look, you have to get the idea that you are holding the equity in these deals now, and equity has to offer at least a 20% yield in order attract capital now.”
B: “20%?! Can’t you give us a schedule for bond is worth at varying discount rates, and let us decide what the right rate should be?”
Me: “I can do that, so long as you don’t say that I backed a return rate under 20% to the regulators.”
B: “Fine. Produce the report.”
I wrote the report, and they chose an 11% discount rate, which corresponded to a $60 price. As an aside, the report from Moody’s was garbage, taking prices from single-A securitizations generally, and not focusing on the long-duration junky collateral relevant to these deals.
In late 2008, amid the crisis, they came back to me and asked what I thought the bonds were worth. Looking at the additional defaults, and that the bonds no longer paid interest to the single-A tranches, I told them $5. There was a chance if the credit markets rallied that the bonds might be worth something, but the odds were remote — it would mean no more defaults, and in late 2008 with a lot of junior debt financial exposure, that wasn’t likely.
They never talked to me again. The bonds never paid a dime again. I didn’t get paid for running my models a second time.
The bank wrote down the losses one more time, and another time, etc. How do you eat an elephant? One bite at a time. It did not comply well with GAAP, and eventually the bank sold itself to another bank in its area, for a considerably lower price than when they first talked to me.
So what are the lessons here?
- Ethics matter. Don’t sign off on an analysis to make a buck if the assumptions are wrong.
- Run your bank in such a way that you can take the hit, rather than spreading the losses over time. (Like P&C reinsurers did during the 1980s.) But that’s not how GAAP works, and the CEO & CFO had to sign off on Sarbox.
- A model is only as good as the client’s willingness to use it. There are lots of charlatans willing to provide bogus analyses — but if you use them, you know that you are committing fraud.
- Beware of firms that won’t accept bad news.
I don’t know. Wait, yes, I do know — I just don’t like it. This is a reason to be skeptical of companies that are flexible in their accounting, and that means most financials. So be wary, particularly when financials are near or in the “bust” phase — when the credit markets sour.
By David Merkel, CFA of Aleph Blog