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Rising Tides, Models, and Asset Prices (Tuesday, May 25, 2010)

“A rising tide lifts all boats" has been often applied to economies and asset prices. What is necessary is that the boats or assets be capable of floating. Sunken boats and submerged assets need more than a rising tide or sea of liquidity. In the case of assets such as securities it may be prohibitive if not impossible.

Many pricing models use capitalization rates or variants of discounted expected cash flows. When mortgages enter the asset mix, then different payment/pre-payment variables are utilized. For simple examples consider an annual income flow of $10 factored at 1 percent or .01. It would be valued at 10/.01 or $1,000. If the cash flow remains the same, but interest rates are now 4 percent then that instrument is priced at 10/.04 at $250. Intuitively, you may now see the problem with ZIRP applications. If interest rates start going up the impact is quite severe especially if the baseline is approximately zero for the interest rate.

The rising boats exhortation is workable for functioning or floatable assets but not fatally damaged ones that can not float. If they show higher prices it is due to the change in mark-to-market accounting standards and/or distortion based purchases. When you compare this to the wordings in standard economics or financial texts you could substitute “interference” for “intervention” and “manipulation” for management. That is not a confidence or trust builder.

These activities have nurtured moral hazard and have papered over balance sheets and income statements. Even equity security analyses are more difficult due to unreliable pricing and quality assessments of basic components such as “cash and cash equivalents”. In other words when security analysts try to calculate the cash-per-share statistic the entire exercise may be seriously inaccurate due to highly questionable line items and investments.

Focusing on mortgage backed securities and the slicing and then dicing thereof we come across 2 main parts: principal only (PO) and interest only (IO). Suffice it to say that these parts can be recombined in a host of ways.

When a CDO or CDO squared holds bad principal portions due to defaults and declining property markets that is very troublesome. However, when the deals are peppered, spiced, juiced or otherwise “filled” with bad to toxic IO pieces then it can become game-ending. When a mortgage is paid off according to terms, pre-paid or even reckoned with at a completed foreclosure if there are funds available, the principal holders can get some, much, or even all of their balances due. But IO holders most likely will receive nothing. Very simply, when there is no mortgage there is no future stream of interest payments. Often these IO pieces show modeled higher “expected” rates of return according to various criteria but the bottom line is that they are intrinsically more risky than the typical PO tranche.

This is a great uncertainty for the securitization market as well as money market and mutual funds. Buy-side investors are now very cautious due to a multitude of bad deals and lessened transparency since the start of the crisis. One reason banks are reluctant lenders is the difficulty of piercing darkly valued baskets of collateral on a daily basis. The problem afflicts the public but it really starts at the institutional points.