06 Oct Eye on Value

It is now clear that for years we have been putting our money where our mouth isn’t.

Non-recourse, off-balance sheet finance, a.k.a. securitization/structured finance, is about the value of a pool of loans where the risks are redistributed inside a structure. What are the loans worth? And what are securities worth that are backed by an undivided interest in these cash flows to which certain financial covenants (the structure) are applied? To have answers, one must do the math. It is clear that valuation precedes pricing. So a mark-to-market regime that uses pricing as an input has it exactly backwards.

In the past, structured securities priced and went to market because of an unquestioning faith in ratings, which served as valuations (S&P/Fitch) or implied prices (Moody’s). Prices formed around the ratings at origination, but not after origination. Even before the crisis occurred, there never had been robust trading in the secondary markets of ABS or risky RMBS. That is empirical evidence that price formation was stunted by the lack of a valuation mechanism. It did not take place even in ordinary market conditions, so why would we expect price formation to emerge, by magic, in a chaotic market situation?

R&R has been reverse-engineering transactions behind the ABX 06-1 index, which many parties have traded. Most of the reference names are profoundly complex, with multiple pools, triggers and swaps that are difficult to model. We believe we are the first shop ever to actually model the transactions as they are.

See the situation from our standpoint. The remarkable thing about the coverage of the financial crisis up until now is the lack of discussion about methodology or value. Nobody knows how to price these things because nobody, it seems, wants to do the work of valuing them. Not when the government is so quick with its handouts. Or when Mr. Buffett is supporting a full employment act for Wall Street.

When will America wake up and realize that KISSing – keeping it simple, stupid – and cutting deals with our power brokers is the wrong solution? We need to take ownership of what we have built. Valuation is the beginning of that process.

– Ann Rutledge