Navigating subprime securities

It was never easy to value sliced-and-diced subprime mortgage bundles. Now that the market's dried up, it's nearly impossible, says Fortune's Katie Benner.

By Katie Benner, Fortune reporter

(Fortune Magazine) -- By now everyone knows that those once wildly popular subprime-backed securities aren't worth as much as was thought. But that still leaves a big question: What are they worth?

For most securities there are procedures for figuring it out. Everyone who takes money from investors - from hedge funds to investment banks to mutual funds - must, typically at quarterly intervals, disclose the net asset value of their holdings. That is no big deal for a mutual fund manager who owns shares of, say, GE, but for a hedge fund manager who has been buying bundles of mortgage-backed securities (which can be, in turn, resliced into another asset class known as a CDO, or collateralized debt obligation), it's a confounding proposition. There simply isn't a reality-based way to value the stuff.

"The only entity that really understood the true value and risk in a mortgage-backed security or a CDO was the mortgage broker who originated the loans that made up the underlying assets," explains Niket Patankar, CEO of hedge fund advisory company Adventity. "And that person was long gone from the picture by the time they were sold as part of a CDO."

A tangled web

Indeed, a typical mortgage-backed product contains slivers of hundreds of thousands of mortgages, all of varying quality and proportions, combined in seemingly infinite ways. Wading through the 400-page prospectus on a typical CDO and then doing diligence on that document would be "an accounting nightmare," as one hedge fund manager puts it.

Some banks did hire outside accountants to try to value the assets, but they could only come up with ballpark figures. So most simply adopted something called mark-to-model accounting, the practice of basing prices on computer-generated models rather than on what buyers and sellers agree upon in an open market.

"When you use a computer model, you're going to see people make bad decisions," says Steve Cesinger, chief financial officer at real estate holding company Dewberry Capital. "Sellers were incentivized to say the assets were worth a lot, because they made a commission on sales. Many fund managers charge fees in part based on the value of their assets, so they also had incentives to say this stuff was worth a lot. It's not impossible to choose models that support the need for a high-value product."

Squeeze play

With the rise in mortgage defaults, however, hedge funds and other investors began to realize these products were hardly the high-value instrument they thought they were buying. The banks that loaned those same investors the money to buy this paper think it's worth less too - and they're calling in the loans.

Funds have been selling anything in their portfolios to pay the banks - though most have avoided selling the asset-backed securities because the market has totally dried up. The funds that have been forced to sell those securities have had to write down values by as much as 50 percent (as London hedge fund Queen's Walk was forced to do last month).

So back to that question: What is this stuff worth? These assets are "so complicated that it may be impossible for accountants to ever value them," says Peter Morici, a business professor at the University of Maryland. "They'll have to wait until they're sold and use the sale price to mark the value."

Some banks aren't waiting that long, and instead are trying to disassemble the messy packages of securities and sell individual loans separately. "Without the accounting it becomes a confidence game," says Bill Laggner, principal at Bearing Asset Management. Unfortunately confidence is something that's in short supply these days. Top of page