In the News: Recent Developments

December 4, 2007

Subprime Seizure Solution May Be in Hospital Bills (Update2)

By Caroline Salas Published in Bloomberg News / BusinessWire

Dec 4 (Bloomberg) — The solution for the subprime-infected credit market seizure that wiped out $66 billion of securities industry capital this year may be found in a bunch of hospital bills.

Day trader Richard Field in Needham, Massachusetts, says his patent for tracking medical invoices can be adapted for mortgage interest payments, helping banks better value securities derived from home loans and other receivables. From its headquarters in New York, accounting firm Deloitte & Touche LLP says it’s developing computer models that will do the same.

Field and Deloitte & Touche are part of a fast-growing cottage industry that includes household names such as Moody’s Investors Service trying to shine a light on the world’s most opaque markets. The inability to properly value the $2 trillion of asset-backed debt outstanding with their own models has led to more than $66 billion of losses for banks and brokerages and the ousters of the chief executive officers at Merrill Lynch & Co. and Citigroup Inc., the largest U.S. bank.

For Wall Street, the choices are either working with people like Field to come up with a solution or having one forced on them by regulators, according to former U.S. Securities and Exchange Commission Chairman Arthur Levitt. To regain investor confidence, “we cannot ignore the need to be transparent at all levels,” he said at an industry conference last month.

‘Demand Transparency’

“The market should demand transparency,” said Mark Amberson, who runs the $5 billion Russell Money Fund for the Russell Investment Group in Tacoma, Washington, and buys asset- backed commercial paper. “I wouldn’t loan my brother money if he hands me a bag and says ‘Don’t look in there, but trust me, it’s really valuable.”‘

Unlike the corporate bond market, which gained price transparency in 2002 when the SEC required dealers to report their trades on a computer system called Trace, the asset-backed debt market has no centralized network for disclosing prices.
Investors and Wall Street firms rely on their own software, models bought ready-made from vendors such as Moody’s, and quotes from brokers to value their debt.

The wide variety of valuation methods and the complexity of the asset-backed securities make it impossible to come up with consistent valuations. Mortgage bonds are composed of thousands of loans. CDOs go a step further, repackaging the bonds, as well as other debt such as loans, into securities with varying credit ratings and yields. CDOs can even be made up of other CDOs.
As much as $2 billion a year could be made by someone with a model that accurately valued asset-backed securities, according to Sylvain Raynes, a principal at R&R Consulting in New York and co-author of “The Analysis of Structured Securities.”

‘Like Teenagers’

Dan Fuss, vice chairman of Boston-based Loomis Sayles & Co., hasn’t found an adequate system to help value CDOs so he refused to include them among the $22 billion of securities he manages.

“It’s like teenagers: You sort of know what’s going on but not really,” said the 74-year-old Fuss. “We spent a fortune on software, $75,000 a month. And what do we end up with? A bunch of zip codes.”

E*Trade Financial Corp., the online bank and brokerage, sold asset-backed debt it valued at $3 billion on Sept. 30 for $800 million, or 27 cents on the dollar, last week to hedge fund Citadel Investment Group LLC.

Less than a month earlier, New York-based Citigroup, the world’s largest U.S. bank, increased its loss estimates on mortgage-backed securities and loans to $17 billion from $6 billion. CEO Charles O. “Chuck” Prince stepped down on Nov. 4.

‘Opaque and Illiquid’

Merrill’s inability to value CDOs forced it to increase its writedowns by almost $3 billion. The New York-based firm, the third-largest investment bank, announced a $5 billion charge for mortgages, asset-backed securities and loans for leveraged buyouts on Oct. 5. CEO Stan O’Neal increased the expense to $8.4 billion on Oct. 24. He was ousted six days later.

Calls to Jessica Oppenheim, spokeswoman for Merrill, and Citigroup’s press office were not returned. Merrill is a passive minority investor in Bloomberg LP, the parent of Bloomberg News.

The world’s biggest financial institutions have written down the value of their asset-backed and loan holdings by about $66 billion, according to data compiled by Bloomberg.

Field, the day trader from Needham, says he has a model that will enable investors to monitor the performance of the individual loans backing asset-backed debt on a daily basis. Field, who works out of his house, also says he plans to standardize information across issuers to make it easier for investors to compare the quality of different securities.

‘Trust Your Input’

Field was issued patent 6,073,104 in 2000 for his computerized system that would help healthcare providers sell their patient claims in the asset-backed commercial paper market.

The model produces statistics on the collection of providers’ claims, which are required by credit-ratings companies and asset-backed commercial paper conduit sponsors, according to the patent’s abstract. It tracks the percentage of claims that have been paid and the timing of the payments, the abstract says. Field says the same model could be applied to mortgages.

“When I look at the entire structured finance industry today, I think you can describe it in three words: complicated, opaque and illiquid,” Field, whose firm TYI LLC stands for “Trust Your Input,” said in an interview. “When you give people the information on the underlying performance of the collateral then they can come to their own conclusions.”

Field is working with Deloitte to piggyback off the accounting firm’s reporting systems, such as a program called “CDO Suite” that’s used by trustees to monitor the collateral backing the securities.

Real Issue

“He has a unique take on how he would present the information,” said Mark Scherer, principal in Deloitte’s securitization group in New York. “The real issue is how do you make deals that aren’t consistent and issuers’ products that aren’t consistent” on the same scale.

New York-based Moody’s, which has been criticized by lawmakers including Paul Kanjorski, a Democrat from Pennsylvania and chairman of the House subcommittee on capital markets, for failing to identify the risk of bonds backed by subprime loans, last month said it is starting a service to help investors value CDOs. The model combines tools and software to analyze collateral and cash flow that it already offered piecemeal.

“One of the things we tried to do was to ensure that it was easily understood, that it was transparent,” said Roger Stein, managing director in structured finance at Moody’s. “Many people in the marketplace have talked about analytic black boxes. We’ve tried to design a glass box.”

‘Rocket Science’

Even Wall Street managers struggle to assess the value of the securities.

Raynes of R&R Consulting was hired two years ago by an affiliate of the Bond Market Association that deals in asset- backed debt to assemble teaching materials on valuing such securities for its members. The trade group paid Raynes half of his fee in advance and failed to pay the remainder after receiving the materials because its members found them too complicated, he said.

“All of the managing directors could not understand any of the formulas so they did not pay us,” he said. “This is basic bond math, duration and convexity. This is not rocket science.”

Duration measures a security’s price sensitivity to changes in interest rates, while convexity is a gauge of the relationship between bond prices and yields. The BMA and the Securities Industry Association merged last year to become the Securities Industry and Financial Markets Association. The group declined to immediately comment.

Heightened Concern

Firms promoting new pricing models are “trying to cash in on fear,” Raynes said.

The Financial Industry Regulatory Authority, the agency that maintains Trace, is considering measures such as including asset- backed securities in the pricing system.

“With the heightened concern here about transparency in the ABS market, we’re actively in conversations internally about determining the best way to go forward,” said Steven Joachim, executive vice president at the agency in New York. “The interest level is increasing.”

Investment banks objected to Trace when it was introduced for corporate bonds, and in 2004 opposed putting asset-backed securities on the system. The banks collected $27.4 billion in revenue from underwriting and trading asset-backed securities last year alone, according to a June 4 report by JPMorgan Chase & Co. analyst Kian Abouhossein in London. He didn’t immediately return calls for comments.

Provide Value

“There is a need for more information in the marketplace,” Joachim said. “We want to be sure that if we expand Trace, we expand it in a way that will provide value to people.”

Dealers saw their fees for corporate bond deals cut in half the year after Trace was introduced, according to a study last year published in the Journal of Financial Economics.

“It could create some harmful effects on liquidity and volatility in valuations,” said Michael Decker, senior managing director for research and public policy at Sifma in Washington. “What happens when a particular security trades at 40 cents on the dollar today and 70 tomorrow? What’s the market value of that security?”

Former SEC chief Levitt helped implement Trace because he wanted a database to collect the prices of trades on all registered corporate bonds. The asset-backed security industry may find itself forced to use a similar system, Levitt said at an industry conference in Orlando, Florida, last month.

“If we don’t, as an industry, work with regulators to come up with a better plan for transparency, one will be imposed upon us,” Levitt said at the ABS East conference. He is a director of Bloomberg LP, the parent of Bloomberg News.

“The first step if you are an alcoholic and you need to stop drinking is to get on the podium and admit to yourself you’re alcoholic,” R&R Consulting’s Raynes said. “We as a market must recognize there is a lack of understanding of what value means in structured finance.”

—To contact the reporter on this story: Caroline Salas in New York at

—Last Updated: December 4, 2007 12:21 EST

Share this Article.: