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Writing-Off Write-Downs

By, 11/13/2007

Story Highlights:

  • One of the biggest up days for stocks of the year doesn't necessarily signal an end to recent downside volatility, but it is encouraging.
  • The smart money is swooping in to take advantage of today's artificially low stock prices and debt valuations.
  • Just because liquidity in the securitized debt markets has diminished doesn't mean the assets are worthless—much of that debt in those illiquid products is still perfectly fine.

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What a wonderful quote this is from Glenn Tongue in today's Wall Street Journal: "Fear has moved away from hurricanes and is now moving into the financial markets." That says it all, doesn't it?

What the heck happened today? Stocks had one of their biggest up days of the year. The big Financials companies rallied hard, getting back some of the heavy losses sustained in recent weeks.

Is this just an anomaly in a bigger down trend, or the start of another kick upward? It's too hard to say, and it doesn't matter. Whether it happens today or months from now, eventually the market will have to recognize today's credit fears as more bark than bite.

What was that old Warren Buffett saying? "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." If you take that as financial wisdom (and we do), then what a great time to get greedy!

A Bit More Fear Would Help Stocks
By Bernie Schaeffer, Forbes
http://www.forbes.com/home/personalfinance/2007/11/12/cisco-wachovia-spyder-pf-guru-in_bs_1112outlook_inl.html

As a matter of fact, Buffett's Berkshire Hathaway is suddenly feeling spry, looking to possibly invest its tremendous horde of cash in today's extremely cheap debt market:

How the Crunch Is Playing Out
By Karen Richardson, The Wall Street Journal
http://online.wsj.com/article/SB119491675764090710.html?mod=todays_us_money_and_investing

Why get greedy now? Particularly when it seems Financials' debt assets are pervasively toxic? The media wants us to believe today's positive market move was due to Wal-Mart's stellar earnings report. But why the earnings of a predominantly US-centric Consumer Discretionary company would necessarily send world markets up nearly 2%, we're not sure.

What's far more likely in our view is the recognition that the stock market is extremely oversold and the fears baked in to today's credit worries are grossly overwrought. At this point, many of the debt securities (CDOs and SIVs in particular) are actually valued well BELOW their liquidation value. This is craziness.

(Editor's Note: For those unfamiliar with, or in need of, a detailed explanation of what Collateralized Debt Obligations (CDOs) and Structured Investment Vehicles (SIVs) are, we have appended a primer on both to the bottom of this commentary.)

Recent increases in subprime mortgage defaults have raised concerns about the debt products containing these loans. Because many CDOs hold subprime mortgages, CDOs in general have been shunned by investors. Many of the big Financials companies are lousy with these securities and have written down their book value—thus, Financials stocks have taken a pounding recently as many fear a big chunk of their assets are imperiled.

CDOs have always been difficult to price in the open market because they don't trade as regularly as stocks. As a result, investors often use complicated models to estimate the value of CDOs based on assumed values of the underlying assets, along with many other factors. This type of pricing has been called into question as the secondary market for debt products withered in recent months. Just what are these securities worth anyhow? Have they been far overvalued for some time?

It's most likely today's asset write-downs are a result of the weak market for these debt products. The market is not very liquid today and companies are being forced to keep the assets on their books for longer. But that doesn't mean the assets are worthless, far from it.

There's a world of difference between not being able to sell a security quickly and the actual value of the assets in that security. In other words, the loans themselves aren't in bad shape, but nobody wants to buy them packaged as CDOs or similar products right now. Eventually, some of these products could very well be dismantled and the parts sold because the individual components are worth more alone than they are together.

Think of it as you would the housing market. A couple years ago, in the hottest growth areas, many folks could actually sell a home the same day they put it on the market! Just because you can't do that today doesn't mean your house is worthless. It might mean demand is a little weaker and even that your house is worth slightly less today, but it certainly doesn't follow that your house has turned into a rotting pumpkin.

The important thing to note is that the asset write-downs making headlines today aren't really losses in the sense companies are hemorrhaging cash. (Actually, 2007 Financials earnings are still expected to be the second best on record).

Very few financial firms are actually liquidating their debt securities, instead they're simply writing down the book value. Today, many CDO book values are less than the value of their underlying assets. So if the market for these products recovers (as it almost undoubtedly will), or if the products are dismantled and sold as parts, or if the underlying debt is simply paid off, the book losses taken now by the big Financials companies could turn into future profits.

The bottom line is folks are confusing an illiquid debt market with the value of the debt itself. Those are two distinct things. As this is eventually realized, look for the markets to write-off asset write-downs, and the bull market to resume its upward climb.

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What are CDOs and SIVs?

Collateralized Debt Obligations (CDOs) are structured debt products. In a CDO, various forms of debt are packaged together and pieces of the pooled debt are sold to investors in various tranches. Although the different tranches include the same underlying debt, the tranches have different ratings because they have differing claims to the income and assets of the CDO. The "senior" tranche has first claim to income generated by the underlying debt and is last to suffer any losses if borrowers default. Because the senior tranche is the safest, it offers the lowest yield to investors. The "mezzanine" tranche has a lesser claim to income than the senior tranche, and suffers losses before the senior tranche. As a result, the mezzanine tranche pays a higher yield than the senior tranche. The riskiest portion of a CDO is the "equity" tranche. The equity tranche has last claim to income meaning investors in the senior and mezzanine tranches must be paid before equity investors. The equity tranche is also first to suffer losses if borrowers default.

Structured Investment Vehicles (SIVs) are entities that issue short term debt to invest in long term debt, earning a profit on the difference in rates. SIVs issue commercial paper at low short term interest rates and buy long-term loans from banks or other loan originators. Often, SIVs package the loans they buy into CDOs, parts of which they hold themselves and parts of which they sell to investors. When SIVs issue commercial paper - very short term debt that is free of registration requirements - the commercial paper is backed by the assets held by the SIV. Because commercial paper issued by SIVs is very short-term, SIVs must continuously issue new commercial paper in order to repay the holders of expiring commercial paper.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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