Wednesday, March 19, 2008

Markit Distortions

The writedowns on mortgage debt at the major banks and brokers has garnered a lot of headlines. How do the banks decide how much to write down? Are they being conservative or aggressive in valuing these securities? I have believed for some time that the amounts being written off were probably more than the actual losses. In this environment, when everyone is expecting a write off it makes sense to just throw out the baby with the bathwater. I suspect many of these writeoffs have valued these securities at close to zero. That may be accurate in some cases but not all. Now comes some evidence that the write offs may have been excessive:

THE credit crunch has been good to Markit Group. The company, spun off from Toronto Dominion, a Canadian bank, in 2003, has built a commanding position in the credit-derivative indices used to value fiendishly complex assets—hence the name. As trading in such products has dried up, investors have come to see those indices—such as the ABX (for subprime mortgages), the CMBX (commercial mortgages) and LCDX (leveraged loans)—as oases in a liquidity desert. Banks use the indices to help them calculate write-downs, or to hedge their exposures. The ABX is popular with hedge funds keen to take a view on the housing market.

The indices' relentless fall (see chart) has added to pressure on banks, such as Merrill Lynch and Citigroup, with big mortgage-related holdings. Citi's shares slid to a nine-year low this week on talk of a further, $18 billion write-down. Banks that mark assets far from where the indices trade incur the ire of their auditors.

The indices are undoubtedly useful, but some people think banks are putting too much emphasis on them. They capture only a narrow slice of the market: the ABX references 20 securities, for instance. And they are prone to distortion (mostly downwards) by heavy speculation. “They are not liquid enough to take the weight of short-selling heaped on them,” says one fund manager, who adds that the ABX “will probably be remembered as one of the most crowded hedge-fund trades in history.” One version of the CMBX implies losses more than 30 times greater than those suffered to date, a multiple that strikes some people as implausible. Dick Bove, a veteran bank-watcher with Punk Ziegel, recently denounced Markit's indices as “fallacious”. He expects to see write-ups as their flaws become apparent.

The CMBX is trading at a level that implies massive defaults in the commercial mortgage market. A bad recession would certainly result in a rise in the default rate but will it be this bad? My guess is no.


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