The UnTradeables
There is an elephant in the room that I haven't yet seen discussed: The UnTradeables.
In our discussion last week on SFAS 157, there was a subtext not articulated: The broad category of items that are actually too illiquid to trade. These include "one offs" such as Dry Cleaning stores, non-chain restaurants, Mom & Pop shops.
They are untradeable because the amount of research into each item, relative to their market cap/size, makes it too inefficient. No one will spend $100k for the due diligence on a $200k store.
For a while, Pez candy dispensers were an UnTradeable -- until eBay created a market where these can be effectively bought and sold. However, the total value of all the Pez dispensers in the world wasn't measured in the trillions, or even 100s of billions. Even tho they are relatively illiquid, their small capitalization makes it viable. And don't forget, there is no leverage involved in any of the eBay items. Hence, no margin calls.
Now consider the size of the derivative marketplace based upon mortgages: Everything from RMBS to CDOs to CDC. It runs into the trillions.
If they cannot be effectively priced, are these products essentially untradeable?
Consider these factors:
• The price relative to the requisite cost of research/due diligence;
• The size of the market relative to the overall regular and ongoing demand for that investment product;
• The buyers and sellers with an expertise and knowledge of this paper.
This may be the crux of the issue with subprime/derivative problem: The paper is, or at least should be, Untradeable . . .
~~~
What say ye?
Wednesday, April 09, 2008 | 07:00 PM | Permalink
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The Big Picture: There is an elephant in the room that I haven't yet seen discussed: The UnTradeables. In our discussion last week on SFAS 157, there was a subtext not articulated: The broad category of items that are actually [Read More]
Tracked on Apr 10, 2008 6:26:55 AM
Comments
All investments are fundamentally valued on their future cash flows. Do all investments need to be traded (tradeable)? No. I know of small lenders who have done quite well lending their own money. These assets could have been traded but it was not a requirement of it being a good investment. If their investments were sound and these stupid firms weren't so outrageously leveraged, then tradeability would not be an issue.
Posted by: Mike M | Apr 9, 2008 7:22:42 PM
They are untradeable because nobody has taken the time to aggregate all of the information available to them and make it publicly available. I'm speaking of credit rating past loan date along with factors available online such as zillow zestimate and geographical statistical data.
I an era when universal default is even possible there's no reason why loans values cannot be calculated.
Posted by: Rich_lather | Apr 9, 2008 7:37:39 PM
I would add that these instruments are untradeable if the sellers are trying to unload them without a haircut.
Jim Sinclair has repeatedly had this to say about these untradeables:
1. They are without regulation.
2. They are without listing on public exchanges.
3. They are without standards.
4. They are not transparent.
5. They are without an open market bid/ask type.
6. They are dealt in by private treaty negotiations (over-the-counter).
7. They are without a clearing house.
8. Their financial ability to perform is dependent on the balance sheet of the loser in the arrangement.
I believe most of these untradeables will eventually make their way onto the Fed's balance sheet.
Posted by: Will T | Apr 9, 2008 7:50:52 PM
I pack my own parachutes before jumping out of airplanes. Turns out that self preservation is more important than being reckless in risk assessment. Tough break to those that love the hype.
Posted by: John Wellman | Apr 9, 2008 7:55:06 PM
YES, tradeability is important - without it, a market cannot exist.
But MORE IMPORTANTLY, is the instrument still functioning? If the derivitive is unbroken, it's just an untradeable but still viable instrument.
Markets are good but operations are more important.
Posted by: paul griffith | Apr 9, 2008 7:56:31 PM
*cough* Goldman *cough*
I think that a lot of the "untradeable" (illiquid) securities are better labeled "reluctant to trade in order to delay loss realization." Isn't the point of securitizing something to make it liquid?
I think that, worse yet, Wall Street banks are colluding in order to keep these assets from trading (and provide "observable" inputs).
Posted by: matt | Apr 9, 2008 7:57:29 PM
Ney ney my good man. This is exactly the type of paper I'm looking for. Small Mom and Pops with a few hundred thou with decent asset bases will be the gold mines. And like you say, they are untradable so the discounts should be hugamongous!
Just form a pool and with modest leverage, take down a few 10's of millions. Yes, the research will be time consuming but I'm guessing the labour for that task will become increasingly friendly.
It would be like the RTC all over again. I understand your point completely as it relates to the big boys but trust me, there will be a market for this paper.
Posted by: Ross | Apr 9, 2008 7:59:36 PM
What if someone does trade one of these and all the other ones are very similar? Can't we use that price?
What if you ask for a bid for your junk, sorry i mean paper, and you get one? Can't you use that price?
Just because you get a low price doesn't mean that's the wrong price!
Posted by: Owner Earnings | Apr 9, 2008 8:01:18 PM
"All investments are fundamentally valued on their future cash flow..."
No. Not true of gold, for example. And there's no debt on it.
Posted by: Bretton Woods | Apr 9, 2008 8:02:08 PM
One more point. It is easy to determine replacement costs for hard assets. Figure the replacement cost, multiply by .35 and there's your bid. The research ain't that hard.
In many cases, I bet you could sell many assets BACK to the borrower at a discount and still make a decent profit. Worst case, keep it leased even with discounts and let the loans simply run off.
Posted by: Ross | Apr 9, 2008 8:08:03 PM
A radical thought: why not re-characterize the CDO, break them up into the each constituent piece (so each home has ten tranches!) If you know Larry Lawnmower's going to pay his mortgage, pick up the next to toxic tranche. Heck, buy your own.
The CDO tranches did not have enough "houses" in them. Is US Bank's mortgage business untradeable? No it's big (i.e. there are so many loans you can look at aggregates.) US Bank trades, it's doing well.
Untradeables should offer better opportunity according to Arbitrage Pricing Theory.
Posted by: VennData | Apr 9, 2008 8:10:52 PM
as has pointed to, above, these securities are 'untradable' merely to delay loss-realization.
there are many ways to liquidate these things, prob is, the current holders of them couldn't stand the losses and are waiting to be bailed-out..
Posted by: Mark E Hoffer | Apr 9, 2008 8:23:03 PM
remember that untradeable is not the same as unsellable. The fact that Joe's bar/grill is not tradeable, unlike common stocks, does not mean that Joe will automatically take a 40% haircut when selling. Barry point is still true, markets were created out of untradeables and this crap has yet to be addressed. Aggregating crap only yields a massive pile of crap.
Posted by: wisedup | Apr 9, 2008 8:29:39 PM
It's traded back and forth between the issuers and their cronies, with a little loss each time - spreading the risk (now a loss) as it was intended to, but not the way it was intended to. Eventually, the true value (perhaps zero) will become evident. But by then, it will be too late. You don't want to know the value, if you don't already.
Posted by: Marcus Aurelius | Apr 9, 2008 8:32:18 PM
What's the point in discussing this, Barry? We all know what the answer is. The SEC and the CPA's are too corrupt and morally bankrupt to see to it that all the crap is valued properly NOW, not when it's convenient for all the liars to do so. With that ass Bernanke running the Fed the whole mess is literally going to be papered over. So, again, what's the point in our yapping about it? At this point the populace has two choices: either "go to the mattresses" or get ready for bread at $10 a loaf in the near future. The $10 thing is probably going to happen anyway.
Posted by: Tom F. | Apr 9, 2008 8:46:54 PM
VennData wrote:
"A radical thought: why not re-characterize the CDO, break them up into the each constituent piece (so each home has ten tranches!) If you know Larry Lawnmower's going to pay his mortgage, pick up the next to toxic tranche. Heck, buy your own."
I like it!
Posted by: John | Apr 9, 2008 8:53:23 PM
VennData wrote:
"A radical thought: why not re-characterize the CDO..."
why would they sell you back that tranch for 40 cents on the dollar, when they get nearly 100 cents at the FED window.
If you want a radical solution, why not propose selling Alaska back to Russia for 7.2 Trillion (after paying $7.2M in 1867)..ok maybe to china, they have tons of dough.
Posted by: Mich(^IXIC1881) | Apr 9, 2008 9:46:19 PM
"I believe most of these untradeables will eventually make their way onto the Fed's balance sheet."
Ditto. There's your buyers; U.S. taxpayers.
Posted by: Pat G. | Apr 9, 2008 10:00:22 PM
Why not test the system here. Why not challange who really owns your property?
It seems to me the way out is to challenge the properties value and offer to pay current value?
Nothing is ever untradable?
I'm sorry you made a bad investment in my mortgage but I'm willing to give you ~60 cents on the dollar? Take it or leave it.
Posted by: Ken H. | Apr 9, 2008 10:01:21 PM
Mike M,
Well true - a loan is just a loan. Feel free to make 4% over treasuries and be happy. That's good business.
The problem is when you loan at 1% over and borrow 97% at .5% over because "it's all so liquid."
We tried that in the 1920s and now we have serious margin requirements on stocks.
Luckily, we found new, unregulated markets and did the same damn thing again :(
Posted by: gorobei | Apr 9, 2008 10:12:49 PM
Very interesting dialog. I can't comment on mom and pop, drycleaner and non-chain restaurant equity trades but I can say that there is already a very active commercial secondary market for the paper. We're talking 10's of millions, not billions. The paper doesn't trade at premiums like the small balance CRE securitization execution provided but the discounts are not huge as long as the facility is operating and the original underwriting was not completely crazy (although I suppose it depends on your definition of huge). Due diligence costs are reasonable, it depends on how much you do yourself vs. third parties, but figure $500-$1,500, less if you have volume discounts with third party providers of valuation, title and tax lien work, etc. This in on a $250K-$300K commercial real estate loan.
Your comment about a fund/pool is correct, small funds and banks are primary buyers.
Posted by: David | Apr 9, 2008 10:16:45 PM
There may be a way to reduce the cost of doing due diligence on this paper.
One might be able to create modules and frameworks of rule-based expert systems to scan the contents of these financial bundles and efficiently produce an accurate rating of the instruments, throwing some light on the dark matter.
Posted by: Aaron | Apr 9, 2008 10:35:04 PM
illusory profits is another good term. Synthocrap constructed by Wall Street mathematicians without a market and supported on nothing but hot air is what they are. Yup, fictitious capital, and that is the root problem of this mess.. it just took the rest of the public a bit longer to figure that out.
Posted by: Stuart | Apr 9, 2008 10:57:59 PM
Houses are liquid in the sense that if they are foreclosed and abandoned they can get so vandalized and stripped that the only value left is the postage stamp of land they sit on, minus the back taxes which have accrued on it.
We of a certain age have all seen abandoned, falling down houses, especially in the Northeast, and wondered how someone could just abandon a perfectly good house and let it fall apart. I know this because I used to explore these 'haunted houses' when I was a kid.
Will this decade produce the new 'haunted houses' for the next generation of kids?
Posted by: Douglas Watts | Apr 9, 2008 11:21:47 PM
These instruments can be valued and are being valued by potential buyers in the secondary market at significant discounts to issuance amounts. Buyers and sellers are miles apart in terms of price and the result is limited to no liquidity. Buyers believe that these instruments are permanently impaired. Sellers believe (or want others to believe) that these instruments are temporally distressed. Holders of these instruments once viewed them as available for sale but now view them as held to maturity. I don’t know who is right but it appears that the underlying collateral is producing less current income and experiencing negative capital appreciation (declining in value), which is personally not what I like to see in a held to maturity portfolio. Most of the holders (potential sellers) of these instruments are highly leveraged and likely technically insolvent without capital infusions if their theory of temporary distress does not prevail. I am a big supporter of the Fed these days because if it fails the U.S. may become a portfolio company of several sovereign wealth funds (potentially the club deal of the century). Maybe the next wave of financial innovation will actually include equity as a component of capitalization…
Posted by: IBGYBG | Apr 9, 2008 11:24:35 PM
