Can Wall Street be trusted to value risky CDOs?

By Neil Shah - Analysis

NEW YORK (Reuters) - The complex models that Wall Street uses to analyze risky investments in subprime mortgages may be as suspect as some of the securities themselves.

With a surge in defaults on subprime home loans jolting credit rating agencies and two Bear Stearns hedge funds in recent weeks, some fear that these models may overlook swift market downturns or corrupt loan data. That could spell further turmoil for credit markets.

The worry is that well-heeled hedge funds, Wall Street proprietary trading desks and ratings agencies may be too optimistic when analyzing or valuing exotic mortgage investments. As a consequence, future drops in market prices may be more severe and possibly trigger panic selling by sophisticated investors.

"These models end up breaking down rather dramatically during abnormal times," said Andrew Lo, a finance professor at Massachusetts Institute of Technology. "And, of course, those are exactly the times that we should and need to worry about."

Ratings companies like Moody's Investors Service use computer models to help predict losses on thinly traded debt investments called collateralized debt obligations, or CDOs, that are often tied to pools of high-risk home loans. The models help the agencies determine what rating a security merits.

Because securities in the $1 trillion CDO market trade infrequently, it is difficult for hedge funds and other investors to mark their values to recent sale prices, called "marking to market."

Hedge funds instead use mathematical models of their own to estimate and report the value of their CDO holdings to investors -- a practice known as "marking to model."

Recent troubles at hedge funds run by Bear Stearns BSC.N, Braddock Financial Corp. and United Capital Markets have highlighted the problems inherent in that approach. Even so, fund managers are resisting market views on the value of subprime assets and continuing to "mark to model," claiming declines represent short-term volatility.

"'Mark to model' is a joke," said Janet Tavakoli, president of Tavakoli Structured Finance, a Chicago consulting firm. "What you need to do now is vet the underlying collateral" in CDOs instead of just modeling, which wasn't done earlier, she said. "It's grubby, roll-up-your-sleeves kind of work."

Some hedge funds may now have to report losses on CDOs, while pension funds and insurance companies may dump other securities if these are dropped by raters to "junk" status.

UNREALISTIC ASSUMPTIONS

While models may be necessary to analyze investments of such complexity and have worked well under normal conditions, they may break down quickly in times of crisis, MIT's Lo said.

Many popular hedge fund models ignore the possibility of a sudden withdrawal of liquidity, while ratings agencies may make overly abstract or unrealistic modeling assumptions and rely on the quality of the data assembled by Wall Street banks.

This week, Moody's and its rivals Standard & Poor's and Fitch Ratings slashed ratings on billions of subprime-related bonds, including CDOs, rattling global financial markets. For details, see ID:nN12370317.

Josh Rosner, managing director at investment research firm Graham Fisher & Co., points to a recent S&P statement that the loan performance data it uses has called into question the accuracy of some of the data initially provided to them.