CDO lemons, a government fruit bowl

Posted by Tracy Alloway on Nov 01 12:51.
‘Asymmetric information’ in Collateralised Debt Obligations is not a good thing.
That much we know from Goldman Sachs’ Abacus 2007-AC1 CDO and, err, Goldman Sachs’ Abacus 2006-13 and Abacus 2006-17 deals. But a new Federal Reserve discussion paper takes the issue a step further to ask: could asymmetric information alone have caused the collapse of private-label securitisation?
The abstract:

A key feature of the 2007-2008 …financial crisis is that for some classes of securities trade has ceased. And where trade does occur, it appears that market prices are well below what one might believe to be the intrinsic value for that class of security. This seems to be especially true for those securities where the payouff streams are particularly complex (for example, CDOs). One explanation for this is that information about these securities’ intrinsic values is asymmetric, with the current holders having better information than potential buyers. We show how the resulting adverse selection problem can help explain why more complex securities trade at signi…cant discounts to their intrinsic values or do not trade at all…

The proving of the hypothesis is probably the least interesting thing in the paper. Authors Daniel Beltran and Charles Thomas find that “when market participants are pessimistic about the state of the economy in the future; the increased pessimism interacts with asymmetric information causing the CDO market to shut down.”
But what’s really worth highlighting here are the authors’ suggestions for fixing the so-called ‘lemon problem‘ in structured finance. And there are three of ‘em:

… The …first policy has the government buy relatively low value securities and commit to holding them until maturity. The government has no better information than any other buyer. What makes the government special, and hence provides a role for policy, is that it is the only agent that can credibly commit to not sell the securities before they mature. The policy is useful because after the government makes its purchase the market for the remaining securities reopens and these remaining securi- ties trade at prices closer to intrinsic values. Although this policy involves a cost to the government, the cost is smaller than the gains that arise from having the market reopen…

Tarp take-two then, government fruit bowl edition:

The second policy considered is the creation of a “bad bank” to purchase all of the securities tainted by the asymmetric information problem. Securities holders sell their securities to the bad bank for a given price. The bad bank …finances the purchases of these securities by issuing identical shares that entitle the owner to interest in the cash flows generated by all the securities in the bank. The bad bank keeps track of the cash flows of each security it purchased, which are used to calculate their ex-post hold-to-maturity values. After observing the cash flows of each security, the bank claws back money from sellers who sold securities that had ex-post values less than the original share price, and makes supplemental payments to sellers who sold securities that have ex-post values that exceeded the original share price. So long as participation in the plan is mandatory and the claw backs can be enforced, this proposal eliminates the asymmetric information problem in a way that is fair to all investors.

The final suggestion:

… The government could lower the appraisal cost by promoting disclosure of the individual mortgages underlying CDOs. Currently, information regarding the …rst generation assets (e.g. mortgages) underlying a particular CDO could be obtained, although at a considerable price, from a database provider such as Intex, which covers over 20,000 structured fi…nance deals. But some CDO structures are so complex that, even with knowledge of the underlying assets, investors would face an enormous computational burden when trying to compute their intrinsic values. Consequently, when market prices vanished for many structured …financial products, investors often pur- chased fair value assessments from third-party appraisers … To address the root of the asymmetric problem and resuscitate the market for private-label ABS, …financial regulators should encourage better disclosure of the underlying loans backing securities and potential conflicts of interest, increased investor due diligence, and reliable ratings or third-party appraisals.

While upping transparency is always an admirable goal, we wonder what forcing appraisal costs lower might mean for third-party valuation firms — many of which already have hefty government contracts for, say the Fed’s Maiden Lane portfolios.

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