Tuesday, September 30, 2008

Subprimes and The Efficient Market Theory

Many active investors who don't believe that markets are fully efficient (if they did, of course, they wouldn't be active investors) nevertheless believe that markets are mostly or frequently efficient (see, for example, Warren Buffett making this point in his 1988 Berkshire Hathaway Chairman's Letter). How then to explain the yawning gap between the market prices of certain mortgage-backed securities and their supposed hold-to-maturity or intrinsic values?

Brian Wesbury, chief economist of First Trust, reiterated on CNBC today a point he made in a recent Forbes column: if 100% of the mortgages in a subprime mortgage CDO defaulted, owners of the security would recover something -- perhaps 40 cents on the dollar -- from the sale of the houses. And yet, two months ago, Merrill Lynch unloaded some CDOs for about 22 cents on the dollar (Barry Ritholtz argued at the time that, since Merrill was financing about 75% of the sale itself, the actual sale price for the assets was about 5.47 cents on the dollar).

If what Wesbury says is right (and it seems reasonable), why aren't institutional investors lining up to bid on subprime-backed paper for 22 cents on the dollar?


J K said...

Given that most CDO's are made out of hundreds and hundreds of mortgages sliced and diced and repackaged every which way, with many middle men between the actual house and the owner of the CDO, it would be a very long time before a subprime security holder got paid from the sale of the actual asset, if that is the premise for intrinsic value (as opposed to rate of monthly payments). In many of those situations the residents would also owe back taxes, have leins piling up, the vacant house is now vandalized/stripped, etc, etc, making for a messy and costly situation to unwind. And we are talking hundreds of such situations to be resolved for the redemption of one CDO. No wonder the banks want to dump them on the government. I could definately see situations where some of the subprime CDO's are absolutely worthless and nobody gets paid anything from them. Many of them have just too much leverage and not enough underlying asset. A subprime home sold now will not come close to covering the mortgage it demanded in 05/06/07. Housing is still overpriced, imo, and I don't think there will be many houses selling in subprime areas to subprime customers for a long time, continuing to drive prices down.

It might be a good deal though. Its just a lot more complicated than Wesbury makes it seems. Its definately not a "redeem this coupon" scenario, the owners of these CDO's will have to get their hands dirty. My guess is that many institutions have looked at it and decided there isn't adequate margin of safety.

DaveinHackensack said...

It seems like 22 cents on the dollar would offer a margin of safety, all things considered -- especially since most of the mortgages are still performing, and those that aren't can be modified by the servicers on behalf of the MBS owners of the loans, to increase the chances that they'll get some income from them.

Going back to my idea of the government buying the loans, in this case, the servicers could simply choose to sell their non-performing loans to the government, and use the proceeds to support the coupon payments. Even if the end result was a CDO with, say, a 30% haircut on the coupon payments, it could still be an attractive investment at, say, a 60% discount to face.

Incidentally, both Buffett and Mark Cuban have said they'd consider investing alongside a Treasury fund, if given the opportunity.