What's So Hard About Putting a Value on CDOs Anyway?

Wall Street firms like Citigroup and Merrill Lynch have spooked investors recently by dramatically reducing the value of their holdings of high-risk U.S. subprime mortgages.

Citigroup on Sunday said it may write off $11 billion of subprime mortgage losses, on top of a $6.5 billion write-down last quarter. Wall Street is now poised for more bad news from financial companies holding subprime-mortgage securities, including so-called collateralized debt obligations, which usually bundle together hundreds of subprime-mortgage bonds.

But why are these subprime investments so hard for Wall Street to value in the first place?

Unlike stocks, debt securities tied to U.S. subprime mortgages trade infrequently. As a result, it's difficult for buyers like Wall Street banks to mark the value of such holdings to recent sales prices, called "marking to market."

Collateralized debt obligations, or CDOs, may be even harder to pin down since they're essentially packages of thinly traded subprime mortgage bonds and other debt.

Instead of market prices, Wall Street bankers and hedge funds often use complex mathematical models to determine prices and report them to investors, a practice known as "marking to model." Some analysts worry that Wall Street has been too optimistic -- or even self-serving -- in its use of such models.

• Such models depend heavily on the credit ratings that firms like Moody's Investors Service put on CDOs and other securities. These ratings, themselves derived from models, represent the credit agency's best guess as to how many of the mortgages within the security will default, leading to lost principal and interest payments for investors.
  
• The models came under stress this summer, when the market for asset-backed securities froze amid a rising tide of mortgage defaults and spectacular hedge fund losses, eliminating observable prices altogether.

Many holders of subprime-related debt argued that despite the absence of market prices, their investments were still "money good," meaning that cash payments from most mortgage borrowers in a security were still flowing to investors. But several rounds of steep ratings cuts by Moody's and other credit-rating agencies are now triggering fairly large revisions in banks' model-driven valuations.

Citigroup on Sunday said it expects to write down $5 billion to $7 billion after taxes -- roughly three or four months of profit -- for its $55 billion of exposure to U.S. subprime mortgages. Merrill Lynch's Chief Executive Stanley O'Neal was recently kicked out following an $8.4 billion write-down that was more than 50 percent higher than the bank had forecast.

• The lesson? While such models may function in good times and even be necessary to analyze complex investments, they are also only as good as their data inputs and underlying assumptions. Some models may ultimately rely on questionable loan data, or ignore the possibility of a sudden withdrawal of liquidity, as was seen this summer.