Obama's toxic asset giveaway

The toxic assets that continue to occupy the balance sheets of most key US banks, and that as a result make these firms a no go area for many investors, are still central to the continuing problem in the US financial system. Solutions have been slow in coming as the crisis is now entering its third year.

The idea that Obama and Geithner are pushing, in essentially enticing investors to take on the risk from the banks, is hardly revolutionary policy. However, given how CDO technology works, now is the very first time it has been sensible to push this solution - any time prior to this and the volatility of many of these assets would have scared away anyone but the most foolhardy of investors. Not to mention the banks themselves were struggling with generating a meaningful valuation. However, it seems that Obama's timing, by accident or design, is possibly perfect. The opportunity in this 'toxic' asset giveaway is a fabulous one for an investor willing to do a little homework now that the first grass shoots of stability in the US housing market have appeared.

There are three key hazards to negotiate before this opportunity becomes a good one. And if you do this properly, the opportunity could be an excellent one:

1. Do your homework on the mortgage pool - some 'subprime' pools are more rotten than others. Finding a subprime mortgage pool with a fundamental supporting market and solid reasons for a stabilising of house prices is key. Some subprime areas, where all the neighbours were borrowing money they couldn't afford, could well become ghost towns. Prices in areas like this are trapped in a race to the bottom. For these pools, any signs of recovery are more a pause before the downward march is resumed rather than a turnaround. Other pools, where subprime mortgages have a fundamental floor on account of solid surrounding economic support, are the pools you need to identify. This requires local analysis. If you can't find a pool you like, stop right there.

2. Once you feel you have a good idea how your chosen mortgage pool is likely to behave, you need to value the CDO derivative correctly. Conventional valuation tools do not work for these securities in volatile markets. Indeed, many CDO tranches generate an effect which is the opposite of diversity - hence why they are so risky. You need to develop a more fundamental approach to valuing these assets and play through some different scenarios from now to asset maturity to frame the risk you are taking on. If you use quantitative techniques you don't fully understand, it is likely they will lead you up the garden path.

3. The Treasury is committed to extending a floor to your asset - it is likely they will value this floor very generously giving you an asymmetric pay off. Governments are not always known for their financial acumen and they also need to price this stuff to sell. The value in this floor is a function of you fully understanding the last two hazards.

If you understand your mortgage pool, how your CDO will behave for different forward scenarios, and then combine this knowledge with a generous Treasury floor, these assets will be a fabulous opportunity. However, get on the wrong side of one of these issues, and it could be very painful one.

And bid low ! Let your scenario analysis drive the size of what you will pay for the asset ensuring that if your price is filled that you make money even if we see further house price falls and rising default rates from today. This is as much a giveaway as an auction. No-one will be bidding aggressively.

Happy hunting,

Andy Shaw