Re-pricing of assets- from ?marked? to model to ?marked? to market

August 1st, 2007

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Back in January, in Prepare for asset repricing, warns Trichet, we echoed the warning of Trichet, the president of the European Union central bank, who said that that instability of global financial markets can lead to ?re-pricing? of assets.

As we all know, this is happening right now in the debt market in the US. The implosion of the sub-prime mortgage mess (see How did the US sub-prime lenders get into trouble?) in the US had led to the re-pricing of risks. Suddenly, the price of securitised debt instruments (see How to dump risk to consumers: securitisation) were no longer what they were thought to be. How did that happen?

Before we can answer this question, we have to understand how such securitised debt instruments were ?priced.? There are two pricing concepts to understanding with regards to pricing??marked? to market and ?marked? to model:

?Marked? to market
This pricing concept should be familiar. Basically, the value of an asset that is ?marked? to market is the price in which it is last traded in a liquid and open market. A very good example of such asset is the value of your current holdings in a stock, which is the last traded price multiplied by the total number of stocks.

?Marked? to model
What happens if that asset is not tradable in a liquid and open market? How can we determine the value of that asset if there is no market to tell us what the price of it is? This is the situation where these sub-prime securitised debt assets were in. In that case, the ?value? of these assets was determined by highly complicated mathematical models. Very often, the ones who hold (or manage) these assets were the ones who derive the ?value? of them. Obviously, we can hardly expect them to be objective and transparent in their valuation.

What happens if we let the market decide the value of those debt assets that were ?marked? to model? With the implosion of the sub-prime crisis, we suddenly find that there are no takers in the market for these risky debt assets. In other words, those formerly ?marked? to model received a severe downward revaluation by the market. Obviously, holders (or managers) of such assets would protest at the market’s valuation. Even worse, what happens if a lot of borrowed money is involved in such ?investments??

As we all know, Macquarie Bank announced last night that two of its funds that were involved in the US sub-prime lending are suffering losses of up to 25%. As expected, retail investors are the ones who are going to foot the bill. As this article MacBank: brace for sub-prime loss reported, the language used to protest against the market’s valuation of ?marked? to model assets were ?Mr Lucas said the underlying assets were ?fundamentally healthy? but the ?supply demand imbalances? in the senior loans market sparked by the sub-prime mortgage turmoil were causing price volatility. ?This price volatility is not related to defaults in the underlying Fortress Notes portfolio,? he said.?

Yes, sure Mr Lucas.