Wednesday, August 5, 2009

Credit market - The write-downs by investment banks

Rumor has it that the recent massive write downs on securities linked to sub prime mortgages has been even more massive because of accountants pricing these on a more market based ABX index (the index of credit default swaps on asset backed securities backed by sub prime mortgages) than the mathematical models. These were adopted by them owing to the fear that many posses about lawsuits which might be hanging on them on wrongly guiding investors.

One thing to notice here is that a difference in these prices makes one question the understanding of these derivatives, which is already a major concern. So the only tool available is the ABX index on which to price these instruments. Also this brings out the concern as to how much liquidity these indices possess (as it was introduced only 3 years ago).

As far as I am concerned the difference between the mathematical models, which gives their prices in standardized situations, and the market prices will determine the understanding of these products. The spread on these two prices are likely to go down as more and more investors start understanding the underlying principle of these instruments.

The US credit turmoil as seen is far from over. A major concern doing the rounds is the uncertainty of losses on derivative sec backed by US sub prime mortgages.

This uncertainty can be reasoned as the lack of transparency or the over the counter nature of these asset classes. The US market for CDS are said to be around 2600 billion dollars. A huge market where there are doubts about pricing and no exchange to take care of transparency related issues. Pricing of these securities remain a concern even in the future.

As far as reason goes a standard universal guideline for valuing these securities and proper regulatory supervision and intervention is the most prudent solution for avoiding another credit crisis.

I am not sure why they would be doing that because if they want an index they should probably look at MBS based credit securities (CDO's based on mortgages) and not just cds's. Secondly, it should not be ABS which is a reference but MBS, generally ABS includes commercial loans, etc. but not housing mortgages.

Apart from that banks generally value mortgages on book value, i.e., the book value (after the applied hair cut) of the mortgage or collateral then why should they be using market based indexes and that too ABS?

Banking system in India. Why banks in India are facing difficulty in getting deposits?

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