The UnTradeables

There is an elephant in the room that I haven’t yet seen discussed:  The UnTradeables.

In our discussion last week on SFAS 157, there was a subtext not articulated: The broad category of items that are actually too illiquid to trade. These include "one offs" such as Dry Cleaning stores, non-chain restaurants, Mom & Pop shops.

They are untradeable because the amount of research into each item, relative to their market cap/size, makes it too inefficient. No one will spend $100k for the due diligence on a $200k store. 

For a while, Pez candy dispensers were an UnTradeable — until eBay created a market where these can be effectively bought and sold. However, the total value of all the Pez dispensers in the world wasn’t measured in the trillions, or even 100s of billions. Even tho they are relatively illiquid, their small capitalization  makes it viable. And don’t forget, there is no leverage involved in any of the eBay items. Hence, no margin calls. 

Now consider the size of the derivative marketplace based upon mortgages: Everything from RMBS to CDOs to CDC. It runs into the trillions.

If they cannot be effectively priced, are these products essentially untradeable?

Consider these factors:

• The price relative to the requisite cost of research/due diligence;

• The size of the market relative to the overall regular and ongoing demand for that investment product;

• The buyers and sellers with an expertise and knowledge of this paper.

This may be the crux of the issue with subprime/derivative problem: The paper is, or at least should be, Untradeable . . .

~~~

What say ye?

Print Friendly, PDF & Email

What's been said:

Discussions found on the web:
  1. Mike M commented on Apr 9

    All investments are fundamentally valued on their future cash flows. Do all investments need to be traded (tradeable)? No. I know of small lenders who have done quite well lending their own money. These assets could have been traded but it was not a requirement of it being a good investment. If their investments were sound and these stupid firms weren’t so outrageously leveraged, then tradeability would not be an issue.

  2. Rich_lather commented on Apr 9

    They are untradeable because nobody has taken the time to aggregate all of the information available to them and make it publicly available. I’m speaking of credit rating past loan date along with factors available online such as zillow zestimate and geographical statistical data.

    I an era when universal default is even possible there’s no reason why loans values cannot be calculated.

  3. Will T commented on Apr 9

    I would add that these instruments are untradeable if the sellers are trying to unload them without a haircut.

    Jim Sinclair has repeatedly had this to say about these untradeables:

    1. They are without regulation.
    2. They are without listing on public exchanges.
    3. They are without standards.
    4. They are not transparent.
    5. They are without an open market bid/ask type.
    6. They are dealt in by private treaty negotiations (over-the-counter).
    7. They are without a clearing house.
    8. Their financial ability to perform is dependent on the balance sheet of the loser in the arrangement.

    I believe most of these untradeables will eventually make their way onto the Fed’s balance sheet.

  4. John Wellman commented on Apr 9

    I pack my own parachutes before jumping out of airplanes. Turns out that self preservation is more important than being reckless in risk assessment. Tough break to those that love the hype.

  5. paul griffith commented on Apr 9

    YES, tradeability is important – without it, a market cannot exist.

    But MORE IMPORTANTLY, is the instrument still functioning? If the derivitive is unbroken, it’s just an untradeable but still viable instrument.

    Markets are good but operations are more important.

  6. matt commented on Apr 9

    *cough* Goldman *cough*

    I think that a lot of the “untradeable” (illiquid) securities are better labeled “reluctant to trade in order to delay loss realization.” Isn’t the point of securitizing something to make it liquid?

    I think that, worse yet, Wall Street banks are colluding in order to keep these assets from trading (and provide “observable” inputs).

  7. Ross commented on Apr 9

    Ney ney my good man. This is exactly the type of paper I’m looking for. Small Mom and Pops with a few hundred thou with decent asset bases will be the gold mines. And like you say, they are untradable so the discounts should be hugamongous!

    Just form a pool and with modest leverage, take down a few 10’s of millions. Yes, the research will be time consuming but I’m guessing the labour for that task will become increasingly friendly.

    It would be like the RTC all over again. I understand your point completely as it relates to the big boys but trust me, there will be a market for this paper.

  8. Owner Earnings commented on Apr 9

    What if someone does trade one of these and all the other ones are very similar? Can’t we use that price?

    What if you ask for a bid for your junk, sorry i mean paper, and you get one? Can’t you use that price?

    Just because you get a low price doesn’t mean that’s the wrong price!

  9. Bretton Woods commented on Apr 9

    “All investments are fundamentally valued on their future cash flow…”

    No. Not true of gold, for example. And there’s no debt on it.

  10. Ross commented on Apr 9

    One more point. It is easy to determine replacement costs for hard assets. Figure the replacement cost, multiply by .35 and there’s your bid. The research ain’t that hard.

    In many cases, I bet you could sell many assets BACK to the borrower at a discount and still make a decent profit. Worst case, keep it leased even with discounts and let the loans simply run off.

  11. VennData commented on Apr 9

    A radical thought: why not re-characterize the CDO, break them up into the each constituent piece (so each home has ten tranches!) If you know Larry Lawnmower’s going to pay his mortgage, pick up the next to toxic tranche. Heck, buy your own.

    The CDO tranches did not have enough “houses” in them. Is US Bank’s mortgage business untradeable? No it’s big (i.e. there are so many loans you can look at aggregates.) US Bank trades, it’s doing well.

    Untradeables should offer better opportunity according to Arbitrage Pricing Theory.

  12. Mark E Hoffer commented on Apr 9

    as has pointed to, above, these securities are ‘untradable’ merely to delay loss-realization.

    there are many ways to liquidate these things, prob is, the current holders of them couldn’t stand the losses and are waiting to be bailed-out..

  13. wisedup commented on Apr 9

    remember that untradeable is not the same as unsellable. The fact that Joe’s bar/grill is not tradeable, unlike common stocks, does not mean that Joe will automatically take a 40% haircut when selling. Barry point is still true, markets were created out of untradeables and this crap has yet to be addressed. Aggregating crap only yields a massive pile of crap.

  14. Marcus Aurelius commented on Apr 9

    It’s traded back and forth between the issuers and their cronies, with a little loss each time – spreading the risk (now a loss) as it was intended to, but not the way it was intended to. Eventually, the true value (perhaps zero) will become evident. But by then, it will be too late. You don’t want to know the value, if you don’t already.

  15. Tom F. commented on Apr 9

    What’s the point in discussing this, Barry? We all know what the answer is. The SEC and the CPA’s are too corrupt and morally bankrupt to see to it that all the crap is valued properly NOW, not when it’s convenient for all the liars to do so. With that ass Bernanke running the Fed the whole mess is literally going to be papered over. So, again, what’s the point in our yapping about it? At this point the populace has two choices: either “go to the mattresses” or get ready for bread at $10 a loaf in the near future. The $10 thing is probably going to happen anyway.

  16. John commented on Apr 9

    VennData wrote:
    “A radical thought: why not re-characterize the CDO, break them up into the each constituent piece (so each home has ten tranches!) If you know Larry Lawnmower’s going to pay his mortgage, pick up the next to toxic tranche. Heck, buy your own.”

    I like it!

  17. Mich(^IXIC1881) commented on Apr 9

    VennData wrote:
    “A radical thought: why not re-characterize the CDO…”

    why would they sell you back that tranch for 40 cents on the dollar, when they get nearly 100 cents at the FED window.

    If you want a radical solution, why not propose selling Alaska back to Russia for 7.2 Trillion (after paying $7.2M in 1867)..ok maybe to china, they have tons of dough.

  18. Pat G. commented on Apr 9

    “I believe most of these untradeables will eventually make their way onto the Fed’s balance sheet.”

    Ditto. There’s your buyers; U.S. taxpayers.

  19. Ken H. commented on Apr 9

    Why not test the system here. Why not challange who really owns your property?

    It seems to me the way out is to challenge the properties value and offer to pay current value?

    Nothing is ever untradable?

    I’m sorry you made a bad investment in my mortgage but I’m willing to give you ~60 cents on the dollar? Take it or leave it.

  20. gorobei commented on Apr 9

    Mike M,

    Well true – a loan is just a loan. Feel free to make 4% over treasuries and be happy. That’s good business.

    The problem is when you loan at 1% over and borrow 97% at .5% over because “it’s all so liquid.”

    We tried that in the 1920s and now we have serious margin requirements on stocks.

    Luckily, we found new, unregulated markets and did the same damn thing again :(

  21. David commented on Apr 9

    Very interesting dialog. I can’t comment on mom and pop, drycleaner and non-chain restaurant equity trades but I can say that there is already a very active commercial secondary market for the paper. We’re talking 10’s of millions, not billions. The paper doesn’t trade at premiums like the small balance CRE securitization execution provided but the discounts are not huge as long as the facility is operating and the original underwriting was not completely crazy (although I suppose it depends on your definition of huge). Due diligence costs are reasonable, it depends on how much you do yourself vs. third parties, but figure $500-$1,500, less if you have volume discounts with third party providers of valuation, title and tax lien work, etc. This in on a $250K-$300K commercial real estate loan.

    Your comment about a fund/pool is correct, small funds and banks are primary buyers.

  22. Aaron commented on Apr 9

    There may be a way to reduce the cost of doing due diligence on this paper.

    One might be able to create modules and frameworks of rule-based expert systems to scan the contents of these financial bundles and efficiently produce an accurate rating of the instruments, throwing some light on the dark matter.

  23. Stuart commented on Apr 9

    illusory profits is another good term. Synthocrap constructed by Wall Street mathematicians without a market and supported on nothing but hot air is what they are. Yup, fictitious capital, and that is the root problem of this mess.. it just took the rest of the public a bit longer to figure that out.

  24. Douglas Watts commented on Apr 9

    Houses are liquid in the sense that if they are foreclosed and abandoned they can get so vandalized and stripped that the only value left is the postage stamp of land they sit on, minus the back taxes which have accrued on it.

    We of a certain age have all seen abandoned, falling down houses, especially in the Northeast, and wondered how someone could just abandon a perfectly good house and let it fall apart. I know this because I used to explore these ‘haunted houses’ when I was a kid.

    Will this decade produce the new ‘haunted houses’ for the next generation of kids?

  25. IBGYBG commented on Apr 9

    These instruments can be valued and are being valued by potential buyers in the secondary market at significant discounts to issuance amounts. Buyers and sellers are miles apart in terms of price and the result is limited to no liquidity. Buyers believe that these instruments are permanently impaired. Sellers believe (or want others to believe) that these instruments are temporally distressed. Holders of these instruments once viewed them as available for sale but now view them as held to maturity. I don’t know who is right but it appears that the underlying collateral is producing less current income and experiencing negative capital appreciation (declining in value), which is personally not what I like to see in a held to maturity portfolio. Most of the holders (potential sellers) of these instruments are highly leveraged and likely technically insolvent without capital infusions if their theory of temporary distress does not prevail. I am a big supporter of the Fed these days because if it fails the U.S. may become a portfolio company of several sovereign wealth funds (potentially the club deal of the century). Maybe the next wave of financial innovation will actually include equity as a component of capitalization…

  26. Kiwi commented on Apr 10

    I am just about to enter a bid for some of this paper as soon as I finalise my numbers:

    Ok, my Bid is: NPV * R.

    Where
    NPV = Net present value of future cash flows
    R (Risk) = 1 – (D * L )
    D = the default rate
    L = the loss incurred if a default arises.

    I figure Default rates must be worse than foreclosure rates which seem to be around 15% on Sub-Prime, so lets say 20%.
    I notice properties dropping by 20%, plus a cost of getting someone to sell it for me so lets take L = 25%.

    Therefore, I am looking at pitching in around 7.5% discount (25% * 20% + 2% for good luck) to NPV. Which should pick up all of the Citigroup paper at that rate.

    My only sticking point is that if D increases at what point will L exponentially jump, when the point of saturation is reached, my loss on resale could be close to 100% if no buyer is found. If L increases at what point will D exponentially jump? As more people will stop paying if they have negative equity in their house.

    Still, the potential gains are huge – I recon about 7.5% on 1.2 Trillion. If the Fed will just lend me the money to get the ball rolling…. But what can I put up as collateral? Oh yes, the paper I am going to buy, it’s worth 100% at the Fed, instant equity of 7.5% – what could go wrong? What’s that? … I could lose my house? Nah, …. I could just offer to buy it back at 60 cents in the dollar, provided the Fed would lend me that and why wouldn’t they? safe as houses mate, safe as houses.

  27. Simon commented on Apr 10

    I don’t understand the risk equation outlined above. But am I right that 25% of 20% is 5%? 5% plus 2% is 7% not 7.5%. or was it 2.5% for good luck?

    Shouldn’t the risk R=1-(D+L) or a discount of 45%? Or at least R=1-D*(L+1)? That would give a discount of 25% more than 20% which is 24% Giving a discount of 25% not 7.5%? Opps I forgot 2.5% for good luck. I want a discount of 27.5% please. But hang on I’m actually very risk averse this is actually my money and I’m 41 not 29 and I don’t drive a maserati so actually I think I’ll let the the fed do the dirty work and buy gold or euros sell my house and rent or perhapse find some mansion to squat in while I manage my portfolio….

  28. American ZIRP commented on Apr 10

    Since I can’t follow most of what’s going on here I would just like to point out that it is errant to say that Pez were un-tradeable prior to eBay. There were email lists, there were trade shows.

    Also…from Wikipedia:
    The frequently repeated story that eBay was founded to help Omidyar’s fiancée trade PEZ Candy dispensers was fabricated by a public relations manager in 1997 to interest the media. This was revealed in Adam Cohen’s 2002 book[2] and confirmed by eBay.

    Incidentally, the first item ever sold on eBay (then AuctionWeb) was a broken laser pointer (for $14!). That probably better illustrates your point about markets for the untradeable.

  29. Greg0658 commented on Apr 10

    IBGYBG says – “….I am a big supporter of the Fed these days because if it fails the U.S. may become a portfolio company of several sovereign wealth funds…..”

    been wondering for years now I’m grown up –
    is America its Business or it’s People?
    I decided Business Rules

    so IBGYBG – to late

  30. Greg0658 commented on Apr 10

    ps – Doug thanks for the haunted house memories

  31. The Stalwart commented on Apr 10

    Les UnTradeables

    The Big Picture: There is an elephant in the room that I haven’t yet seen discussed: The UnTradeables. In our discussion last week on SFAS 157, there was a subtext not articulated: The broad category of items that are actually

  32. SPECTRE of Deflation commented on Apr 10

    The SEC recently gave the boyz an out:

    “Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability.”

    http://www.sec.gov/divisions/corpfin/guidance/fairvalueltr0308.htm

  33. Unsympathetic commented on Apr 10

    Barry, it should be worth $0.

    No buyer? No market? $0.

  34. The Financial Philosopher commented on Apr 10

    Fear has overcome greed in the short-term. Once greed becomes “tradeable” again, then riskier assets will become tradeable as well…

  35. mr reality commented on Apr 10

    $10 bread…just go to panera and check out their prices. getting close to $10 already!

  36. Ed commented on Apr 10

    Great debate. Barry’s comment from a month or so ago (“maybe some things just weren’t meant to be traded”) has resonated more and more recently.

  37. SPECTRE of Deflation commented on Apr 10

    During the Q & A with Bernanke who’s in Richmond today, the question of mark to market was raised, and his answer reiterates my post above. It gives the banks time to absorb the losses without a fire sale:

    SEC recently gave the boyz an out:

    “Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability.”

    http://www.sec.gov/divisions/corpfin/guidance/fairvalueltr0308.htm

  38. William Roth commented on Apr 10

    I think you are correct. Moreover, this is part of a broader problem: because the ratings agencies are now seen as unreliable due diligence must be done on any investment one makes. But who has the time and resources. This promotes reluctance to buy-a freeze up. One unforseen effect of the ratings agencies failure to downgrade the monolines is that it made it clear to anyone watching that they cannot be trusted.

  39. Kaleberg commented on Apr 11

    Has anyone actually tried selling any of these CDOs on eBay, or better yet, Craig’s List?

    I’m remembering the Creditor’s Ball back in the early 90s. Does anyone remember suit size? hat size? ring size?

  40. DH@TH commented on Apr 16

    FYI:

    Banks’ new tool to deal with counterparty risk

    http://www.euro2day.gr/ftcom_en/126/articles/308874/ArticleFTen.aspx

    Rudimentary and idiosyncratic versions of these so-called contingent credit default swaps (CCDS) have existed for five years, but they have been rarely traded due to high costs, low liquidity and limited scope.

    But now there are high hopes that a revamped version of CCDS, which will bear the formal blessing of the International Swaps and Derivatives Association, will be more successful when it is released in two to three months’ time.

    Counterparty risk has become a particular concern in the markets for interest rate, currency, and commodity swaps – because these trades are not always backed by collateral, leaving banks vulnerable to sudden losses if counterparties collapse.

    he new CCDS was developed to target these institutions. Some banks have already started doing deals using a rough and ready version of the forthcoming standardised documentation.

    Trading volumes are thought to remain relatively small but, according to Bill Mertens, head of CCDS at Icap, the interdealer broker, demand has started to grow.

    “We’re constantly looking for the [point where growth] explodes. That may happen shortly,” he says.

    Unlike in a normal credit default swap, where the notional risk that is hedged is defined at the outset of the contract, each CCDS is linked to a second derivative, so the risk being hedged varies over time according to market movements in the underlying transaction. That means these contracts can be used to protect or lock in mark-to-market gains on the values of derivative contracts, as well as to protect dealers against counterparty risk.

    But dealers are sceptical that the instrument will take off, particularly where more liquid, if imperfect hedges are available, for example through more traditional CDS. GFI, a rival interdealer broker to Icap, abandoned CCDS last year because of a lack of interest, though it said it would re-enter the market if demand picked up.

    One counterparty risk officer at a leading European bank called CCDS “a product with nowhere to go”.

  41. chaz commented on Apr 18

    people must bash what they don’t understand. it gets old.

    if derivatives were “untradeable,” then “trillions” — it’s only NOTIONAL that’s trillions, but hey, it’s a sensational amount — wouldn’t have backed them.

    the problem is that, be degrees, NOTHING is “tradeable” when there’s NO CREDIT available to trade it.

Read this next.

Posted Under