So-called toxic assets may be losing their poison, according to one gauge of investor confidence in mortgage-backed securities. But that doesn't mean banks will be marking up or selling their most troubled assets anytime soon, industry watchers say.
A rebound of a somewhat obscure index that tracks derivatives tied to subprime home loans is signaling that hedge funds, private-equity firms and other investors may be seeing more value in the intricate financial products at the heart of the credit crisis.
Markit Group Ltd.'s ABX Indexes — designed to track how much investors pay for protection against a mortgage-backed security defaulting — have spiked sharply higher in the last six months.
One bellwether ABX index tracking credit-default swaps covering triple-A-rated pools of home equity loans issued to people with weak credit in 2006 has risen 30% since April.
What this means for banks is that the subprime loans and asset-backed securities on which they have lost billions of dollars may be rebounding in value. It also shows that investors in troubled securities appear to have been heartened by the government's moves to jog the market for toxic assets, including the recent extension of the Term Asset-Backed Securities Loan Facility, or Talf.
"Banks have been very reluctant to sell off assets at fire-sale prices. What we're seeing is somewhat of a validation of that reluctance," said Kevin Petrasic, of counsel in the financial services group of law firm Paul, Hastings, Janofsky & Walker LLP. "Markets are starting to come back." That said, banks are still too hobbled with credit issues to take advantage of any rally in the market for their most troubled loans and securities, Petrasic and other industry watchers said.
Also, the ABX index is hardly a concrete assessment of how much a bundle of troubled home loans is actually worth, as it deals with credit-default swaps, a complicated financial product that is essentially a kind of insurance that investors buy against a security defaulting.
Ann Rutledge, the principal of R&R Consulting, said the index doesn't necessarily indicate the actual price or performance of the pools of securities it references, something that has been nearly impossible to do since the market for such assets petered out last year. What the index shows is the level of risk associated with particular securities.
"The index is something that markets can get together and trade," Rutledge said. "It doesn't reflect intrinsic value at all."
When the index rises, it becomes less expensive to purchase debt insurance on the kinds of securities it tracks.
For instance, as of Friday the index stood at 70.67, up from a low of 53.1 in April, according to Markit.
At that rate, an investor on Friday would have paid $2.35 million for swaps covering $10 million worth of triple-A securities, down from $4.04 million for the same level of protection in April.
While these securities may becoming less risky, industry watchers said they don't expect to see banks booking gains anytime soon by rushing to sell troubled assets or to mark them up in value.
Dorsey Baskin, a partner with Grant Thornton LLP, said most banks don't have the option of marking up the value of their most troubled securities or loans, as they were marked down and classified as assets to be sold or held until maturity. Accounting rules forbid companies from marking up those types of assets, he said.
Though assets in banks' trading books have to be marked to market, few regional and large banking companies trade in volatile securities, Baskin said.
"I don't know how a rebound in price would affect folks," he said. "Since most banks carried most of their securities in available-for-sale or held-to-maturity [portfolios] — they won't see the gain in value on their income statement unless they sell the security."
Fred Cannon, co-director of research at KBW Inc.'s Keefe, Bruyette & Woods Inc., said few banks are in a position to unload assets, given their still-tenuous capital positions and the specter of more losses in their housing and commercial lending portfolios. They simply cannot afford to absorb further losses by selling securities at a loss, as they still aren't worth anything close to their initial value.
"I think — especially for the regionals — it is still problematic to sell many assets because of their reserve levels," Cannon said.
Petrasic agreed.
Even if the actual value of troubled securities is rebounding, they still aren't worth what they were a year ago and may not fully return to their pre-recession levels for two to three years, he estimated. Also, the surge in the ABX could be seen as a validation of banking companies' hesitancy to sell assets.
"We're not at the point where we should expect banks to be suddenly jumping into the market and conducting a lot of sales," he said.
"What you don't want to do is jump into the market too soon … and realize three months later after you've sold off whatever you sold off that the price ended up increasing another 10% or something like that."
