I've been having a great debate with one of my closest colleagues about what is going on with the financials and the housing market. We differ on many points, the largest being that he believes that a mark-to-market system is essential and that if you can't sell something or there is no market for something that it is worthless. I completely disagree.
My analogy is that of a large piece of land you own. The land is so large that very few buyers can buy it. If the asset can't be sold does that mean it is worthless? Certainly not. But what if there are rumors that your piece of land is toxic and there are environmental issues with it? Does that mean it is worthless? Maybe. But what if there is no evidence to prove that? Most people in that situation would just sit on the land and not really care what it was valued at. But let's say that one day you get into some financial trouble and your bank is forcing you to value your land in order to loan you money. Rumors continue to swirl that your land is tainted. Eventually you give in and value it close to zero.
This is essentially the situation we are in. However, the reason that CDOs are being forced to be valued so low is that the companies that hold them are public companies and investors are demanding that those assets be valued. There is no market in the CDOs because no one wants to touch them. But the truth is that no one knows what they are worth and no one knows how to value them. And the reason they are difficult to value is because they are debt obligations and the only way to know their true value is for them to play out and see which debts get paid back and which don't. Even the most scientific method of valuing debt obligations will not come close to what they truly will be worth when all is said and done.
Is anybody who is reading this wondering one key question - IF WE DO NOT KNOW HOW TO VALUE CDOs AND WHAT THEY ARE COMPOSED OF, WHY ARE FINANCIAL COMPANIES IN SUCH DIRE STRAITS? Well that question points to how messed up the entire situation is. It really is a combination of fear factor, overdramatization by the media, and those two factors forcing the value of CDOs be marked to market. In plain English it means that CDOs are difficult to value and investors got worried and labeled them as tainted. The public markets demanded to know their value and since no one was willing to buy them, they booked their value at close to zero.
If you look on TV in the days and weeks forthcoming you will undoubtedly hear people saying that CDOs will turn out to be good investments and that buyers of CDOs will make out like bandits. If that is true, why the hell did we force them to be valued at zero?
And if the government bailout occurs, what will happen is that a floor for the value of those CDOs will be set and then private equity and other buyers will come in and start buying them. And to make matters worse I suspect that even banks and investment banks will get back into the trading of those very CDOs that brought them to their knees!
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