Several weeks back, shares in E*Trade Financial
E*Trade sidestepped that outcome when hedge fund Citadel Investment Group purchased some $3 billion of E*Trade's debt. Yet a closer look at the deal reveals some useful insights into the likely future state of the mortgage-backed-securities market.
A weak floor
The value of the portfolio of troubled debt, which included collateralized debt obligations (CDOs) and mortgage-backed securities, suggests that Citadel paid about 27 cents on the dollar for these securities, a 73% discount to face value.
One of the most troubling aspects of the mortgage-backed-securities market is that no one really knew (or knows) how to properly value these securities -- not even the companies themselves. Valuing these instruments is so opaque that Merrill Lynch
The difficulty with proper valuation makes it highly likely that E*Trade simply let Citadel name its price for the portfolio of mortgages. Of course, E*Trade also knew that the alternative was to risk going under. So it becomes obvious that Citadel's purchase price was a rock-bottom offer and therefore represents a very good floor price for such securities going forward.
Ultimately, an asset is worth only what the next guy is willing to pay for it. And some of the recent toxic waste that was neatly packaged into CDOs still means that these instruments are still very difficult to value. Still, the Citadel purchase does offer a floor for what these securities could be worth.
Not a pretty picture
If Citadel's price for E*Trade's debt were applied to Citigroup
These are staggering figures. However, they're not likely to occur. For one thing, it's not accurate to assume that Citigroup's CDOs are similar to those at E*Trade, Merrill, or even Goldman Sachs
Second, Citigroup is much bigger and stronger than E*Trade, which sold off its debt at rock-bottom prices in an attempt to appease shareholders. Citigroup, in contrast, would probably not face such a dire situation. In addition, Citigroup's CDO portfolio includes some $25 billion in "super senior" notes that, although probably worth less than face value, given what we know about "triple A" ratings these days, are probably worth more than 27 cents on the dollar.
Still a scary scenario
Nonetheless, companies with heavy loads of CDO-type assets still have a lot of balance-sheet cleaning to do. Valuation is hazy at best, too, and securities markets hate uncertainty. Sometimes, that kind of revulsion leads to amazing investment opportunities when the high uncertainty is coupled with low risk. Yet in the CDO market, the situation is high in both uncertainty and risk. In this situation, you're better off leaving these investments to the most seasoned investors.
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Fool contributor Sham Gad is the managing partner of the Gad Partners Fund, a value-centric investment partnership operating in similar fashion to the 1950s Buffett Partnerships. He has no stakes in the companies mentioned here. The Fool has a disclosure policy.