Have you ever had the classic nightmare about walking into a final exam not having cracked a book or attended a lecture? Me too, and last night I had the appraiser’s version: I had to testify in court about the value of a CDO – a collateralized debt obligation (a package of mortgages) – one of those “toxic assets” we read so much about.
After a cup of coffee this morning, I started to think about how to actually do this. Let’s see, the Market Approach will not work, since right now there is no transaction activity that I know of (if there is any, I do not know how to find it) and pre-Crash trades, if available, are certainly not relevant now. The Asset Approach is out – clearly a replacement cost-based methodology is not correct.
That leaves the Income Approach. Hey, we can project cash flows (interest and principal) and discount them to present value! Yes, we will need to do MAJOR research to determine the values of the mortgaged houses, the credit status of the borrowers, and so forth, but given enough time and funding, that is not impossible! (Humor me with that assumption, OK
We can build a DCF model! If we are quantitatively adept, we can use advanced risk analysis techniques like Monte Carlo simulation to incorporate probability assessments! Then we can add a discount for lack of marketability…we are VERY familiar with that!
I concluded the following from this exercise:
1. The Income Approach will theoretically work (assuming we can get the data).
2. There is no way that I would take on such an assignment,
3. Because there is no way I could condense all of the uncertainties into a single estimate of the value of a CDO!
(Incidentally, if you have some time, Google “valuing CDO’s” and check out the first ten or so links … there are some pre-2008 presentations and current blogs that you will find interesting, infuriating, and somewhat saddening.)