Financials: Worse than they look?
On Tuesday, we wondered aloud what the S&P500 might have looked like had the true nature of the Financial sector's true risk-adjusted earnings been known (S&P500 ex-Risk ?).
We questioned how the Financials looked historically, now that they wiped out so much profitability from the past few years.
One of the more interesting emails came from a person who wanted to know how $100 in defaulted sub-prime mortgages could do so much damage. The short answer is that its not merely the mortgages, but the entire derivative house of cards built on the backs of the sub-primes. Mortgages got repackages into residential mortgage-backed securities (“RMBS”). These were in turn repackaged into collateralised debt obligations (“CDOs”). These were re-repackaged in part as credit default swaps (“CDS”).
This entire derivative pile was based upon the explicit assumption that default rates would stay within the range of historic averages. That turned out to be a false assumption. So as the Mortgages increasingly enter delinquency, default and foreclosure, the highly leveraged alphabet soup on top of them took a giant hit. (See the graphics here for a visual explanation).
The situation may be even uglier than we previously believed:
"When it comes to working out the impact on banks, the task becomes even harder. For in recent years, banks have not simply been acquiring subprime loans, they have been repackaging them into complex “asset-backed securities” (ABS) that can be difficult to value. The Bank of England, for example, suggests that on the basis of industry data some $700bn-worth of bonds backed by subprime loans are now in circulation in the world’s financial system, with another $600bn of bonds backed by so-called “Alt A” loans, or those with slightly better credit quality.
Moreover, these bonds have then been used to create even more complex securities backed by diversified pools of debt, known as collateralised debt obligations (CDOs). According to the Bank’s calculations, for example, some $390bn of CDOs containing a proportion of mortgage debt were issued last year – though the precise level of the subprime component varies.
The multi-layered nature of these complex financial flows means it is hard to assess how defaults by homeowners will affect the value of related securities."
We've all heard those numbers bandied about -- but what do they actually mean to the various banks and brokers? Consider the Level 3 assets. Marketwatch describes these as follows: "Some assets are so esoteric and trade so infrequently that investment banks have to value them based on mathematical models, rather than the market prices of similar or related securities."
In other words, these are the least traded, most estimated, hardest-to-accurately-value-because-there-is-a-dearth-of-buyers paper.
Here's the truly ugly side of this: When valuing these assets (derivatives, private-equity investments, CDOs and mortgage-servicing rights) the mark-to-model techniques are applied to an unhealthy slice of these holdings. According to Brad Hintz, an analyst at Bernstein Research (he was formerly Lehman Bros' CFO), a huge amount of this stuff is still improperly priced:
% Level 3 trading inventory valued using mark-to-model techniques
Goldman Sachs 15%
Morgan Stanley 13%
Lehman Brothers 8%
Bear Stearns 7%
Merrill Lynch 2%Source: Bernstein Research
I am not sure of the precise amount of Level 3 assets currently held, but it is substantial.
The next tier, Level 2, are described as those assets that may not trade much, but that can be theoretically valued by checking market prices of similar securities and making assumptions about variables such as interest rates (MBS, some corporate bonds and CDOs).
According to Dick Bove of Punk Ziegel, the five largest U.S. brokers and banks -- Citigroup, J.P. Morgan Chase and Bank of America -- have $4.1 trillion of these Level 2 assets on their balance sheets.
That's almost 10 times their shareholder equity.
When the final coda of this era is written, wiping out 5 years or so of earnings is going to look like a bargain . . .
>
Sources:
What’s the subprime damage to banks?
Gillian Tett and Paul J Davies
FT, November 4 2007 18:08
http://www.ft.com/cms/s/0/3ca7bbc0-8af5-11dc-95f7-0000779fd2ac.html
Wall Street's stress test
Alistair Barr
MarketWatch, 7:57 PM ET Sep 7, 2007
http://tinyurl.com/33brp4
Banks Face $100 Billion of Writedowns on Level 3 Rule
John Glover
Bloomberg, Nov. 7 2007
http://www.bloomberg.com/apps/news?pid=20601087&sid=ap42s_XrP58Q&
Risk of securities fire sale mounts
David Wighton and Saskia Scholtes in New York and Gillian Tett in London
FT, November 6 20
http://www.ft.com/cms/s/0/17f683c2-8c9b-11dc-b887-0000779fd2ac.html
2007 Global CDO and Credit Derivatives Outlook
Fitch, 13 December 2006
http://www.mortgagebankers.org/files/Conferences/2007/CREFFebruary/Fitch2007GolbalCDOforEvolution.pdf
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Tracked on Nov 8, 2007 9:28:48 AM
Comments
This doesn't sound good, Barry. And more bad news -- The NYT says this morning that falling home values may slow down consumer spending. Now, why haven't you ever mentioned an important thing like that? (yuk yuk)
Posted by: Ted | Nov 8, 2007 7:07:55 AM
Enron was repackaged where? Was subprime allowed as cover? Or a fixup.
Posted by: Greg0658 | Nov 8, 2007 7:14:39 AM
If the HUGE banks hold so much of these derivatives...Can't they theoretically agree to simply cancel or modify these OTC Contracts... If two of these banks are counterparties on a deal where Bank A loses $100 billion and counterparties on a deal where Bank B loses $100 billion then can't banks A and b just say, You forgive my losses and I'll forgive your losses, so NET we are even so we really lost nothing...Isn't the real issue the NET exposure of these banks...
Also if everyone is losing money on these instrument who is making money on their decline who were the counterparties and to what degree???
Another thing no one mentions...what about the derivatives contracts based on different currencies...Considering the huge moves in the dollar and other currencies versus the dollar i would think alot of players got burned hard on those...
Posted by: SINGER | Nov 8, 2007 7:19:53 AM
Singer - who is making money?
Not sure who is making money on these loses (look at those instruments on regional house'g solvency)
You know this, just a reminder:
who made money? the initial lenders, the building product manufacturers, the builders, the laborers, the community, the government thru taxes, the home and apartment renters.
Thank you investors for helping commerce. Sorry if you got burned.
Posted by: Greg0658 | Nov 8, 2007 7:53:38 AM
For real ... I'm sorry if ya got burned ... really
:-(
Posted by: Greg0658 | Nov 8, 2007 7:56:23 AM
I'm just wondering how the permabulls are going to spin the fact that the past 5 years of financial earnings have been a fraud the likes of which we haven't seen since...
The tech bubble
LTCM (and so on)
Well, I guess I should end that sentence with "since the last bubble burst."
Greenspan is a wrinkled bag of wind. Paulson should be fired as CEO of Sachs for exposing them to this dreck - or leading the Treasury, one of the two.
But good times!
Posted by: Unsympathetic | Nov 8, 2007 8:05:39 AM
ps - its sad but true
who else lost - areas that didn't go for the ride above
Posted by: Greg0658 | Nov 8, 2007 8:06:04 AM
October same store sales flooding in. Generally speaking, it appears to be very weak. Walmart at +0.7% when you include gas/food prices! Not a good showing at all. A lot of other discretionary stores way down. I wonder how Wall Street will spin this? Probably will be discounted as people are looking towards the Christmas sales period.
Posted by: W.Edwards | Nov 8, 2007 8:09:45 AM
"If the HUGE banks hold so much of these derivatives...Can't they theoretically agree to simply cancel or modify these OTC Contracts..."
Singer, unfortunately it doesn't quite work that way. Banks use the money of their depositors (people like you and me, and other institutions) to fund purchases of assets of this sort - the old borrow short and lend long game. So unless you're ok with them coming to you and telling you that the money you deposited in the bank is now worth significantly less than it was when you originally deposited it, just canceling obligations like that is likely not a viable solution.
Posted by: Salomon | Nov 8, 2007 8:24:54 AM
Noriel Roubini's blog had a recent post that breaks down the Level 3 assets at the big boys...
http://www.rgemonitor.com/blog/roubini/224871/
If it's accurate... these are the Level 3 amounts:
GS - $72b
C - $135b
MS - $88b
BSC - $20b
LEH - $35b
MER - $16b
There's also some math to put these numbers as a % of equity capital base. Fascinating and frightening.
Posted by: Jaosn G. | Nov 8, 2007 8:28:15 AM
As mentioned in Dr. Roubini's blog and earlier elsewhere, the SFAS157 rule will play an interesting disclosure effect on these highly leveraged derivatives. Morgan Stanley is in big trouble, the insurers are in big trouble, etc.
" Nov 15 the SFAS157 rule goes into effect, as i think i mentioned, it "requires banks to divide their tradable assets into three "levels" according to how easy it is to get a market price for them. Level 1 assets have quoted prices in active markets. At the other extreme Level 3 assets have only unobservable inputs to measure value and are thus valued by reference to the banks' own models."
Here is the Level 3 assets to equity ratio summary:
Citigroup 105%
Goldman Sachs 185%
Morgan Stanley 251% Morgan Stanley: $88 billion in Level 3, equity base is $35 billion.
Bear Stearns 154%
Lehman Brothers 159%
Merrill Lynch 38%
"
Posted by: Alan Greenspend | Nov 8, 2007 9:11:18 AM
How much of these problems, is caused by the severe financial imbalance of the governments, state and federal?
Posted by: Old Ari | Nov 8, 2007 9:17:54 AM
IT has been caused by nothing more than greed, greed and still more greed.
Case in point.....the people at Citigroup actually thought that they could roll over all that crap debt (well they did'nt think it was crap while they bought it)each and every month and then collect the spreads on them to make the profit margin.
These are people that make millions of dollars a year and have years of experience and all they could come up with is hold and hope. Well now that's ALL they have. THE CFO of C even said as much
"we'll continue to hold these and wait for a calmer market"
I bet you will....
Hold and Hope.......works for major banks but not you.....
Ciao
MS
Posted by: michael schumacher | Nov 8, 2007 9:29:17 AM
Barry - when do you sleep ? Excellent post with a lot of work in it but 0608 ? Sheesh - you must have started at 0400 at least. But as long as you don't sleep and can still work a couple of questions for your next depth post, if you don't mind:
1. Could you walk thru the leverage multiples as they build up across the chain. Seen some complex versions of that but not sure my simple mind got it. Nonetheless by the time you walked across the chain leverage multiples on original equity went from 10X to 70X.
2. Have you thought about what happens if this same structural breakdown applies to other asset classes ? Corporate debt, EM Bonds, etc.
For example:
Next Fear: Corporate Debt ( http://tinyurl.com/2gk2op )
Fitch Ratings says downgrades of corporate bonds rose in the third quarter to $92.1 billion, their highest level in two years, a potential sign of rising distress.
Took my pass at it as well but high-finance ain't my field:
Next Shoe Drops: http://tinyurl.com/yqgj3o
Appreciate it.
Posted by: dblwyo | Nov 8, 2007 9:40:43 AM
here comes Benny to rescue the markets with his speech.....
Watch the market ignore anything bad and totally focus on whatever sunshine comes out of his ass.
Where is Ron Paul when you need him??-LOL
Ciao
MS
Posted by: michael schumacher | Nov 8, 2007 10:02:53 AM
BTW the LTCM problem is such small potatoes in contrast to what we have going on now.
LTCM took about $4.7 billion and leveraged it up to a little over $130 billion.
Obviously we have the LTCM situation on steroids.......
Ciao
MS
Posted by: michael schumacher | Nov 8, 2007 10:06:00 AM
What I find interesting is that simple common sense could see all of this coming without the use of economic statistics, fundamental analysis, chart analysis, or any kind of quantitative consideration whatsoever...
Posted by: The Financial Philosopher | Nov 8, 2007 10:11:48 AM
The problem feeds itself, creating a pernicious downward spiral.
Many of these institutions own the same or similar bonds. So, when one writes down a bond that reverberates through all the others.
Which then lowers the value of all similar bonds etc. etc.
Posted by: Ralph | Nov 8, 2007 10:14:20 AM
We must also consider:
1. How classification adjustments will change what is now considered Level 3 once the new accouting rule kicks in.
2. Ratings downgrades effecting what is considered level 3?
3. Whether there will be another hideout somewhere on the books for these companies OR if this new accounting change will really make untradable holdings more transparent?
With AAA ABX index plunging yesterday, this problem is far from contained. You will be hearing more about this as months pass.
Ben may have to do an inter-meeting cut, even with oil near $100 and commodities so high as this credit problem is quickly turning out to be the worst threat we have seen in a long time.
Posted by: UrbanDigs | Nov 8, 2007 10:20:01 AM
Kent-
I gather that they all knew it was coming but when you get record profits (and bonus') the motivation to correct it is less and less. Just like the CDO/SIV trader that Barry had posting here a month or two ago. He saw it, participated in it, enriched himself from it and ONLY NOW is apologetic about the whole process. Just like the banks and brokers are now.
we are a nation of apologists.......
Ciao
MS
Posted by: michael schumacher | Nov 8, 2007 10:20:20 AM
Haven't see it discussed here, but here's Jay-Z's new video, rather than waste time with benjamins, he flips through a massive stack of 500 Euro notes:
http://youtube.com/watch?v=wiuNd5SoU8E
Check around the 50 second mark for those of you who don't wanna sit through it.
Posted by: a guy called john | Nov 8, 2007 10:28:53 AM
How about the SIV part of this package. Most are not part of the normal books, rather Enron style Cayman Island record keeping. No discussion in the financial press about these SIV's and what of anything they are worth.
Posted by: ron | Nov 8, 2007 10:48:33 AM
Seems to me the problem is much worse than just the sum of subprime and Alt-A mortgages of questionable value. Due to packaging these loans into other derivatives like CDOs they mixed questionable loans into assortments of other "good" loans. Now that the default assumptions have turned out to be faulty, instead of this arrangement protecting the performance of the weak loans it has impaired the performance of the good loans as well. Kind of like making hamburger using one e-coli tainted cow and a thousand good ones -- the whole lot is now headed to the dumpster.
Posted by: pclema | Nov 8, 2007 10:54:32 AM
market getting additional help today to the tune of $32.75 Billion in repo's.
http://www.newyorkfed.org/markets/omo/dmm/temp.cfm
But it's just fine.....
One of the top 10 amounts of all time......add in the $41 billion from last thursday and a BAD pattern emerges...
Ciao
MS
Posted by: michael schumacher | Nov 8, 2007 11:00:40 AM
just cut overnight rates to 2% now and put everyone out of their misery. It will also let us move on past the continued inane speculation of Fed cuts and onto what is actually happening. Inflation and dollar be damned.
Posted by: zao | Nov 8, 2007 11:06:33 AM
