Banks to Gain from Sub-Prime Rally

We are witnessing a rally in the market for sub-prime securities which will likely deliver a significant boost to U.S. banks’ Q3 earnings, if they choose to book accounting gains on assets that caused them billions of U.S. dollars in losses during the recent crisis.

Savvy market observers say the significant rise in the price of mortgage-backed securities and other once-hammered debt offers banks the first meaningful chance to adjust up some of the value of these assets.

Over the last three months, the Markit ABX index, which tracks securities backed by home loans such as sub-prime mortgages issued to borrowers with weak credit, has gained more than 30% as investors re-discovered their risk appetite and the U.S. government flooded the debt markets with liquidity.

The extent of the write-ups is hard to predict because of banks’ complex balance sheets and uneven use of accounting rules, but experts believe the rallying credit markets could pave the way for billions of dollars in gains.

A partial reversal of the U.S. $1,000B+ in write downs of securities suffered by the financial system during the crisis augurs that the industry is recovering its health as the global economy and capital markets improve. In addition to the write-downs, banks around the world have had to absorb U.S. $600B of actual losses on loans that have turned sour.

It is widely predicted that the size of the write-ups will be revealed in Q3, which ends this Wednesday, and are dependent on how aggressive banks will be in their use of the accounting rules available to them.

Some bank executives believe that their boards and auditors may advise a cautious stance, pointing out the market for "toxic" assets has been thin, suggesting that the price increases might be short-lived and that a market reversal would force banks to take further write-downs. From an accounting point of view, the banks must mark-up positions if an active market develops.

We should be keenly aware that many institutions have sold off their "bad" assets as prices have risen, thus reducing the scope for write-ups, or have hedges on those positions, making it difficult and expensive to book a gain. The fact is that the riskiest kinds of bonds have rallied strongly in recent months as investors have increased their risk tolerance and search the market for higher-yielding assets needed to boost their portfolio returns.

Add to that the coming launch of U.S. government-backed investment funds targeting assets hammered hardest by the financial crisis (e.g. securities backed by residential and commercial mortgages). This action has helped to drive the rally in these distressed securities.

Comments

[Mad Hedge F...:]

ins I’ve never been much of a jock. But at least once a year, recollections of my sporting childhood irresistibly draw me towards the crack of the ash, the mile long hot dog, and the beer of a baseball game. Of course there was no more beautiful place to watch the San Francisco Giants take on the Chicago Cubs than the spectacular retro bayside AT&T stadium, surrounded on two sides by tacking sailboats, and a flotilla of kayakers with mitts hoping to catch a lucky right field home run. The contrast between the two sets of fans couldn’t be more obvious, with the latte sipping, sushi eating Giants fans lithely gliding between the wallowing, voluminous, garlic fries smelling Cubs supporters. Clearly bad breath obesity are sadly rampant in that unfortunate city. I’ll say no more, lest my futures trades on the CME suddenly start failing. And Obama is a White Sox fan. So it’s the second inning when a Cub batter fouls out and nails the Bank of America (BAC) sign on the third tier, neatly missing the billboards for Visa (V), Charles Schwab (SCHW), and Chevron (CVX). Is it a sign from above? An omen? Do Cubs players know that despite choking on a subprime portfolio and baskets of bad real estate loans, the stock has soared by 620% in six months? Should I be shorting this stock? I made a note to run the charts and stats as soon as I got home. Alas, the home team was trounced 6-2, allowing the fans from the windy city to return home to happily wolf down more polish sausage and suds. It was a miserable performance by the Giants. In four hours I didn’t see a single first down. Hey, I told you I was never much of a jock!

Sep 28 12:58 PM

[Gary A:]

Good to know that someone understands that the banks are now in great shape, NOT.

You can roll the dice on these banks and I wish you well.

Sep 28 06:42 PM

[sethmcs:]

As I suspected all along....those toxic assets are worth more than nothing. I hope that the banks mark up those toxic loans drive a rally and bury the shorts. What comes around goes around.

Sep 29 12:02 AM

[Joe Shareho...:]

Not sure how these assets can be "written up" when they were already inflated to book value during Q2 name-your-value bank reporting.

Sep 29 12:03 AM

[CIK:]

- bank exposure typically to the worst tranches, no upside potential

- while overall rate of decline in housing and mortgage markets slowed via govt stimulus things are still deteriorating and the stimulus is starting to come-off, does not bode well

- 700 Alt-A and Jumbo RMBS deals recently down at S&P, contagion is a process that will continue some time

Would like to see banks and world economies on solid footing, but it certainly will not come from slight improvements in sub-prime assets and will take years.

Sep 29 05:41 AM

[Mark Alexander:]

It would be extremely interesting if someone could quantify the likely boost in profits due to improvement in spreads. Meredith Whitney did this in the early stages of the credit crisis.

A similar idea came to mind a few months ago, but after digging into a few bank balance sheets, the amounts were smaller than I expected. In addition, some banks carried RMBS at amortized cost (Citi Alt-A might be an example?).

There will definitely be a boost, perhaps more from CMBS than RMBS. This along with the refinance boom will probably make the third quarter (and perhaps the fourth) look good for the large banks.

Sep 29 11:33 AM