Subprime Write-Downs More Than 50% Done? Write-Ups Coming Next?

S&P was out with a report Thursday saying that the banks are more than half-way through in recognizing losses attributed to sub-prime mortgages. They revised their estimate of total losses up to $285B from $265B but this is much less than the estimates put out by investment banks: $325B from JPMorgan Chase, $400B from Morgan Stanley and Goldman Sachs, and even $600B from UBS.

This week different government agencies have started taking serious action to introduce liquidity into the MBS secondary market. The Fed’s decision to allocate $200B to exchange AAA rated MBS held by investments with Treasuries helped stabilize the market. Later today, news came out that Congress was considering more efforts to stabilize the mortgage market. A proposal which will allow the FHA to offer $300B more in guarantees to help refinance distressed mortgage got some attention. Treasury Secretary Paulson introduced proposals to introduce rules to regulate over the counter markets which are currently unregulated, to restore confidence in counterparties and prevent future bubbles.

The message being sent is that the Fed, the Congress and the Treasury are now serious about intervening in the MBS market to ensure stability. The equity market rallied and Treasuries sold off after digesting the news of Carlyle Capital Mortgage Fund’s liquidation. This indicates that the markets are now internalizing the beginning of the end of the credit-crunch. The equity markets were frozen because of the credit-crunch; the attention shift away from credit problems bodes well. Investors can now start looking at the fundamentals of equities instead of being stuck in a technical trader driven market.

Write-Ups Coming

The write-downs taken by major banks for their sub-prime based securities were based on mark-to-market rules. Since many of these securities do not trade actively, the banks used the ABX Home Equity Indices or some trades executed in an illiquid market to get the mark. However, many of the banks continue to hold the securities.

Fed Chairman Bernanke has suggested that banks should allow home-owners who are upside down, to refinance at lower principal levels. This gives the home-owners an incentive to stay in their home. The banks in-turn will not have to foreclose on the homes. This will allow the bank to recognize the principal loss, get the bad loan off their books and provide stability to the housing market by reducing the amount of foreclosed inventory.

This also means that severity rates which measure the principal loss realized during a foreclosure may be lower than what the market has been using. Further, the expense associated with foreclosure: court fees, legal fees, auction fees, house taxes, home maintenance costs will be eliminated. For example if a bank agrees to refinance the loan at 80% of the original principal value, the original loan will be paid back with a 20% loss of principal. The severity rate in this case will be 20%.

To get an idea of how the banks have been marking down their assets, it would help to review the transcript of the Morgan Stanley’s Q4-2007 conference call (pages 7 and 8):

Prashant Bhatia - Citigroup
Hi, can you just help us reconcile the accounting impact of the $9 billion versus what the cash impact has been, so just realized versus unrealized?
John Mack
I’m sorry Prashant, in respect to what sorry?
Prashant Bhatia - Citigroup
How much of this is just marked downs that you haven’t been able to sell out of position?
John Mack
Of the $9.4 billion, the great focus is unrealized. Obviously, the $400 million that related to the CMBS was realized right. But the great focus is very much mark-to-market, is that what you are asking?
Prashant Bhatia - Citigroup
Right. Okay. So when we think about — I think the $1.8 billion in exposure that’s left, is it fair to say that from where you are sitting, you’d probably just want to leave that exposure on until you have the cash flows end up performing on some of these positions? Or would you, if given the opportunity, liquidate that $1.8 billion?
John Mack
Well, I think that’s trading column. We’re on doing with the $1.8 billion is shown you a net exposure that comes out of our valuation using consistent valuation methodology. And just to get it out, the $1.8 billion exposure, remember what I said on November 7th, that is a function of assuming a 100% default with zero recovery and all your short expiring worthless. Within that, you can have some mark-to-market volatility.

…
Roger Freeman - Lehman Brothers
Hi. Good morning. So just wanted to follow up on the mortgage exposure. So it’s fair to assume, I think you said that the vintages are all ‘05, maybe early ‘06 in the CDO holding, is that right?
John Mack
I think that she gave a ratio, but I am prepared to say that roughly 50% of the vintages are ‘05 and that’s what quarters in November.
Roger Freeman - Lehman Brothers
But I guess the question would be if it’s only about 50%, the mark seems kind of stiff, if the remainder is later vintages where those ABS indices actually ended November roughly flat with the October. Can you give us little more color on?
John Mack
Sure. Of course I can. Well, first of all, we are absolutely confident that the valuation we gave as of 31 October was a right using consistent valuation methodology. Two things happened in November, which changed the valuation which we have to look to is identifiable inputs. One was the sell off as you know in the ‘05 collateral which we can described. But two is in risking this position, we actually did execute observable trades, which we have to calibrate to, and it was that calibration to external marks that has driven the valuations

.
A few observations:

• Morgan Stanley continues to hold the securities. The losses were based on trades done in an illiquid market in November 2007.
• Much of the portfolio consists of CDOs based on mortgages issues in 2005 and early 2006. Many of the loans in these pools were 2/28 ARMs. The 2005 would already have reset, and hopefully refinanced. Many of the 2006 vintage will be reset this year and hopefully be refinanced as the interest rates come down and liquidity in the MBS market increases.
• The portfolio was valued using 100% default rate and 0% recovery (100% severity) to come up with the $9B write-down.

We will get a better idea of the real loss rates realized in the sub-prime portfolio next 18 months. Given all the action in Washington, it is very likely that the losses realized will be significantly less than what a 100% default rate with 100% severity would imply.

What does this mean to Morgan Stanley’s bottom-line: Potentially billions of dollars of write-ups over the next 2-3 years as these securities start trading based on intrinsic valuations.

Comments

[Tony Soprano]

Good read -- thanks for doing it Vikram.

This site is heavily skewed to the negative. That's a buy signal.

What is most troubling about the negative bloggers it that they provide no counter points or potential solutions. They don't want to do this because they are padding there own and their clients positions.

[venividivici]

Every projection so far has proved to be too optomistic. The excesses of the past five years were outrageous and the punishment will probably be far more severe than anything we've seen so far.

As for Tony Soprano, you will probably end up like your namesake and get wacked!

[catrabbit]

Here are the flaws with your analysis:

The $285 billion loss thrown out by S&P is attributable to SUBPRIME. Now:

(1) do you really trust that S&P knows what they're talking about at this point?

(2) the $285 billion was revised up from $265 billion. So even if you trust S&P, who's to say the number won't be revised up again?

(3) As mentioned above, that number is associated with SUBPRIME losses only. Subprime is only the tip of the iceberg. What about Alt A Hybrid Arms, Option Arms, HELOC's, credit cards, auto loans, commercial loans, and even prime loans. Deliquencies and defaults are getting worse on all products and will only continue to do so for the next 2/3 years. Now I don't know where exactly where you get your other numbers from (the $600 billion put out by UBS for example), but most estimates I've read which range from $500 billion to even $1 trillion include all credit losses, not just subprime. The quicker we all get out of this 2007 mindset that this is only a "subprime" problem, the clearer the picture will become.

[bhakta]

I don't think we are seeing the beginning of the end of this insanity. "THEY" wants us to think so, but I am not falling for it.

[Fabian]

It is incredible that S&P still has an ounce of credibility on this market. It is also incredible that this industry still has an ounce of credibility after the last bubbles. However they hold the market and no matter what you think about them your money always go to them. I would not be surprised that they come we a "trick" and reverse to a bullish trend, all bad news discounted, in a near future. Now trying to explain this and that with hard quantitative figures is pretentious. Just follow the trend and be prudent.

[STILL RENTING]

Ha ha! About the time they are done "recognizing"... the losses from sub-prime, they can start looking at the losses from Alt-A.

And then prime.

[Vikram]

As I wrote in the article, MS took the $9B write-down assuming 100% default and 100% severity. Houses are tangible assets and not going to be worthless in nominal dollar terms. You do the math.

[Pent up demand]

Tony Soprano has been all over this site pumping stocks. Yeah, a negative consensus is a buy signal - except when it isn't.

This thing has been spun from day one as a subprime problem. That is what they are feeding the masses. As freedomrenter says, who cares if they wrote the subprime down to zero. Only after the Alt-A, option-ARM, and HELOC losses been counted will I think about becoming a buyer. In the meantime I stay in cash and watch my insurance policy (commodities) pay off, and keep my powder dry.

[texasgolfer]

without real transparency there is no trust, look as BSC today. are we suppose to believe that everything happens in just one day? BS

[Matt Blackman]

Write ups next Vikram? I'll take the other side of that trade.

Not long ago Bernanke estimated that total subprime writedowns would not exceed $100 bn. Now more credible estimates put that number in excess of $1 trillion and even that number assumes that home prices level off (see seekingalpha.com/artic... ). At last estimate more than 8 million Americans have mortgages exceeding their home's value and for the first time in history, home equity has fallen below 50%. Home prices are so far down 10% but this occurred in the absence of recession. If we enter a recession which is looking increasingly likely (see tradesystemguru.com/co... ) home price declines will accelerate.

The old market adage is to buy when their is blood in the streets but it overlooks one important reality to avoid catching a falling knife. I prefer to wait till there is some evidence that the blood flow has been stopped and is starting to dry up first.... but then again I'm not a value investor who believes in buying on the way down....

[Vikram]

Thanks for all the messages folks. Some observations.

The bond market has already priced most sub-prime based bonds at very low valuations. Mark to Market rules ensure that the banks have to take the write-downs as they occur. Bonds originally rated as AAA are trading in the 50s, reflecting extreme risk even though there is real tangible collateral backing them.

1. ABX sub-prime indices
markit.com/information...

Index Series Version Coupon RED ID Price High Low

ABX-HE-AAA 06-1 6 1 18 0A08AHAA1 86.19 100.38 84.17
ABX-HE-AAA 06-2 6 2 11 0A08AHAB8 70.06 100.12 66.1
ABX-HE-AAA 07-1 7 1 9 0A08AHAC6 55.94 100.09 53.46
ABX-HE-AAA 07-2 7 2 76 0A08AHAD4 52.92 99.33 52.47


2. The TABX index tracking the BBB sub-prime mezannine debt which fund many CDOs is trading as almost worthless; even the 40-100 tranche which start taking losses after 40% of the principal is exhausted are trading in the teens

markit.com/information...

3. Salvage Value: The salvage value for loans on homes in foreclosure varies between 50-80% of the home's market value depending on the size of the loan and the market condition. And not all these loans were no-down payment loans; in many cases they homeowners had some kind of equity in the deal (downpayment).

Homes have a tangible value and use; in nominal dollar terms there are unlikely to fall significantly below the replacement costs.

4. Creative solutions for Tough Times:
The Fed has shown that they are willing to reveal weapons most people do not even know exist.

Similarly it is also likely that the stakeholders affected by the high amount of foreclosures will band together to find a solution.

For example, subprime related foreclosures are concentrated in specific pockets of the country. The geographical concentration means that it is easy to form entities to manage them as rentals. If the homes are transferred at 60-70cents to the dollar to new entities, a bulk of these homes are going to be cash flow positive rentals from day #1; Californa, Nevada and Florida continue to be very attractive places to live in. The original note-holders can continue to have an equity stake in the entities.

Time, inflation, and the devalued USD will fix things. The wash-out is occuring as we speak.

[ratsharp]

i am learning..but i wonder if i buy ..where will it get back to ..and if it will gets back to a higher level ..will stay there long enough for me to exit my trade .. or shd i hold till maturity..and pay the interim MTM ...and if i do that is my broker stable enough to keep the trade or will I have to get all the cash... and if it goes down again ( due to insufficient liquididty) ...what happens to me. SO nett i will trade only when the issue has been or close to resolution.. (i.e. till people start acepting losses and the fire sale actually happens ..not the one where the bid ask price simply gravitate lower and the bid ask spread make the quotes look stupid..

[oldtrdr]

I cast my vote with the "it ain't over, yet" crowd....how about commercial real estate? Just one more dangling shoe....

Jan

[mtclm]

Did anyone note the line "and all your short expiring worthless"? If you look for write-ups against severe assumptions of default and severity, you must also account for the reversal of shorts expiring worthless. I don't know the magnitude of their short position, but I do know these are very expensive shorts to maintain.

[Vikram]

mtclm:

I think what he meant was that all the short positions which MS has will expire worthless; i.e. the loss and severity will not be as bad and MS will not earn anything on these after accounting for the maintenance cost. The write-downs, as noted by the Lehman analyst and specificially probed by the City analyst factor in the worst case scenario on BOTH sides of the trade!



www.risk.net/public/sh...

"Chief financial officer Colm Kelleher said that the the mortgage desk had decided to short the subprime market by taking a $2 billion short position in low-rated subprime mortgage-backed securities (MBS). In order to meet the cost of the negative carry of the short position, the desk also went long $14 billion of AAA-rated super-senior [tranches] of BBB subprime securities, which we refer to as mezzanine," he said. The investment in the top tranches of collateralised debt obligations (CDOs) of MBS was assumed to be safe enough to provide a reliable source of funding to meet the cost of the short position, even if the underlying market declined"

As it is clear, their short positions are in much worse tranches since they needed $14B of long mezannine debt to balance out the negative carry spread on $2B of the short sub-prime.

Their long positions are going to be worth a lot more before the short positions start losing money. And the principal of the short positions which earns interest will detoriate much faster than the long position, decreasing the cost of carry.

Again, do the math.

[nitroae23]

Interest rates coming down?Did I read that right,no saaah!Thev've been on the rise for weeks,and,as defaults pick up will go higher.Gonna complicate things significantly.The market can't sustain Fed cure du jour much longer,they have to shut the hey up and let markets repair themselves.

[Vikram]

www.aleablog.com/dont-.../\
Dont Mark to Markit


seekingalpha.com/artic...

10) Be careful using the ABX indices. They are too easy to short, and do not represent the values that are likely to be realized in the cash markets. The same is true of the CMBX indices. This would lead me to be a bull, selectively, in AAA CMBS, after careful analysis of the underlying collateral. (CMBS was a specialty of mine when I was a mortgage bond manager.)