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 it's 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' (LEH) CFO), a huge amount of this stuff is still improperly priced:
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 (NYSE:C), J.P. Morgan Chase (NYSE:JPM) and Bank of America (NYSE:BAC) -- 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 . . .
What’s the subprime damage to banks?
Gillian Tett and Paul J Davies
FT, November 4 2007 18:08
Wall Street's stress test
MarketWatch, 7:57 PM ET Sep 7, 2007
Banks Face $100 Billion of Writedowns on Level 3 Rule
Bloomberg, Nov. 7 2007
Risk of securities fire sale mounts
David Wighton and Saskia Scholtes in New York and Gillian Tett in London
FT, November 6 20
2007 Global CDO and Credit Derivatives Outlook
Fitch, 13 December 2006