Bloodbath In Credit Will Sharply Worsen

The Bloodbath In Credit And Financial Markets Will Continue And Sharply Worsen

By Nouriel Roubini | 5 November 2007

It is now clear that the delusional hope that the severe credit and liquidity crunch that hit US and global financial markets would ease has been shattered by the events of the last few weeks. This credit crunch is getting much worse and its financial and real fallout will be severe.

The amount of losses that financial institutions have already recognized— $20 billion— is just the very tip of the iceberg of much larger losses that will end up in the hundreds of billions of dollars. At stake— in subprime alone— is about a trillion of sub-prime related RMBS and hundreds of billions of mortgage related CDOs.

But calling this crisis a sub-prime meltdown is ludicrous as by now the contagion has seriously spread to near prime and prime mortgages. And it is spreading to subprime and near prime credit cards and auto loans where deliquencies are rising and will sharply rise further in the year ahead. And it is spreading to every corner of the securitized financial system that is either frozen or on the way to freeze: CDOs issuance is near dead; the LBO market— and the related leveraged loans market— is piling deals that have been postponed, restructured or cancelled; the liquidity squeeze in the interbank market— especially at the one month to three months maturities— is continuing; the losses that banks and investment banks will experience in the next few quarters will erode their Tier 1 capital ratio; the ABCP and related SIV sectors are near dead and unraveling; and since the Super-conduit will flop the only options are those of bringing those SIV assets on balance sheet (with significant capital and liquidity effects) or sell them at a large loss; similar problems and crunches are emerging in the CLO, CMO and CMBS markets; junk bonds spreads are widening and corporate default rates will soon start to rise. Every corner of the securitization world is now under severe stress, including so called highly rated and “safe” (AAA and AA) securities.

The reality is that most financial institutions— banks, commercial banks, pension funds, hedge funds— have barely started to recognize the lower "fair value" of their impaired securities. Valuation of illiquid assets is a most complex issue; but starting with the November 15th adoption of FASB 157 the leeway that financial institutions have used so far for creative accounting will be much more limited. Valuation of illiquid assets is a most technical issue. But new regulations will limit the ability of financial institutions to put "illiquid" assets in "level 3" securities, i.e. securities where the lack of market prices allows them to use dubious "valuation models" and "unobservable inputs" to value such assets. As suggested by a commentator (Bernard) of my recent blog many Wall Street firms are still playing the game of putting too many assets in the "level 3" bucket of mark-to-model to models that don’t make much sense. As reported by the FT today research by the Bank of England shows that small minor changes of assumptions in these models can lead to changes in the value of "safe" asset of 35%. So even AAA or AA assets may be worth much less than par, as the ABX is telling us. But financial institutions are not using the prices derived from the ABX indices to value most of their sub-prime assets. As the FT puts it:

"the banks have not yet made write-offs as large as the ABX might imply. Merrill Lynch analysts, for example, calculate that mid-quality ABX debt is on average now trading at 40 cents in the dollar. But these analysts say that Merrill Lynch itself has only written this type of debt down to 63 cents in the dollar— and UBS is still assuming this debt is worth 90 cents. “Simple math would imply that UBS needs an additional $8bn write-down [on its $15.4bn holdings] if the ABX pricing is correct," Merrill says.

This is indeed the message that comes from true market prices that are now indirectly available via the ABX indices. Those prices tell you not only that the mezzanine and equity tranches of subprime CDOs are now worth close to zero; they also tell you that prices for the AAA and AA tranches— that until recently were hovering near par of 100— are now down to 79 and 50 respectively. Hundreds of billions of subprime RMBS and senior tranches of CDOs are still being evaluated as if they are worth 100 cents on the dollar. What the ABX is telling you is that they are worth much less; thus the losses from subprime alone are an order of magnitude larger than recognized by most firms. But most firms are not using such market prices— or their proxies— to value their illiquid assets.

Indeed, according to a MarketWatch article from September— based on Bernstein Research— many Wall Street firms put an excessive amount of securities in the level 3 bucket that uses unreliable models for valuation. The share securities in the level 3 is:

15% for Goldman Sachs;

13% for Morgan Stanley;

8% for Lehman Brothers;

7% for Bear Stearns

and only 2% for Merrill Lynch.

No wonder that Merrill has been one of the few firms to report massive losses: it is at least one of the few firms that has come out clean on this valuation game and put only 2% of its assets in the voodoo valuation model bucket; compare that with the 15% put by Goldman or the 13% by Morgan Stanley. But the forthcoming adoption of FASB 157 (unless current lobbying pressure by interest group forces the postponment of its November 15th adoption) will reduce the ability of financial firms to play such accounting games and tricks.

As explained in three recent white papers by the Center for Audit Quality (CAQ) using the excuse of "illiquidity" to put assets in the model driven valuation bucket is highly inappropriate:

The white paper notes that it is important to distinguish between (1) an imbalance between supply and demand (e.g., fewer buyers than sellers, thereby forcing prices down) and (2) a "forced" or "distressed" transaction. Because persuasive evidence is required in establishing that an observable transaction is forced or distressed, it is not appropriate to assume that all transactions in a relatively illiquid market are forced or distressed. The SEC, in a 2004 accounting and auditing enforcement release, determined that using a definition of fair value that assumed supply and demand were in reasonable balance was a violation of GAAP and that the registrant should have considered the current market environment, such as imbalances of supply and demand, in the determination of the then-current market value. Further, the SEC objected to the practice of taking a long-term view of the market while ignoring prices quoted by external sources. Other key points from the draft white paper include the following: •  A decline in a market’s transaction volume does not necessarily mean that the market is not active. A market is still considered active if transactions are occurring frequently enough on an ongoing basis to obtain reliable pricing information. When an active market exists, a quoted price provides the best evidence of fair value (Level 1 per Statement 157). •  In the absence of an active market for the identical asset, entities often use valuation models. Entities may not ignore available market information or market participant assumptions that are reasonably available without undue cost and effort. Valuation models that use historical default data, or an entity’s own default assumptions, rather than assumptions that marketplace participants would use, are not appropriately using current market participants’ assumptions, even if the default assumptions are "stressed." •  Statement 157 contains disclosure requirements regarding fair value measurements that apply to entities that have adopted Statement 157. Entities that have not yet adopted Statement 157 should consider disclosures required by existing pronouncements (for example, AICPA Statement of Position No. 94-6, Disclosure of Certain Significant Risks and Uncertainties) in situations in which fair value measurements have a significant effect on the financial statements. When an entity that has not adopted Statement 157 measures fair value using significant unobservable inputs, the white paper suggests that the entity may wish to consider disclosures similar to those found in Statement 157.

The message from FASB 157 and the CAQ white papers is clear: using dubious models and accounting tricks to avoid using market prices or proxies for market prices to value illiquid asset is extremely inappropriate. And appropriate disclosure of the methods used to estimate the "fair value" of assets is now a requirement. Note that the proposed Super-conduit is another one of these schemes aimed at parking securities and avoiding having to recognize their true market value. So, the process of recognizing hundreds of billions of losses, not just in sub-prime related assets but across the board of trillions of dollars of securitized assets has barely begun. Thus, you can expect that the ongoing credit crunch will get much worse in the year ahead and its fallout spread from the US to Europe and throughout Asia and the globe. Trillions of dollars of securitized assets that were sliced and diced in the long food chain of securitization are now at some risk. The first crisis of financial globalization and securitization is thus only at its beginning stage.

Update:

Bernard— a contributor to the comments on this blog— has provided further insights and data on the "level 3" assets of some major US financial institutions. He says:

Look at the info Citigroup just filed with the SEC today: they have $135 BILLION in LEVEL 3 ASSETS.

I have a neat idea. Why don't we take every single major financial institution out there and then divide their total Level 3 assets by their equity capital base and make comparisons? This will give us a better idea as to which of them may really remain solvent at the end of the day. Shall we? Let's have a look at Citigroup. Their equity base is $128 billion. Therefore, their Level 3 assets to equity ratio: 105% How about Goldman Sachs? Level 3 assets are $72 billion, equity base is $39 billion. Their Level 3 assets to equity ratio is 185%. Morgan Stanley: $88 billion in Level 3, equity base is $35 billion. Ratio: 251% (WOW!) Bear Stearns: $20 billion in Level 3, equity base is $13 billion. Ratio: 154% Lehman Brothers: $35 billion in Level 3, $22 billion in equity. Ratio: 159% Merrill Lynch: $16 billion in Level 3, $42 billion in equity. Ratio: 38% Here is the Level 3 assets to equity ratio summary: Citigroup 105% Goldman Sachs 185% Morgan Stanley 251% Bear Stearns 154% Lehman Brothers 159% Merrill Lynch 38% This becomes very interesting now, doesn't it?

Looks to me like Goldman Sachs and Morgan Stanley are by far in the WORST situation among the investment banks.

[ Normxxx Here:  Outside of the media, did anyone have any doubts? Who was playing fastest and loosest with the gung-ho derivatives?  ]

And yet the media is focusing all of their attention on Merrill Lynch— which actually has by far THE LEAST EXPOSURE of all of them. What a joke! The media should stop diverting attention [[from the real culprits: normxxx]] and trying to make this into a "Merrill-specific" problem.

All of the investment banks are in deep trouble. These numbers should make that extremely evident. The deception must be exposed.

Normxxx    
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