Nouriel Roubini | Nov 05, 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” asset 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 put it by the FT:
“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....
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.
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.
As I said before, the media should stop diverting attention 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.
[Bernard adds in another post:]
I would like to follow up again on the Level 3 asset to equity ratios for Wall Street that Nouriel highlighted before.
The numbers for almost all the Wall Street banks are actually WORSE than what I originally posted. The revised figures are shown below.
The original ratios used Total Equity. To be more accurate, the ratio should have used Tangible Equity instead. My thanks to another blog reader for pointing this information out.
Tangible Equity is essentially Total Equity minus "intangible" assets like goodwill that would have no value in a liquidation.
Take a look at these new numbers. What jumps out is Citigroup. It shows their Level 3 asset ratio at 205% of tangible equity. The old numbers had them at 105%.
Citigroup: Level 3 assets of $135 billion, equity of $66 billion, ratio is 205%
Goldman Sachs: Level 3 assets of $72 billion, equity of $34 billion, ratio is 212%
Morgan Stanley: Level 3 assets of $88 billion, equity of $32 billion, ratio is 275%
Lehman Brothers: Level 3 assets of $35 billion, equity of $18 billion, ratio is 194%
Bear Stearns: Level 3 assets of $20 billion, equity of $13 billion, ratio is 154%
Merrill Lynch: Level 3 assets of $16 billion, equity of $34 billion, ratio is 47%
Summary of Level 3 assets to tangible equity ratios:
Citigroup 205% Goldman Sachs 212% Morgan Stanley 275% Lehman Brothers 194% Bear Stearns 154% Merrill Lynch 47%
Level 3 asset writedown needed to wipe out ALL tangible equity:
Citigroup 49% Goldman Sachs 47% Morgan Stanley 36% Lehman Brothers 52% Bear Stearns 65%
And remember that we are not even factoring in writedowns on Level 2 assets either.
Note: Data was derived from Yahoo Finance. Tangible equity figures for Citigroup and Merrill are as of June 30. Their equity is very likely to be worse as of September 30, so the ratios you see here are very likely understating the problem.