Prophets of Doom?

Lately we have been reminded of the impending collapse of the American economy as a result of the sub-prime loan crisis and ‘level 3’ asset portfolios. Sub-prime loans and ‘level 3’ asset portfolios are phrases which we have never heard of before.

The latter term, to the local and HK Chinese, is likely to suggest soft porn films. To some, it sounds like ‘lavatory’. But to the writer, Martin Hutchinson, it is more like ‘toxic waste’ in investment bankers’ balance sheets.

“We may be about to find out. From November 15, we will have a new tool for figuring out how much toxic waste is in investment banks' balance sheets. The new US accounting rule SFAS157 requires banks to divide their tradable assets into three "levels" according to how easy it is to get a market price for them. Level 1 assets have quoted prices in active markets. At the other extreme Level 3 assets have only unobservable inputs to measure value and are thus valued by reference to the banks' own models.”

“Goldman Sachs has disclosed its Level 3 assets, two quarters before it would be compelled to do so in the period ending February 29, 2008. Their total was $72 billion, which at first sight looks reasonable because it is only 8% of total assets. However the problem becomes more serious when you realize that $72 billion is twice Goldman's capital of $36 billion. In an extreme situation therefore, Goldman's entire existence rests on the value of its Level 3 assets.

The same presumably applies to other major investment banks - since they employ traders and risk managers with similar educations, operating in a similar culture, they probably have Level 3 assets of around twice capital. Citigroup, J P Morgan Chase and Bank of America may have less since their culture is different; before 1999 those institutions were pure commercial banks and a substantial part of their business still lies in retail commercial banking, an area in which the investment banks are not represented and Level 3 assets are scarce.”

"The reason analysts should worry is that not only are Level 3 assets subject to eccentric valuation by the institution holding them, but the ability to write up their value in good times and get paid bonuses based on their capital uplift brings a temptation that few on Wall Street appear capable of resisting. Both Goldman Sachs and Merrill Lynch are reported to have made profits of more than $1 billion on their holdings of Level 3 assets in the first half of 2007, for example, profits on which bonuses will no doubt be paid at the end of their fiscal years. Given that we have had five good years on Wall Street, years in which nobody has known the amount of Level 3 assets on banks' balance sheets, and no significant media waves have been made questioning their valuation methodologies, it would not be surprising if many banks' Level 3 assets had become seriously overstated, even without any downturn having occurred.”

”When Nomura Securities sold its mortgage portfolio and exited the US mortgage business in this quarter, it took a write-off of 28% of the portfolio's value, slightly above the 27% of the portfolio that was represented by subprime mortgage assets. Were Goldman Sachs's Level 3 assets similarly value-impaired, it would result in a $20 billion write-off, more than half Goldman's capital, leaving the bank severely damaged albeit probably still in existence.”

"Defenders of Goldman Sachs and the rest of Wall Street will insist that less than 27% of their Level 3 assets are represented by subprime mortgages yet that is hardly the point. Subprime mortgages, estimated to cause losses of $400-500 billion to the market as a whole, though only a fraction of that to Wall Street, have been only the first of the Level 3 asset disasters to surface. There is huge potential for further losses among assets whose value has never been solidly based. These would include the following:

Mortgages other than subprime mortgages. With the decline in house prices accelerating, the assumptions on which even prime mortgages were made are being exposed as fallacious. As house prices decline, debt to equity ratios increase, and for mortgages with an original loan-to-value ratio of 90% or more, quickly pass the 100% at which a mortgage becomes uncovered. If the value of conventional mortgages decline many securities related to them, currently classed as Level 1 or 2 assets, will become un-marketable and descend into Level 3.”

“Securitized credit card obligations. $915 billion of credit card debt is currently outstanding, the majority of it securitized, and its default rate is likely to soar as the full effects of the home mortgage market's crack-up spread to the credit card area. The risks in Level 3 portfolios derived from this asset class arise particularly in the areas of complex derivatives and manufactured assets based on credit card debt pools.”

“Complex derivatives contracts. Even simple interest rate swaps and currency swaps caused large losses in the last significant credit tightening in 1994, although most of those losses were suffered by Wall Street's customers rather than Wall Street itself. The more complex transactions that have been devised during the last 12 giddy years are much more likely to prove impossible either to sell or to hedge. Goldman Sachs reported that in the third quarter of 2007 its profits on derivatives used for hedging more or less matched its losses on subprime mortgages. It is likely in reality that the bulk of those profits were incurred through model-based write-ups of value on contracts that were within the Level 3 category - after all, Goldman's Level 3 assets increased by a third during the quarter. It's not much good shorting to match a long position you don't like if your hedging shorts prove to be impossible to close out."

Earlier, we have come across explanation of how the US seems to thrive on being the world’s biggest spender, fed by loans from the world’s biggest eager producers of goods.

Together with the subprime loans and ‘level 3’ asset portfolios write-offs, we seem to be heading towards the world’s greatest financial tsunami which will inevitably affect Malaysia. Before this phenomenon, even when US sneezes, we catch a cold. I cannot imagine what the situation is going to be – ‘The Great Depression of the Millenium’ or ‘The Greatest Depression Ever’?