By Martin Hutchinson
October 29, 2007
Martin Hutchinson is the author of "Great Conservatives" (Academica
Press, 2005) -- details can be found on the Web site www.greatconservatives.com
There's a mystery on Wall Street. Merrill Lynch last week wrote off $8.4
billion in its subprime mortgage business, a figure revised up from $4.9
billion, yet Goldman Sachs reported an excellent quarter and didn't feel
the need for any write-offs. The real secret of the difference is likely
to be in the details of their accounting, and in particular in the murky
world, shortly to be revealed, of their "Level 3" asset portfolios.
Both Merrill and Goldman have Harvard chairmen - Merrill's Stan O'Neal
from Harvard Business School and Goldman's Lloyd Blankfein from Harvard
College and Harvard Law School. Thus it's pretty unlikely their
approaches to business are significantly different - or is a Harvard MBA
really worth minus $8.4 billion compared with a law degree? (The special
case of George W. Bush may be disregarded in answering that question!)
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 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. The former commercial banks 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.
There has been no rush to disclose Level 3 assets in advance of the
first quarter in which it becomes compulsory, probably that ending in
February or March 2008. Figures that have been disclosed show Lehman
with $22 billion in Level 3 assets, 100% of capital, Bear Stearns with
$20 billion, 155% of capital and J.P. Morgan Chase with about $60
billion, 50% of capital. However those figures are almost certainly low;
the border between Level 2 and Level 3 is a fuzzy one and it is
unquestionably in the interest of banks to classify as many of their
assets as possible as Level 2, where analysts won't worry about them,
rather than Level 3, where analyst concern is likely.
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.
* Leveraged buyout bridge loans. After a hiccup in August, the
market in these has reopened recently, although around $250 billion of
them still remains on banks' balance sheets. The value of a leveraged
buyout bridge loan that has failed to find a pier to support the other
end of the bridge is very dubious indeed, even though these loans are
being carried in the books at or close to par. As the value of
underlying assets declines and the cash flow fails to match debt
payments, the deterioration in credit quality of these loans will
accelerate.
* Asset backed commercial paper. The amount of asset backed
commercial paper outstanding has dropped from $1.2 trillion to $900
billion in the last three months. This financing structure was always
unsound; it was basically a means of removing the assets backing the
commercial paper from bank balance sheets, and always faced the problem
of a severe mismatch between asset and liability duration. The $100
billion vehicle intended to rescue this market has found a mixed
reception to say the least. It is likely that as credit conditions
deteriorate, the assets underlying ABCP vehicles will increasingly find
themselves on bank balance sheets, where they will prove to be almost
completely unmarketable.
* 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 twelve 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.
* Credit Default Swaps, the global outstanding value of which in
June 2007 was $2.4 trillion, according to the Bank for International
Settlements. These are a relatively new instrument, the efficacy of
which has not been tested in a downturn. It appears likely that the
value in banks' books of their Level 3 credit derivatives contracts
bears no relation whatever to reality. As discussed above, the
incentives have been all in favor of inflating it.
The capital underlying Wall Street, at the top, is not all that large -
a matter of a few hundred billion. Given the piling of risk upon risk
that has been engaged in over the last few years, and the size of the
losses in the mortgage market alone that seem probable - my own estimate
last spring of $980 billion looks increasingly likely to be somewhat
below the final figure - it appears almost inevitable that in a bear
market in which liquidity dries up and investors become skeptical, Wall
Street's capital will be wiped out. Only the commercial banks like
Wachovia and Bank of America whose investment banking ambitions have
been largely thwarted and portfolios of Level 3 rubbish are
correspondingly lower are less likely to disappear.
Given the size of the overall figures involved and the excessive
earnings that Wall Street's participants have enjoyed over the last
decade, a taxpayer-funded bailout of Wall Street's titans would seem
politically impossible, however loud the lobbyists scream for it.
In the long run, that is probably a blessing for the US and world
economies.
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