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Wednesday, November 07, 2007


the real damage in level 3

the financial times today cites a report from creditsights regarding the crashing of the abx quotes, which are intended to mirror conditions in the residential mortgage-backed securities markets.

Many banks, if not financial institutions in general, would have you believe that the current rout in mortgage-backed debt is largely being driven by irrational fear. A few bad subprime debts buried around the structured universe are scaring buyers out of markets.

But, said CreditSights, in a note to clients on Wednesday, current pricing levels reflect fundamentals, even for the most highly-rated debt. Mortgage securities across the board are overrated and overvalued:

The harsh truth about the outlook for the AAA tranches - necessary downgrades, if not defaults - should put the lie to the argument that current low prices in AAA RMBS tranches - let alone AAA tranches of mezzanine RMBS CDOs - are somehow the victim of poor liquidity conditions, and do not reflect the true fundamentals of the situation.

CreditSights publish the results of a survey they have conducted on “188 individual relatively large RMBS deals”. The outlook, by all accounts, is grim.

At root, CreditSights calculate a severity loss ratio for lenders on individual defaulting subprime mortgages based on mortgage market data collected over the past few weeks. The survey results indicate that such loss severity rates on mortgages are “painfully high”. They range from 24 per cent to 55 per cent - with a weighted average at 35 per cent. And they’re expected to rise. For second-lien mortgages - that is, second mortgages on a property, the loss severity rates average 94 per cent. (ed. note -- it has been anecdotally reported to be as bad elsewhere; i suspect janet tavakoli was talking there about second-lien.)

So how do those figures translate into the capital structure of structured mortgage-backed debt? Foreclosure rates are rising higher and higher - which means the number of occasions when the above loss severity ratios have to be applied are increasing.

And it doesn’t look like the blame can be pinned on any particular vintages of MBS. Here’s a graph of foreclosures on vintages since 2004:

According to CreditSights, that should “up-end the idea that the 2004 vintage was perhaps sufficiently seasoned and composed of loans that had enjoyed enough home price appreciation since 2000, to avoid any further erosion.”

As it is, foreclosure rates are hovering at around 13 per cent on 2005 and 2006 mortgage debt. But CreditSights say there is “no end in sight” when it comes to that figure rising.

Consider then the outlook for delinquancy rates - a measure of mortgage loans not yet in foreclosure, but in trouble:

Add the 7 per cent delinquency rate for the 2006 vintage to the 2006 foreclosure rate at 12.6 and it’s already close to 20 per cent.

How then does that translate into the world of structured finance, and those RMBS tranches?

To trigger a default on the most secure subprime RMBS debt - rated AAA, and structured with a typical 18 per cent attachment rate - foreclosure rates would have to reach the 30 per cent.

As can be seen from the results of CreditSights’ survey, that scenario is indeed becoming “less and less unthinkable”. Adding the foreclosure and delinquancy rates takes us close to 20 per cent. Both are set to increase. Then there’s those painfully low severity loss ratios. Add it all together and that AAA debt is far, far, far from safe.

And we haven’t even mentioned prime tranches lower down the structure.

Far from mispricing RMBS, CreditSights even go so far as to suggest that actually, the ABX indices (which list AAA RMBS debt at around 80 cents in the dollar) are throwing up some pretty appropriate figures.

near as i can tell, most cdo's are accounted as level 3 assets -- that is, highly illiquid and without quotation, their value is assessed subjectively by the management. as is being seen with citigroup and others, the amount of such assets overwhelms the amount of equity in several major american banks. these cdo's were invented particularly to make palatable the very worst mortgages -- you can be sure they are packed to the gills with subprime. that means that much of these banks level 3 assets will have to be written off.

currently, however, citi is pricing them somewhat differently.

In a statement, Citigroup said the declines in the value of the bank's subprime exposure "followed a series of rating-agency downgrades of subprime U.S. mortgage-related assets and other market developments which occurred after the end of the third quarter."

When trading in the subprime-linked securities all but dried up amid this summer's credit-market turmoil, Citigroup and other banks suddenly faced the difficult task of putting a value on securities that investors no longer wanted to trade.

For lack of any market pricing, Citigroup used credit ratings as a key input in figuring out the value of the future payments it expected to receive on the securities, according to a person familiar with the bank's valuation models. For example, in valuing the payments on pieces of subprime-backed CDOs with the highest triple-A rating, the bank would look to how the market was valuing payments on corporate bonds with the same rating.

one gets the feeling that writedowns are in very early stages at citi, even with $15bn already announced. how big a problem are we talking about? try royal bank of scotland on for size:

``This credit crisis, when all is out, will see $250 billion to $500 billion of losses,'' London-based Janjuah said. ``The heat is on and it is inevitable that more players will have to revalue at least a decent portion'' of assets they currently value using ``mark-to-make believe.''

and we're talking only about exposure to rmbs and cdo's. what of aggressive lbo financing, which is now stagnant and laying on investment banking books? what of citi's own mortgage book? what of its commercial real estate book? and please remember that prices haven't really started to fall yet, nothing anything like they're going to, in either residential or commercial real estate.

as noted, these cdo's are being valued on their rating. they're going to be rerated in due time, and drastically lower. particularly in citi's case, where the cdo's were funded by now-frozen commerical paper, that is an existential threat. citi is fighting for its life. and it isn't alone.

further, i will say this: if there's a forced deleveraging from citi and the IB complex, it spells deflationary depression short of the fed wrecking its own balance sheet and doubling m1. with the amount of leverage in the system and the deficiency of capital-strong buyers (as opposed to liability-dependent buyers), it's just possible that we're beyond that tipping point after which asset sales lead to such rapid price declines that balance sheet repair from asset sales just isn't possible, as writedowns on your remaining assets outpace the liabilities you're able to pay down.

UPDATE: moody's is giving yet more credence to creditsights by performing what it terms a "bottom-up" analysis that yields a mortgage- and cdo-related writeoff figure for the financial industry of $225bn.

unfortunately, to get to that figure it assumes a 10% loss rate, based on a 12% fall in house prices and a mild economic slowdown. that is, $225bn is the best case scenario. in all probability, losses will be much worse.

to date, the banks have announced writeoffs in aggregate of just $28bn.

UPDATE: jim grant calls it "an old-testament-caliber credit crisis -- this is the real thing". and worse, it's compounded by a simultaneous currency crisis in the dollar. i can't say i disagree.

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