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Thursday, November 01, 2007


why the trouble is just beginning at the banks

it's summarized very nicely by the financial times:

Having weathered the storm through August and September, October has been disastrous for CDOs. The value of the leading tracker indices has plummeted as the rating agencies have rushed to downgrade senior debt across the CDO spectrum.

It’s all been part of a subprime chain reaction. First there was all that bearish housing news in September - which markets ignored because the Fed had cut rates, equities were rallying and CDS spreads were tightening.

Second, the rating agencies hit mortgage backed securities. That bad housing news - rising subprime delinquencies and a sector which looked like it was heading for a recession fed into the outlook for MBS. On October 8 Fitch downgraded $18.4bn of MBS. Then, on the 11th, Moody’s followed suit with $33.4bn in MBS downgrades. Five days later and Standard & Poor’s joined in - cutting ratings on $23.25bn of subprime securities. And again, three days later, on a further $22bn.

And then, predictably, CDOs - chock full of MBS - came in line for downgrades: On October 22 Standard & Poor’s said it could cut ratings on $21bn of CDOs. Moody’s said it would do the same with $33.4bn on October 26, and on October 29, Fitch said it was reviewing ratings on all $300bn of CDOs out there. Moody’s not wanting to be outdone went one further: saying this Wednesday that it could downgrade 500 CDO deals by tomorrow.

Little wonder then, that the main tracker indices have crashed in the past couple of weeks.

So why is the AAA taking a battering? CDOs are opaque and generic. Investors bought CDO paper purely on the back of its ratings. What’s spooking people are some of the shock downgrades - Moody’s, for example, cut the Aaa rated trance of a CDO issue called Vertical 07-01, issued by the absurd-sounding Vertical Capital, by fourteen notches to B2. In one go.

Some are sanguine. The Fed rate cut on Wednesday provoked a small return in confidence - evident in the graphs above. And Pimco has announced it’s going to invest heavily in CDOs. The fund said it bought $5bn of CDOs over the past few weeks, and intends to buy another $2bn in the next couple.

But on the other hand, evidence from the US housing market would suggest there’s plenty of pain yet to work itself out of the system. Given the way subprime delinquencies are set to carry on rising into 2008, there could yet be a lot of subprime, Alt-A and even prime securities to be downgraded.

And some CDOs themselves are beginning to crack. Moody’s said seven have experience “events of default” on Wednesday. And true to their word, they’ve downgraded tranche after tranche of CDO debt since then.

What’s more, since the CDO markets have crashed in the last few weeks, writedowns in banks’ Q3s - only just reported - are likely to be much worse. Citi, for example, reported writedowns totalling $1.3bn on subprime MBS it had warehoused for use in CDOs. That was on October 1. The graphs above give a pretty good indication of where the market has moved since then.

changes in the fed funds rate are going to do very little to mitigate this problem; in the end, it is very likely that only monetizing these impaired securities -- the government taking them off private balance sheets in exchange for treasury securities or dollars -- would do the trick, in the most massive bailout in american history.

to take citigroup as an example: at june 30, 2007, its shareholder equity was $128bn -- but its assets were $2200bn. of that, some $235bn were securities held for sale, another $350bn in securities purchased under agreements to resell, another $760bn in loans and lease receivables.

of the "held for sale", some $21bn in nonconforming mortgage-backed securities -- $45bn in mbs backed by fannie or fhlb -- $28bn of other asset-backed securities, of which $20bn is home equity loans and $4bn credit card receivables. of course, these securities cannot be sold at the moment because of the buyer's strike in the collateralized loan markets.

of the loan receivables, $171bn is first-lien mortgages, $41bn second lien, $92bn in credit card loans.

beyond that, citi is affiliated to over $100bn in structured investment vehicles (siv's) that are largely made up of cdo and rmbs tranches, which it will soon be obligated to fund.

against just $128bn in equity, it becomes clear that it would not take a truly radical loss in just its residential lending exposure to dent citi's equity very seriously and put it in violation of banking laws regarding loan loss reserves. (it may also be noted that a more severe decline in housing may put citi in play for outright bankruptcy -- mish notes that the leverage involved means just a 5% loss on the entire portfolio, most of which is housing debt, means insolvency.)

and then what of credit card debt, where default rates are suddenly ticking up and loans are totally unsecured?

the realization of which is behind today's very negative action in citi stock and debt, on (well-founded) speculation that citi's dividend will be endangered by its need to build loss reserves and hoard capital against further writedowns.

A longtime banking analyst said late last night that Citigroup may be forced to cut its dividend or sell assets to stave off what she said was a $30 billion capital shortfall, moves that could pull down its shareholder returns for several years.

The analyst, Meredith A. Whitney of CIBC World Markets, downgraded Citigroup’s stock to sector underperform, from sector perform, and called for the bank to bring precariously low capital levels more in line with its peers.

“We believe the stock will be under significant pressure and could trade in the low $30s,” she wrote. That would be as much as a 28 percent decline from yesterday’s $41.90 closing price for Citigroup shares.

In the third quarter, Citigroup said it lost $1.3 billion from mortgage-related securities amid the credit market downturn. Executives conceded they did not pay enough attention to credit risk or adequately hedge their positions.

But Ms. Whitney’s report turned the spotlight on other potential miscues, including Mr. Prince’s growth strategy. The report points out that Citigroup’s capital levels have declined to their lowest levels in decades after a recent spate of acquisitions. Citigroup’s tangible capital ratio stands at 2.8 percent, nearly half of the level of its peers.

Other banking and risk experts agree with Ms. Whitney’s analysis, however, and some suggest that it may even be conservative. Citigroup’s capital position “is too low based on the risks on the trading side but the kicker is that Citigroup is going to have a lot more losses” on the consumer side, said Christopher Whalen, the managing director of Institutional Risk Analytics. “It is going to be a one-two punch.”

it's very likely that the banks will have to suffer terribly well before such a public bailout materializes. credit contractions from such highly-leveraged peaks tend to be self-perpetuating and force bankruptcies. home loan defaults will very likely be followed by trouble in commercial real estate lending, jobs, car loans, credit card receivables and more. i certainly expect some bankruptcies among major banks as writedown follows writedown, quite possibly sooner than anyone believes.

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