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Sunday, December 02, 2007


the e*trade portfolio sale

the worst case scenario for american financial services just got a whole lot worse.

Citigroup investment bank analyst Prashant Bhatia said E*Trade actually received 11 cents on the dollar for its portfolio, if you factor in that the brokerage received $800 million in cash minus 85 million shares it issued. He said that implies Citadel's received stock compensation worth about $450 million, leaving E*Trade with only $350 million for its $3.1 billion portfolio.

the best case valuation -- ignoring the share issuance -- is still just 27 cents. e*trade's portfolio is not particularly risky for a financial services company.

And everyone was surprised by the price considering the assets in the portfolio:

Goldman Sachs analysts said they were surprised by the size of the discount on the E*Trade portfolio because 73 percent of the assets were backed by prime mortgages, or loans to people with solid credit.

It is worth emphasizing that a large portion of the assets were backed by prime - not subprime - mortgages. And many of the prime loans were first liens with decent average FICO scores (average 725) and LTV (71%).

the first, most obvious question: if this is what prime and near-prime mortgage portfolios are worth, what is the capital condition of the banks?

The implication are ominous. While admitting using simplistic analysis Credit Suisse analyst Susan Katzke estimates the following writedowns based on what happened at E*Trade, assuming pricing at 26 cents on the dollar.

  • Merrill Lynch (MER) could take a $9 billion after-tax hit to the valuation of assets underpinned by subprime mortgages.

  • Citigroup's (C) after-tax write-down could be $26 billion.

Note that in reference to Merrill Lynch, Susa Katzke said $9 billion was related to subprime. Note that 73% of E*Trades portfolio was prime. That is quite a haircut on so called prime paper.

... [W]hat happens when they need another $26 billion as Credit Suisse analyst Susan Katzke is suggesting [on the heels of a deal like this]? What happens if those level 2 assets [much less level 3] were marked to market? What happens if Citigroup has to bring those SIVs back on to its balance sheet? What happens when Moody's, Fitch, and the S&P continue downgrading CDOs? What happens now that credit card losses are rising and commercial real estate is tanking?

the depth of the markdown here is so severe that citi is far from the only bank in very serious trouble.

it's worth noting that citadel may well be scoring a wonderful deal here -- the income that will eventually be derived from the portfolio might be significantly more than they paid for it. but their advantage is the ability to be patient, which is an advantage few if any of the highly-leveraged financial service companies with capital reserve ratio problems have. they need capital now, and look to be selling into an utterly devastating market to get it.

UPDATE: more evaluation, via calculated risk, from the new york times.

A large part of E*Trade’s basket of assets was securities backed by high-quality mortgages — loans to homeowners with strong credit ratings and reasonably large equity cushions. That could raise troubling questions on Wall Street about the true value of “prime” mortgage assets, especially when they need to be liquidated in a hurry.

The picture becomes clearer when you look at this breakdown, which E*Trade shared with investors in October. It shows that more than $1.35 billion of E*Trade’s asset-backed portfolio consisted of prime, first-lien residential mortgages rated “AA” or better — hardly toxic sludge by any stretch of the imagination.

So consider this: Even if E*Trade got nothing — not a cent — for anything but these top-quality mortgage securities, it still sold $1.35 billion in prime mortgage assets for $800 million, or less than 60 cents on the dollar.

That’s just a back-of-the-envelope calculation, but a potentially unnerving one.

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At last the first buyers are timidly appearing. Soon there will be a market and better prices will be paid. The mortgages are being paid, even most of the subprime mortgages are being paid. If there is full employment and mild inflation, this crisis will pass too.

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i actually doubt it, j -- or at least the kind of market most people envision.

most of us are used to equity market events where such events as these mark a bottom -- the return of buyers.

but this is not an equity event -- this is a credit event, and the first buyers in credit events tend to end up providing marks. now the rest of the field can go back to their own portfolios and apply those marks -- and determine what steps they need to take to maintain solvency.

some will be more than capable of being patient. for others, it will be forced selling, which will probably provide lower marks.

credit events tend to be prolonged, with waves of writedowns at progressively lower marks, each lower level bringing newly-distressed parties in.

The mortgages are being paid, even most of the subprime mortgages are being paid.

true, j, but that's not the point at all. the point is that default rates that were much lower were used to predicate very-low-equity credit constructs like cdo's, from which were issued tranches amounting to hundreds of billions and which are now essentially worthless. and they were soaked up by SIVs that were, in good times, levered on average 14x.

it's not just the underlying assets that are the problem; it's the credit that was predicated on the assets, which must now be unwound. in a word, DELEVERAGING.

if mortgage portfolios are going to end up with distressed marks like 27 cents and worse, the amount of deleveraging we're about to witness may well be a generational event -- something you tell your grandkids about.

this crisis will pass too

again true, j, but so did the great depression pass. it's the path taken to get to the passing that matters! :)

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