Page 2 of
2 THE BEAR'S
LAIR Level 3 storm
about to hit Wall Street By
Martin Hutchinson
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 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.
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 whose 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.
Martin Hutchinson is
the author of Great Conservatives
(Academica Press, 2005) - details can be found
at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
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