THE
BEAR'S LAIR Tears on Wall
Street By Martin Hutchinson
As fourth-quarter earnings
numbers emerge for Wall Street, with analysts
expecting a US$15 billion write-off for Merrill
Lynch and an $18 billion write-off for Citigroup
(which is also tipped to be planning to
layoff about 20,000 staff, about a third of
them in its investment bank), Wall
Street's denizens, anxious for the future of their
bonuses and their jobs, are asking: Where will it
all end? The answer is: Not close to here, not
soon, and not before the landscape of Wall Street
and the scattered remaining fragments of the City
of London have been transformed beyond all
recognition.
Examining the nature of the
assets being written down suggests
that
we are not close to the end of Wall Street's bad
news. Subprime mortgages and the asset-backed
derivatives thereof form a large part of the
write-offs, but even in this area we do not appear
to be approaching the bottom of the cycle. If, as
seems likely, my own August 2006 forecast of a
15-20% decline in house prices and a $1 trillion
write-off from the $11 trillion in mortgage debt
is close to accurate, Wall Street should still
have several hundred billion to go, even in that
area - total write-offs so far, including the new
Citigroup and Merrill Lynch announcements, only
just top $100 billion.
While Wall Street
houses do not directly own more than a modest
fraction of the $11 trillion in US mortgage debt,
their share of both the lower quality debt and the
more recent debt, the two sectors most likely to
suffer losses, is very much higher. A total
housing finance write-off in the $300 billion
range for Wall Street, with the remaining $700
billion falling on investors, foreign banks and
the two behemoth housing finance entities Fannie
Mae and Freddie Mac, would seem a reasonable
expectation.
In London, most of the 25
billion pound ($50 billion) capital injection into
the quasi-fraudulent housing lender Northern Rock
appears to have been lost. Since British house
prices have only just begun to decline, and in
London at least must have much further to fall
than in any comparable region of the US, mortgage
losses in the UK market are still hidden well
below the surface, with only the tiniest fraction
of the iceberg being visible. After all, even a
50% decline in top-end London house prices would
still leave them excessive in terms of income
levels - it must be remembered that Tokyo housing
lost 70% of its value after 1990.
This
will not however be the end of the story. Wall
Street's woes and those of the City of London are
not limited to the mortgage sector. Credit card
debt, leveraged buyout debt and emerging market
debt all seem likely to leave their imprint on
Wall Street's balance sheets. In addition, there
is a huge quantity of toxic waste from the
derivatives and private equity businesses that is
currently infesting Wall Street's balance sheets,
and those of London houses.
Institutions
like Goldman Sachs, that have so far held
themselves haughtily superior to the write-offs of
their competitors, are bound to suffer severely as
these other losses appear. The write-offs we have
seen so far are probably only at most a fifth of
the final total, which should exceed $500 billion.
The key to working out how exposed to
unexpected losses are the major Wall Street houses
is contained in their holdings of "Level 3"
assets. From November 15, 2007, the new accounting
rule SFAS157 has required 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.
This column looked at Level 3 assets in
October, and since then a number of commentators
have been attracted to the topic. There is only a
modest correlation between Wall Street write-offs
that have so far been disclosed and Level 3 asset
totals; for example Merrill Lynch had only $16
billion in Level 3 assets at September 30, less
than its announced and proposed write-offs.
There are three factors that explain this.
First, the Level 3 methodology is very new, so
different institutions are classifying assets
using different standards. Second, it's perfectly
possible to lose your shirt with traded assets -
conversely the fact that assets are illiquid does
not automatically make them worthless. Third,
Merrill Lynch, which replaced its chief executive
Stan O'Neal with a $161 million payoff, may wish
to bring all the problems out up-front, in order
that the blame can be placed on old Stan, where it
belongs, and not on the new chief executive
officer, John Thain.
Nevertheless, it is
reasonable to suppose that there is at least a
substantial correlation between the amount of
Level 3 assets that an institution owns and the
damage it will suffer in a downturn. Because Level
3 assets are valued only by mathematical models,
their valuation is likely to have been inflated
beyond all reason by managements seeking to make
quarterly numbers and achieve bonus goals. One of
the lessons in dealing with the Wall Street of the
past two decades is: If the temptation is there,
these people will succumb to it.
Hence
even institutions whose trading operations and
risk management are in good order are likely to
suffer severe haircuts on their Level 3
valuations, as the assumptions made when the
valuations were carried out prove false and the
illiquidity of the Level 3 assets makes them
impossible to sell in an orderly manner. You
cannot assume that an institution that happens to
have avoided one particular disaster, for example
in subprime mortgages, will have avoided all
potential disasters, or will have resisted the
temptation to inflate its Level 3 valuations in
order to pad bonuses.
In this context,
therefore, the most vulnerable institutions on
Wall Street appear to be Morgan Stanley, Goldman
Sachs and Citigroup, in that order. Morgan
Stanley, according to Nouriel Roubini of RGE
Monitor, has $88 billion in Level 3 assets on an
equity base of $35 billion, meaning a write-off of
less than 40% would wipe out its capital. Goldman
Sachs, which claims to have made money on the
subprime debacle (though it is not clear how much
of its profits consisted of write-up of Level 3
assets) had $72 billion of Level 3 assets on
capital of $39 billion. And Citigroup, which after
all benefits from a banking license and deposit
insurance, has $135 billion in Level 3 assets on a
capital base of $128 billion (before this
quarter's expected write-down.)
How the
Fed's banking regulators allowed a commercial bank
to invest more than its capital base in assets for
which there was no discernable market is rather
beyond me. However, of the largest commercial
banks Citigroup appears to be in a unique
predicament as JP Morgan Chase had only $60
billion of Level 3 assets and Bank of America $22
billion.
It's thus primarily a question of
how large Wall Street's losses will be. At
present, holes can be plugged by the simple
expedient of getting dozy sovereign wealth funds
from China, the Middle East and elsewhere to
invest their excess liquidity in Wall Street
equities. However, eventually even the Chinese
government will get wise to the fact that in this
version of capitalism, prices have an annoying
tendency to go down as well as up. At that point,
the spigot will be turned off.
Since
successive write-offs will by that stage have
soured the US equity market on financial sector
stocks, it is likely that a number of government
bailouts will follow, with affected institutions
being slimmed down until they are too small to do
more damage. Of course, given the US budget's
precarious position and the likely size of the
problem, it is possible that even Uncle Sam will
not have enough cash to help. Judging by the
Northern Rock debacle and the current UK budget
deficit, John Bull's credit card may already be
maxed out.
One of the lessons of the
mid-1970s secondary banking debacle in Britain is
that discounted purchases of affected institutions
can turn out to be very expensive indeed. Because
the value of the affected institution's loan
portfolio continues to decline, and its ability to
write new business dries up in the downturn, these
deals can destroy value in the acquirer as well as
the target. Bank of America's initial share
purchase in the home lender Countrywide, which
valued the latter at $30 billion, was clearly such
a value-destroying transaction, in view of the
current agreed buyout for $4 billion.
Even
this new deal may turn out to be overpriced;
indeed it is difficult to see how it can be
otherwise, as Countrywide management, laden with
stock options, would presumably only have agreed
to it if the alternative was immediate bankruptcy.
While Bank of America was relatively unburdened
with Level 3 assets, therefore, it may find that
its Countrywide purchase, taking on no less than
$209 billion of assets, mostly mortgage related,
will put it in difficulties equal to those of its
long-time rival Citigroup.
As this column
has written previously, the share of global output
absorbed by the financial services sector has
increased inordinately in the great bull market of
the last quarter-century and is now due to fall
back towards its previous level, around half its
relative size currently. That process will
inevitably be far more painful for the sector than
is currently being envisaged even by the most
pessimistic analysts. At the end of it, it is
likely that a high proportion of prominent names
will have disappeared, or been forced into a
shotgun merger.
The bonuses of the last
decade may have to support bankers for a great
deal longer than they think!
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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