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     Jan 16, 2008
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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6. Gold in the time of
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7. Taiwan, and president, take a drubbing

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(24 hours to 11:59 pm ET, Jan 14, 2008)



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