There's a mystery on Wall Street. Merrill Lynch wrote off $8.4 billion in its subprime mortgage business, a figure revised up from $4.9 billion, yet Goldman Sachs reported an excellent quarter and didn't feel the need for any write-offs. The real secret of the difference is likely to be in the details of their accounting, and in particular in the murky world, shortly to be revealed, of their "Level 3" asset portfolios. <...> From November 15, we will have a new tool for figuring out how much toxic waste is in investment banks' balance sheets. The new US accounting rule SFAS157 requires 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. Goldman Sachs has disclosed its Level 3 assets, two quarters before it would be compelled to do so in the period ending February 29, 2008. Their total was $72 billion, which at first sight looks reasonable because it is only 8% of total assets. However the problem becomes more serious when you realize that $72 billion is twice Goldman's capital of $36 billion. In an extreme situation therefore, Goldman's entire existence rests on the value of its Level 3 assets.
From November 15, we will have a new tool for figuring out how much toxic waste is in investment banks' balance sheets. The new US accounting rule SFAS157 requires 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. Goldman Sachs has disclosed its Level 3 assets, two quarters before it would be compelled to do so in the period ending February 29, 2008. Their total was $72 billion, which at first sight looks reasonable because it is only 8% of total assets. However the problem becomes more serious when you realize that $72 billion is twice Goldman's capital of $36 billion. In an extreme situation therefore, Goldman's entire existence rests on the value of its Level 3 assets.
Goldman Sachs has disclosed its Level 3 assets, two quarters before it would be compelled to do so in the period ending February 29, 2008. Their total was $72 billion, which at first sight looks reasonable because it is only 8% of total assets. However the problem becomes more serious when you realize that $72 billion is twice Goldman's capital of $36 billion. In an extreme situation therefore, Goldman's entire existence rests on the value of its Level 3 assets.
(assets) = (liabilities) + (shareholders' equity)
What this piece is saying is that it is possible that Goldman Sachs' shareholders' equity can go from $36 billion to $36 billion in the red if its "Level 3 assets" turn out to be worthless.
Note that, by deciding to report "Level 3" 3 months early, Goldman Sachs avoids having to recognize losses on its balance sheet. As I wrote earlier...
quarterly results are not audited, but yearly ones are - things will get interesting when auditors force the recognition of losses, or give negative opinions on the accounts, when the annual reports are published
Interestingly, in case you got the impression Merryl Lynch are the good guys here, I posted that comment in response to a Front Page story by Jerome which started with the following quotation from the WSJ:
European Tribune: Credit Crunch - Act II by Jerome a Paris on November 2nd, 2007
Merrill Lynch & Co., in a bid to slash its exposure to risky mortgage-backed securities, has engaged in deals with hedge funds that may have been designed to delay the day of reckoning on losses, people close to the situation said.
Holy Molly!
...is the polite version.
Is it an exaggeration to say that all of the biggest investment banks are now either marginally solvent (at best) or bankrupt (at worst)?
If any of them had 64 thousand dollars, they would say "That's the 64,000 dollar question."
The Fed Chief is famous for saying that he would throw money from helicopters if that is what it took to keep the US from going the Japan route. Of course, the US will be lucky if it can only go the Japan route. At least Japan has a lot of people with a lot of savings, they have a lot of American money saved up, and they have companies who continue to make things. In fact, the story of Canon is finding out that retreating from outsourcing led to faster times to market, and better products that can be sold for a profit. Nope, the US will not merely go through deflation and a decade of 0 percent interest.
But it is hard to say how the next bailout will occur. For it seems that there is always a mechanism for bailing out the failure of US capitalism to rein in the greedy and criminal requirements that are inherent in the system. Recently the Fed was encouraging collusion between the big competitive banks in order to suck off the good traunches and get something of value into the system - maybe that will work, but it doesn't look like it.
The S&L scandal had a congressional bailout and the Reagan/Bush transition to cover up the cancerous membranes. The WorldCom/Enron/Andersen/etc plus tech bubble burst scandal had the ramp up of the money machine, and the blind eye to the the housing bubble/refinance ATN that floated the rest of the economy. Then the blind eye to the phoney creation of money that are hedgefunds, in order to keep that bubble going too early. It is as if they knew that the war/housing bubble/McJobs economy wasn't going to do it, but they wanted to keep pushing it out until they could blame it on the democrats or something...or maybe they weren't even that smart.
IIRC, part of the S&L solution was to lower the standard amount of capitalization required. Would that and a bunch of juggling keep the investments banks afloat until they can jigger the economy to their favor again? Bush could fire all the regulators, but that won't work again since there are so many fewer investment backs compared to the number of S&Ls.
The problem is that there is no easy suckers to bilk anymore. The underemployed who financed the last part of the housing bubble are turning in their houses by the millions now and for the next couple years. Jobs are being lost at 10s of thousands per month, which will be even more of a drag on the housing market, and which will feed itself. Banks won't even lend money to themselves, much less to the masses to who they are supposed to be in business to serve.
Nope, the only bright side is that the EU and Japan and China will compete with each other to pick over the bones of American industry. Reminds me of The Man in High Castle by Phillip K. Dick. But instead of Nazi Germany we have an EU that will impose the EU social legislation on the EU owned corporations, and Japan won't make the mistakes of hubris that they made in the 80s.
As far as China goes, I'm certain that they want to put all this off until after the Olympics. But they must be seeing how much the populace of the US wants to live under a tyranny. I can just imagine what they are thinking as the price of the American worker goes down down down.
Oops. Seems like your question triggered a rant. [Bows, requesting forgiveness] [Exit, stage left] Never underestimate their intelligence, always underestimate their knowledge.
Frank Delaney ~ Ireland
But let's look at the basics here.
There are two insolvency tests: one is the "Assets vs Liabilities" test, and the other is the "ability to pay debts as and when due" test.
Banks are in trouble on the latter test of course (although the former is problematic), and when repayments cease it is both the return on Capital (Interest) and return of Capital (Principal) that they have to fund from somewhere else, if they can, by raising new equity and debt.
To the Bank, the value lies in the future stream of payments in respect of the asset they have a claim over, and when this stream ceases, they write off the asset.
Now, while the stream of payments ceases, it does not mean the underling asset is "value-less" since, if the asset is then repossessed (and not sold off to the vulture funds now gathering) then the banks would in fact in due course "write back" quite a considerable chunk.
The result is that someone else could then occupy the property essentially at a lower financial occupancy cost than at the top of the bubble.
This is what happened in Japan. The "real" economy didn't go into "crisis" (although the surreal "financial" economy did) and it has burbled along quite nicely since on the basis of the huge flow of land and property rental values that remained.
Very much like the way that Stock market prices are, in extremis, supported by the underlying dividend flows.
I believe that there is a straightforward solution to the crisis which would involve what is essentially a "Debt"/ "Equity" swap by creating what would in effect be enormous "Land Rental Pool" "quasi-REIT' asset-owning vehicles.
Units (essentially quasi Equity "shares" aka land rental units) in these vehicles, with a payment stream of maybe 2 to 3% index-linked would be sold to pension funds.
The outcome for property occupiers would be "affordable" rentals (since there is no capital repayment, and a lower cost of capital), and of course the "affordability" gives greater certainty of payment to the Investor.
In other words I am proposing a simple new way of "asset-based" unitising as opposed to "deficit-based" "securitising". "Any economic unit can emit money. The serious problem is to get it accepted" Hyman Minsky
and it has burbled along quite nicely since
Before Migeru steps in, what would have happened had the Japanese not taken in gazillions of dollars from their trading surpluses is an interesting question... "Any economic unit can emit money. The serious problem is to get it accepted" Hyman Minsky
I have a horrible cynical faith that the powers-that-be will always be able to game the system.
You may be asking for the right thing, but I can't imagine that the powers will give up so easily. They already have the money that this latest fraud sucked from the system. They will allow all sorts of things, but they will not allow the system to be changed so much that their ill-got gains will disappear, or be ineffective for the next game.
I also have a great faith that the evolution of the model always will take on a more and more progressive tilt...but only when viewed from a great distance. Never underestimate their intelligence, always underestimate their knowledge.
Look at the 4th graph from this link in Mauldin's weekly wrapup from last week on how one item for sale at GS went from AAA to junk or worse: http://www.investorsinsight.com/thoughts_va_print.aspx?EditionID=606
This week's wrap up is pretty interesting too: http://www.investorsinsight.com/thoughts_va_print.aspx?EditionID=610
(Sorry for the poor linking. I split water on my keyboar_ an_ some letters are not working an_ it is a pain to type, or e_en copy an_ paste or tab between open win_ows, etc. No left han_ shift or comman_ key...arrrgh.) Never underestimate their intelligence, always underestimate their knowledge.
The higher they climb the harder they fall, these "Masters of the Universe". We have met the enemy, and he is us — Pogo
I think this concept had roots with those buccaneers at Salomon so well profiled in Liar's Poker
They opened up "The Mortgage Corporation" in the UK in the late 80's I think, and rapidly built up quite a business. However, it went "pear-shaped" in the early 90's, if not before,when funding conditions changed.
They eventually got shot of the "rump" portfolio in 1996 to First National Society of Ireland after it had become an embarrassment.This was because it was in "run-off" (ie no new business) and they therefore had no reason not to screw the "rump" of borrowers by keeping rates as high as possible for as long as possible.
Lessons here for Northern Rock borrowers, by the way, if the likes of JC Flowers get their hands on the portfolio. "Any economic unit can emit money. The serious problem is to get it accepted" Hyman Minsky
If senior management set rules which said 'Do not do this - it looks clever but in fact it's suicidal' there would be no problem.
But Wall St culture demands the opposite.
So here we are.
And Mauldin in turn links to a Fortune article available here on CNN Money that takes apart a Goldman Sachs issue called GSAMP. ("just one of 83 mortgage-backed issues totaling $44.5 billion that Goldman sold last year").
Junk mortgages under the microscope - Oct. 16, 2007
The average equity that the second-mortgage borrowers had in their homes was 0.71%. (No, that's not a misprint - the average loan-to-value of the issue's borrowers was 99.29%.) It gets even hinkier. Some 58% of the loans were no-documentation or low-documentation. This means that although 98% of the borrowers said they were occupying the homes they were borrowing on - "owner-occupied" loans are considered less risky than loans to speculators - no one knows if that was true. And no one knows whether borrowers' incomes or assets bore any serious relationship to what they told the mortgage lenders. You can see why borrowers lined up for the loans, even though they carried high interest rates. If you took out one of these second mortgages and a typical 80% first mortgage, you got to buy a house with essentially none of your own money at risk. If house prices rose, you'd have a profit. If house prices fell and you couldn't make your mortgage payments, you'd get to walk away with nothing (or almost nothing) out of pocket. It was go-go finance, very 21st century. (my bold).
The average equity that the second-mortgage borrowers had in their homes was 0.71%. (No, that's not a misprint - the average loan-to-value of the issue's borrowers was 99.29%.)
It gets even hinkier. Some 58% of the loans were no-documentation or low-documentation. This means that although 98% of the borrowers said they were occupying the homes they were borrowing on - "owner-occupied" loans are considered less risky than loans to speculators - no one knows if that was true. And no one knows whether borrowers' incomes or assets bore any serious relationship to what they told the mortgage lenders.
You can see why borrowers lined up for the loans, even though they carried high interest rates. If you took out one of these second mortgages and a typical 80% first mortgage, you got to buy a house with essentially none of your own money at risk. If house prices rose, you'd have a profit. If house prices fell and you couldn't make your mortgage payments, you'd get to walk away with nothing (or almost nothing) out of pocket. It was go-go finance, very 21st century. (my bold).
So how much is this (at first-mortgage level) to do with families buying a home or (at second-mortgage level) refinancing to be able to consume, and how much about plain old speculating on margin (ie borrowing to speculate)? (As per dot-com bubble?)
Now see where GSAMP has gone:
