by Jerome a Paris
Wed Nov 7th, 2007 at 05:36:14 PM EST
Today, the Dow Jones dropped by 2.6% (or 360 points), so you'll have the usual talk about volatile markets, and the just as usual dismissals that the Dow is just a few percent off its all time high.
But what's happening in the banking markets, and on the balance sheets of the banks is a lot more worrying. In particular, smart players are now focusing on so-called "Level 3" assets.
The Financial Accounting Standards Board's rule 157 will make it harder for companies to avoid putting market prices on securities considered hardest to value, known as Level 3 assets, Royal Bank's chief credit strategist Bob Janjuah in London wrote in a note today. The new rule is effective Nov. 15.
(...)
Under FASB terminology, Level 1 means mark-to-market, where an asset's worth is based on a real price. Level 2 is mark-to- model, an estimate based on observable inputs and used when there aren't any quoted prices available. Level 3 values are based on ``unobservable'' inputs reflecting companies' ``own assumptions'' about the way assets would be priced.
(link further below)
What's at stake is the value of the assets on banks' balance sheets, ie the quality of the loans they have made. The problem is that they don't hold traditional loans only anymore, they hold lots of increasingly complex and sophisticated instruments - the infamous alphabet soup of ABS (asset backed securities), MBS (mortgage backed securities), CDS (credit default swaps), CDO (Collateralized Debt obligations) and siblings.
Many of these assets (bonds, many derivatives, and some of the more liquid of the structured products) are traded on various financial markets, and are thus easy enough to value - you just use the market price, thus the "mark-to-market" moniker, and the "Level 1" label.
Level 2 are assets that are not directly traded, but whose value can be calculated indirectly from existing prices, by using more or less tandard models. Simple options and derivatives are in that category, as are various tranches of repackaged instruments whose underlying value can be understood easily enough. This is called "mark-to-model", and big chunks are likely to be innocuous (but not all models are simple, and not all have been tested in periods of stress, so there may also be troubles bits in there).
Level 3 assets are those that are so complex, or so remote from the initial underlying assets (because they have sliced, repackaged, resliced, repackaged, and combined with other bits) that there simply is no way to calculate what they are worth, because there is no market for them, and no market for the easily identifable bits. Banks are allowed to give them the value they want - but, and that's the important bit, they are now obliged to tell regulators and the markets how much stuff they have in that category.
And that's where all the gory details come out.
Banks Face $100 Billion of Writedowns on Level 3 Rule
Nov. 7 (Bloomberg) -- U.S. banks and brokers face as much as $100 billion of writedowns because of Level 3 accounting rules, in addition to the losses caused by the subprime credit slump, according to Royal Bank of Scotland Group Plc.
(...)
``This credit crisis, when all is out, will see $250 billion to $500 billion of losses,'' Janjuah said. ``The heat is on and it is inevitable that more players will have to revalue at least a decent portion'' of assets they currently value using ``mark- to-make believe.''
Wall Street's biggest firms have written down at least $40 billion as prices of mortgage-related assets dwindle because of record foreclosures. Morgan Stanley, the second-biggest U.S. securities firm, has 251 percent of its equity in Level 3 assets, making it the most vulnerable to writedowns, followed by Goldman Sachs Group Inc. at 185 percent, according to Janjuah.
(...)
Citigroup Inc., which this week said losses from subprime assets may be $11 billion, has 105 percent of its equity in Level 3 assets, Janjuah wrote.
(...)
``If you look at the writedowns just at Citi and Merrill already it's about $20 billion, so $100 billion may be on the conservative side globally,'' said Sajiv Vaid, who manages the equivalent of about $10.5 billion of corporate debt at Royal London Asset Management in London, a unit of the U.K.'s biggest customer-owned insurer.
(...)
Banks may be forced to write down as much as $64 billion on collateralized debt obligations of securities backed by subprime assets, from about $15 billion so far, Citigroup analysts led by Matt King in London wrote in a report e-mailed today. The data excludes Citigroup's own projected writedowns.
(...)
ABX indexes, which investors use to track the subprime-bond market, are showing ``observable levels'' that would wipe out institutions' capital if the benchmark's prices were used to value their Level 3 assets, according to Janjuah.
You can go see the value of the ABX indices on this page:
AAA 71.88
AA 43.44
A 27.66
BBB 21.53
That's the value as a percent of their face value. ie ultra-safe AAA paper (AAA is the rating of a few governments and a smaller number of corporations) have lost 30% of their value - more than half of that in the past couple days. AA paper (Japan is rated AA, as are the best banks, to give you an idea of what we're talking about) has lost more than half its value. Lower rated indices (well, all is relative - "A" used to be a pretty damn good rating) are not dropping so much anymore, but they are already so low (20 cents on the dollar...) that it no longer matters...
and the worst thing is - this is just one bit of the problems that banks may have: noty only do they have to worry about the real value of all the Level 3 paper on their balance sheet, but also:
- what amount highly leveraged private equity or hedge funds that bought similar Level 3 paper were financed by them...
- how many clients that purchased similar Level 3 paper (or other 'toxic sludge') from them have "guaranteed sell back" clauses in their initial agreements to purchase the stuff from the banks...
- how much financing was provided by the banks to real estate and construction groups (and private equity funds) whose business model was underpinned by cheap credit to finance their buyers (their acquisitions)...
So we have more than enough to potentially wipe out a number of banks. Will it come to that? Nobody knows. But the question is being asked right now in the markets.
