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Money managers under the microscope

Chicken Little was Quite the Optimist

January 23, 2009

By Martin de Sa’Pinto


If the sky falls, at least you know how far it can go – the worst case scenario is that it will hit the ground.


That’s not the case for the hedge funds, asset managers and banks exposed to toxic assets.


rtr22p3jAt the onset of the subprime crisis (identified in early 2007 although it began way before that), pundits who offered a worst case scenario of $200 billion in mortgage losses were accused of alarmism. That was in June 2007.


Those numbers only referred to defaulted loans. The effect of these defaults on securitized products such as collateralized debt obligations could only be guessed at, and at the time, few were guessing.


Worse still, the most highly rated tranches of these products were distributed to pension funds, insurers and municipalities around the globe.


By November 2007 Deutsche Bank analysts were estimating losses from subprime related assets (presumably including collateralized securities) could reach $300 to $400 billion worldwide, with banks and brokers writing down up to $130 billion.


Fast forward to January 2009. Subprime-related losses at banks and other institutions around the world have reached hundreds of billions of dollars, and total bailout funds proffered by governments around the world run into trillions.


And the write downs are not over yet.


In the meantime, defaults on the mortgages at the root of the problem have gone beyond the worst early estimates.


Even so, even if the value of all subprime mortgages together had gone to zero - meaning that the houses they went to pay for in the first place had no residual value after debts had been paid off – losses would not have gone far beyond $1-1.5 trillion.


Losses of that size would have been “ground level”, when the value of the underlying securities reached zero.


But kick in mortgage backed securities, collateralized debt obligations (CDOs), so-called CDOs-squared and credit default swaps, and losses could potentially – and with increasing probability – be far larger.


Which is why, where derivatives that turn bad are involved, it is possible for asset values to fall to the ground, and keep falling.





You’re wrong. The maximum loss can only be the difference between the amount lent on the subprime mortgages and the value of the properties, plus all the fees the investment banks earned on collateralising all the mortgages and then selling them on (repeatedly).

The “losses” being posted by many banks and investment houses now are based on either the “market value” (when there is no market) of a trading asset or worst-case (i.e. most pessimistic) value of an asset held through to term.

Most of the analysts commenting (and driving down) the market values are Chicken Littles or Turkey Lurkeys – they’re not using their brains. Neither market values nor worst-case valuations are reliable in this atmosphere of hysteria. Globally, the real losses end to end are restricted.

But now I’m wrong – they’re not that stupid. The problem in this complex world of global financial engineering is to work out just where vested interests lie. Virtually every comment we hear is motivated by self-interest, to the detriment of small retail investors.

We need real regulators with teeth, acting under a global mandate, to fix this. That’s one of the topics Brown and Obama should have on their list.

Posted by John Lancashire | Report as abusive

The maximum loss on the underlying assets may, as you say, be the difference between the amount lent and the realizable value of the properties plus the amount of principal, if any, that has already been repaid.
But when collateralized products are introduced to the equation the situation changes.
If a house with a market value of $500,000 falls down, the implied loss to the owner is $500,000. If the house has been insured, then the loss to the insurance company is $500,000 less premiums. But if ten different people – including parties with no interest in the property – have each insured the house for $500,000, then the potential loss to the insurance company is $5 million less premiums, that is, ten times the value of the underlying asset.
This is, in effect, what we are seeing, albeit in a far more complex form. Add in counterparty failure, and the equation becomes more complex still.

Posted by Martin de Sa'Pinto | Report as abusive

It is complex, but the underlying accounting principles are straightforward. Your article is about the net value destroyed across the economy as a whole, not just one company. If I take your insurance analogy then ten different parties gain a payout of $500,000 each, and only one (the owner) has lost the house. So the net value lost in the economy is $500K.

Credit derivatives are a form of credit insurance and so for example CDSs fit exactly into this analysis. The only difference with a CDO is that it is traded as an asset backed security. Apart from fees, all trading adds zero value to the economy. When the market value changes one party loses, but another gains. Only the loss on default counts as a true loss in economic value.

For example, if we unwind the entire Lehman’s balance sheet the actual net loss (or gain) should only be difference between the value of the assets and the value of the liabilities. For the “credit crunch” assets, we can’t get a market value. But that doesn’t mean they’re worthless. In the end either the underlying loans will run to term or they will default. The proportion which will default could maybe be as high as 15 to 20%, but that still means that 80% should be valued at 100%. The true “credit crunch” loss only occurs on the 20% and is mitigated by the residual value of the properties.

The real problem today is that there is no market for the trading assets which are “marked to market” in a bank’s balance sheet – so they are marked down to zero.
But these notional losses are not real – as both Barclays and the Institute of Chartered Accountants would argue. You can’t claim that a value from a dysfunctional broken market is real – it’s not.

But the bigger issue is that this $200Bn setback has been turned into a full blown global recession by a general loss of confidence across all markets. That loss of confidence was partly driven by sensationalist reporting from journalists who concentrated on the bad news and partly by commentary from “industry insiders” motivated by their own vested interests. The underlying reality is not that bad.

Posted by John Lancashire | Report as abusive

I hear what you are saying, and it makes perfect sense.
The problem is that, while securitization per se can be used to reduce market risk, we are looking at an exaggerated form of securitization that increased risk simply because it was no longer very easy–or even possible–to identify where the risk is.
Your logic is certainly without flaw. But the fact is, when, via products which appear to reduce risk as well as low interest rates, credit becomes very, very cheap, asset prices begin to reflect this (by becoming far more expensive than they should be).
Then, if you remember how credit has been expanded, we’re talking fictitious value, even if the money has been printed or created so that it can sit on balance sheets somewhere.
What’s going to happen? Is credit going to be reined in? If not, the printing presses will have to roll sooner or later to bring the amount of money out there more into line with waht has actually been spent, on tick. If so, on the other hand, prices should drop as a consequence of less available cash (and credit).
This is one reason why the word deflation has crept back into the vocabulary. While deflationary fears seem to be subsiding, people (and that includes economists), the prospect was far more frightening than even a relatively high level of inflation…
The credit crunch isn’t some bogeyman created by journalists, although the crisis is being fueled by worries about getting back into the credit markets. Credit investors see huge value in some CLOs, but with spreads this wide they are not ready to buy.
Which reminds me–wouldn’t TARP have been better used to put a floor under good quality credit products with cahs flows that are intact and underlying assets whose value hasn’t deteriorated too much?
That, at least, would bring otehr buyers back to the beleaguered credit markets, reduce the spreads… and the taxpayer might even make a profit.

Posted by Martin de Sa'Pinto | Report as abusive

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