What is the deal with all the banks taking write downs?
Takestock asks: What is the deal with all the banks taking write downs?
WHAT IS THE VALUE OF THE US MORTGAGE LOAN PORTFOLIO
WHAT HAPPENS IF THAT VALUE FALLS
HOW WILL OWNERS OF THOSE LOANS RECORD A LOSS
The mortgage value of US residential property is $10 Trillion. In 1998, US residential property was worth ~$10 Trillion. Today it is worth $20 Trillion. If you connect the dots, you realize that the value of housing is exactly the value of loans.
If defaults on those loans reaches 10%, that's $1 Trillion in losses. As long as the housing market stays strong, defaults can be covered by claiming the collateral (the house) and selling it. The lender recovers the loan one way or another.
Unless the housing market collapses. In which case there are losses.
When banks switched from being loan holders to being middlemen, they loosened standards. Mortgages were packaged and re-sold as CLO or CDO (collateralized loan or debt obligations). Banks made more money on loan processing - the more loans, the more money. The consequence of which was that banks and other lenders had looser and looser standards as they sought more and more loan activity.
Asset prices always rise when money is cheap. Housing prices rose as easy lending terms and low rates brought in investors and potential homeowners. Housing prices rose, and started to become self fulfilling - drawing in more investors and flippers.
Loan activity soared and with it the average value of each loan.
Meanwhile, the CDOs/CLOs were sold to investment houses, insurance companies, and foreign investors. An important thing to be aware of is that many of these CDOs/CLOs carried an interesting condition: loan writers had to buy back the CLO/CDO if the value fell.
Of the $10 Trillion in loans, $1.5T is held by the government (Fannie Mae and Fannie Mac). Of the remaining $8.5T, about $2T is subprime. As ARM's reset, borrowers began to default. And - surprise - that home is not worth as much anymore.
Today's defult rate on subprime is a movingtarget, but it's at least 15% nationwide. So ~$300B in CDOs will be written off. Ouch.
Except that these CDOs are currently trading for 25% of face value. In effect, $1.5 Trillion in loan value is gone. Now throw in Alt A and other tiers where defaults are also happening and we are looking at a $2 Trillion writeoff. (BTW that figure is about what Goldman Sachs recently said we'd be seeing.)
The consequence of these mounting losses is that Lenders aren't in the mood to provide easy money when they are looking at $2 Trillion in losses. That hurts hedge funds and others, and leads to a reduction in leverage. Put differently, M&A activity and general investment activity slows down.
Back to writedowns. If a company owns gold then the value of that investment is today's gold price. That's called marking to market - the act of assigning a value to an investment or portfolio based on the current market value. But not every investment can be so clearly valued. An investment in a start-up company, for example, could be worth the original investment, more, less, who knows. There may not be a current market for that investment.
Into that hole falls CDOs/CLOs. US accounting lets the owners of CDOs/CLOs to declare their value based on whatever the owner says it's worth. That $1B CDO could be worth $1.5B or $100M, but the owner gets to state the value. In a post-Enron environment, and with massive scrutiny, accounting firms are not going to play along with that game.
A mark to market approach would have subprime CDOs worth only 25% of original investment value. These CDO owners face massive losses and they want to play for time in the hope that this is just a fire sale and the current values will rise. A fine strategy, but it's not kosher if a company is going to report current value of investments.
Citigroup and JP Morgan recently tried an Enron-esque scheme whereby these CDOs could be shoved into a separate entity and then traded by - surprise - Citigroup et al. In essence, they were trying to create a market and manipulate the pricing higher by playing the role of buyer. They hoped that they could create a price that was much higher than the 25%.
That scheme went nowhere.
These entities are facing a very real scenario where the value of their investments is worth a lot less and they have to be honest about it.
How much less? The current view is that lenders will write off amounts that approximate default rates. After all, the loan still has value as long as someone is paying the interest and principal. That default rate varies, but it's at least 15% on subprime, or $300B. That $300B equals 1 Million residences. Or 500K residences at California prices. Interestingly enough, 100,000 notices of default have been issued this year in California.
So far, I think we've seen maybe $100B of writedowns. Which means there is a lot more coming. And that assumes that others won't default. I think that we are facing $2T in defaults and the associated downward spiral of the wealth effect.
WHAT IS THE VALUE OF THE US MORTGAGE LOAN PORTFOLIO
WHAT HAPPENS IF THAT VALUE FALLS
HOW WILL OWNERS OF THOSE LOANS RECORD A LOSS
The mortgage value of US residential property is $10 Trillion. In 1998, US residential property was worth ~$10 Trillion. Today it is worth $20 Trillion. If you connect the dots, you realize that the value of housing is exactly the value of loans.
If defaults on those loans reaches 10%, that's $1 Trillion in losses. As long as the housing market stays strong, defaults can be covered by claiming the collateral (the house) and selling it. The lender recovers the loan one way or another.
Unless the housing market collapses. In which case there are losses.
When banks switched from being loan holders to being middlemen, they loosened standards. Mortgages were packaged and re-sold as CLO or CDO (collateralized loan or debt obligations). Banks made more money on loan processing - the more loans, the more money. The consequence of which was that banks and other lenders had looser and looser standards as they sought more and more loan activity.
Asset prices always rise when money is cheap. Housing prices rose as easy lending terms and low rates brought in investors and potential homeowners. Housing prices rose, and started to become self fulfilling - drawing in more investors and flippers.
Loan activity soared and with it the average value of each loan.
Meanwhile, the CDOs/CLOs were sold to investment houses, insurance companies, and foreign investors. An important thing to be aware of is that many of these CDOs/CLOs carried an interesting condition: loan writers had to buy back the CLO/CDO if the value fell.
Of the $10 Trillion in loans, $1.5T is held by the government (Fannie Mae and Fannie Mac). Of the remaining $8.5T, about $2T is subprime. As ARM's reset, borrowers began to default. And - surprise - that home is not worth as much anymore.
Today's defult rate on subprime is a movingtarget, but it's at least 15% nationwide. So ~$300B in CDOs will be written off. Ouch.
Except that these CDOs are currently trading for 25% of face value. In effect, $1.5 Trillion in loan value is gone. Now throw in Alt A and other tiers where defaults are also happening and we are looking at a $2 Trillion writeoff. (BTW that figure is about what Goldman Sachs recently said we'd be seeing.)
The consequence of these mounting losses is that Lenders aren't in the mood to provide easy money when they are looking at $2 Trillion in losses. That hurts hedge funds and others, and leads to a reduction in leverage. Put differently, M&A activity and general investment activity slows down.
Back to writedowns. If a company owns gold then the value of that investment is today's gold price. That's called marking to market - the act of assigning a value to an investment or portfolio based on the current market value. But not every investment can be so clearly valued. An investment in a start-up company, for example, could be worth the original investment, more, less, who knows. There may not be a current market for that investment.
Into that hole falls CDOs/CLOs. US accounting lets the owners of CDOs/CLOs to declare their value based on whatever the owner says it's worth. That $1B CDO could be worth $1.5B or $100M, but the owner gets to state the value. In a post-Enron environment, and with massive scrutiny, accounting firms are not going to play along with that game.
A mark to market approach would have subprime CDOs worth only 25% of original investment value. These CDO owners face massive losses and they want to play for time in the hope that this is just a fire sale and the current values will rise. A fine strategy, but it's not kosher if a company is going to report current value of investments.
Citigroup and JP Morgan recently tried an Enron-esque scheme whereby these CDOs could be shoved into a separate entity and then traded by - surprise - Citigroup et al. In essence, they were trying to create a market and manipulate the pricing higher by playing the role of buyer. They hoped that they could create a price that was much higher than the 25%.
That scheme went nowhere.
These entities are facing a very real scenario where the value of their investments is worth a lot less and they have to be honest about it.
How much less? The current view is that lenders will write off amounts that approximate default rates. After all, the loan still has value as long as someone is paying the interest and principal. That default rate varies, but it's at least 15% on subprime, or $300B. That $300B equals 1 Million residences. Or 500K residences at California prices. Interestingly enough, 100,000 notices of default have been issued this year in California.
So far, I think we've seen maybe $100B of writedowns. Which means there is a lot more coming. And that assumes that others won't default. I think that we are facing $2T in defaults and the associated downward spiral of the wealth effect.
posted by Andrew at
8:05 AM
2 Comments:
Thanks for the detailed reply Andrew . Eventually banks will have to liquidate the foreclosure property at lower prices in future if not now and one can imagine what that will do to the market whenever that happens. I don’t think this Government will go to the Christmas with S& P @ 1250... So Fed cut is sure on Dec 11.
Well said.
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