FYI | Mar 14 2008
By Greg Peel
On Thursday night in the US, ratings agency Standard & Poors lifted its estimate of ultimate subprime write-downs from US$265bn to US$285bn. While it’s all beginning to sound like Monopoly money now (and it might as well be, given it never really existed in the first place), this little increase is unwelcome but that wasn’t the point. The point is that S&P believes that this should be the last increase, and that the end is now in sight for subprime write-downs. There is light at the end of the tunnel.
Oh joy of joys, the troops will soon be coming home.
Wall Street responded to news by turning a Dow loss of 235 – which had been precipitated on the news lenders would be moving in to seize the mortgage security assets of a Carlyle Group hedge fund – into a gain of 105. If the end is in sight, we can now start buying these distressed financial stock bargains.
While this may have been the knee-jerk response of the wider market, a glaring irony was not lost on many a Wall Street trader. For it was Standard & Poors, and its cohorts including Moody’s and Fitch, who were a vital part of why the world got itself into this subprime mess in the first place. It was the ratings agencies who assigned AAA-ratings to complex, high-yielding mortgage securities known as collateralised debt obligations (CDOs). Under any normal circumstances, AAA-rated debt is the lowest yielding of all, because there is very little risk to demand a reward. But these instruments had higher yields because they contained a proportion of subprime loans, including loans made to homeowners not just with a low income, but even with no income.
The accusation is that the ratings agencies were complicit in the process receiving, as they do, a fee to provide a credit assessment. That will be something for the courts to decide, and any outcome will take most of an eternity. But in the meantime, S&P has endeavoured to assuage the market by suggesting the rot will soon be over – that the banks, brokers, insurers and hedge funds of the world will soon be able to stop writing down their toxic waste any further. It was bittersweet news.
But was it particularly good news?
Subprime mortgages have simply been the flapping butterflies. Having flapped, they have now caused a global financial credit market tsunami. Indeed, wave after wave. Waves that are not going to stop until they hit the shallow water and break with sufficient force. S&P may have made its subprime statement with a conciliatory blush, but the devil remained in the detail. For the market reacted only to news which was contained to the subprime market. The agency went on to warn that the broader credit crunch had dented the market prices of many other types of securities, which will likely trigger further write-downs anyway.
“A major re-pricing of credit risk is taking place across the debt markets,” S&P declared. “If the wider spreads hold to the end of the first quarter or half of this year, financial institutions will suffer further market value write-downs of a broad range of exposures, including leveraged loans.”
For the write-downs that S&P has foreseen as reaching an end are only part of the equation. The agency can only make estimates based specifically on the CDO securities it has rated – 85% to which it assigned AAA – and not on securities which weren’t repackaged into such instruments. Between 2005 and 2007, US$1 trillion of subprime loans were granted. Losses from other products remain unknown.
The chart below was published many times over in 2007. It clearly shows the extent of the problems still well ahead. S&P is considering only from the subprime level up. Those mortgages below – Alt-A, prime and agency (Freddie and Fannie) are not included, although agency loans are supposedly guaranteed by the government.
Nor is S&P assessing commercial mortgage loans, corporate loans, home equity loans or securities issued in Europe.
To date, banks and brokers have written down US$188bn of losses. Goldman Sachs economists this month estimated mortgage related losses would ultimately total US$500bn, and that losses on all the rest would add a further US$656bn, for a total of US$1.156 trillion. The estimates are based on house prices falling 25%.
These numbers are mind boggling, and do not take into account provisions made for loan losses, and tax write-offs. But either way, that net amount would no longer be available to fuel the economy.