Sunday, November 18, 2007

Subprime Losses May Reach $400 Billion, Analysts Say

Subprime Losses May Reach $400 Billion, Analysts Say

Losses from the falling value of subprime mortgage assets may reach $300 billion to $400 billion worldwide, Deutsche Bank AG analysts said.

Wall Street's largest banks and brokers will be forced to write down as much as $130 billion because of the slump in subprime-related debt, according to a report today by New York- based credit analyst Mike Mayo. The rest of the losses will come from smaller banks and investors in mortgage-related securities.

Citigroup Inc., Merrill Lynch & Co. and Morgan Stanley led more than $40 billion of writedowns as record U.S. foreclosures plundered asset prices. Estimates are rising with Lehman Brothers Holdings Inc. last week predicting losses linked to U.S. mortgages may reach $250 billion over the next five years. Zurich-based Credit Suisse Group in July forecast $52 billion of costs related to mortgage-backed securities.

Banks' balance sheets will hit fan in January

If you think banks have trouble now, just wait until they report financial results in January.

That's when the balance sheet will really hit the fan.

The problem involves a rule passed a couple of years ago that will put the banking industry's outside auditors in peril if they sign off on results that they really can't verify.

And right now there is nothing verifiable - or even understandable - about the banking industry's exposure to derivatives.

The auditors' dilemma was caused by a rule change that now prohibits banks from indemnifying auditors against mistakes.

All other kinds of companies can hold their auditors blameless in the event of errors that might generate investor and government lawsuits.

And sometimes that's the only way the accountants will give a nod to the company's books.

But a rule enacted in February 2006 by the Treasury Department, Federal Reserve and the Federal Deposit Insurance Administration now prohibit banks from doing that.

U.S. Banks, Brokers May Face $100 Billion in Additional Write-offs

Recent rule changes by the Financial Accounting Standards Board make it more difficult for companies to avoid putting real-world market prices on their hardest-to-value securities, known as Level 3 assets.

As Easy as Level 1, 2, 3…

Level 1 assets are easy to price using mark-to-market accounting, you have all probably heard that term. This is where an asset's worth is based on a real price. For instance IBM… check the quote on the NYSE that's the "mark to market" price.

Level 2 assets use something called "mark-to- model", but I call it Mark-to-Maybe. This is an estimate based on "observable inputs" which is used when no actually price quotes are available. An example might be a private transaction between two banks. They're saying "Maybe" this is what its worth.

Then there's Level 3 asset values, which are based on "unobservable" prices. This is basically the banks' own "assumption" as to what the assets are worth. This is what's been called "Mark-to-Make-Believe" accounting. Because it's all just Fantasyland pricing… pure guesswork on the part of these Wall Street firms who of course are looking to cover their butts with the most generous valuation they can dream up.

Rule change sounds alarm on Wall Street

The new rule from the US Financial Accounting Standards Board - known as FASB regulation 157 - comes into force on Thursday. It affects the Level 3 tier of assets that are currently valued according to in-house models, or 'mark-to-make-believe' in the words of Bob Janjuah, credit chief for the Royal Bank of Scotland.

Mr Janjuah says the FASB rule change could lead to a further $100bn of writedowns as banks are forced to come clean, with total losses climbing as high as $500bn across all forms of distressed credit. The top six banks alone have $365bn of assets in Level 3.

Although Level 3 assets are thinly traded, a series of ABX indexes give a rough guide to the market value of some $1,200bn sub-prime mortgage securities. These show that the lowest grades of 2006 vintage debt are worthless; BBB grades are down to just 18 cents on the dollar. AA grades are trading at around 60 cents, and AAA are near 85 cents.

Moreover, much of the entire $3,000bn global market for collateralised debt obligations is under strain. Merrill Lynch has declared a 30pc writedown on its holding of CDOs, offering a glimpse into the true values.

Few of the banks have admitted to losses on anything like the scale suggested by market prices. UBS is still booking its US mortgage debt at 90 cents on the dollar.

While nobody knows what lies under the Level 3 rock, the new rule could spell trouble. Citigroup has $128bn of assets in this category, or 205pc of its tangible equity. The figures for other banks are: Morgan Stanley $88bn, (275pc); Goldman Sachs $72bn (212pc); and Lehman Brothers $35bn (194pc).

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