Naughty, naughty?
About four weeks ago, the FT tallied up the losses from the mortgage problem, and found them to be manageable, if large. Merrill Lynch alone said it had $5 billion in losses, but Wall Street breathed a sigh of relief when it understood that the risks were being identified and circumscribed:
The toll of big bank losses from the credit squeeze topped $18bn on Friday after Merrill Lynch and Washington Mutual revealed heavy damage inflicted by financial market turmoil. Merrill Lynch said it would take a $5bn writedown and record a third-quarter loss, while WaMu warned that profits for the period would plunge 75 per cent. The announcements followed writedowns from Citigroup, UBS, Deutsche Bank and others….
But then, some weeks later, Merrill took a bigger writedown than it previously had told the Street. Almost nothing makes Wall Street unhappier than unanticipated bad news of this nature. The CEO of Merrill even lost his job. Now it turns out that there might be even more unanticipated bad news to come (perhaps another $4 billion in write-offs), with rumors of a cover-up in the mix, through the firm’s use of some inappropriate repo deals. WSJ:
Merrill has become ground zero of mortgage problems in the U.S. Last week, the firm announced a $7.9 billion write-down fueled by mortgage-related problems — one of the largest known Wall Street losses in history — after projecting just a few weeks earlier that the write-down would be $4.5 billion…Some analysts and others say they expect Merrill to take additional write-downs of roughly $4 billion in the fourth quarter…
Merrill’s deals have attracted the interest of some mortgage investors and specialists. “Merrill has been making the rounds asking hedge funds to engage in one-year off-balance-sheet credit facilities,” Janet Tavakoli, who consults for investors about derivatives, told clients in a recent note. “One fund claimed that Merrill was offering a floor return (set buy-back price),” she said in the note, “so this risk would return to Merrill.” Ms. Tavakoli said such transactions would explain how Merrill’s mortgage-related exposure dropped in the third quarter…
By the end of June 2007, Merrill had CDO exposure of $32.1 billion and a subprime-mortgage exposure of $8.8 billion, totaling $40.9 billion…By the end of September, Merrill says it reduced such positions through sales, hedges and write-downs to $15.2 billion of CDOs and $5.7 billion of subprime mortgages, a total of $20.9 billion…
In recent weeks, Merrill has been scrambling to line up hedge funds to take as much as $5 billion in mortgage-related securities…In accounting for such transactions, “the general guiding principle is whether the benefits and risks of ownership were transferred,” says Charles Niemeier, former chief accountant for the SEC’s enforcement division and now a director of the Public Company Accounting Oversight Board.
Legal questions can arise if the seller retains some exposure to the risk of the assets losing value, and if the deal is designed to disguise the picture of a business’s financial health. Jay Gould, a securities lawyer at Pillsbury Winthrop Shaw Pittman LLP, says if a firm is unloading securities from its books “without a real commercial purpose other than to create a value for pricing purposes, that can be a problem.”
It remains to be seen just what is rumor and what is fact. But trust is the coin of the realm in a financial institution, and Merrill Lynch would appear to have squandered a great deal of that particular asset in recent days. History has often not been kind to firms that depend on the trust of their customers and waste that asset.
It has been three months now since the Bear Stearns conference call that energized a great deal of the genuine fear and panic that gripped markets for weeks. Much has calmed down since then. We’ll just have to see what Merrill Lynch may contribute to the remnants of the ongoing turmoil.
November 2nd, 2007 at 1:37 pm
I always wonder about the magnitude of this problem. The global size of the writedown due to the sub-prime mess is estimated to be in the order of 40-100 billion dollars. Relative to the global cost of the war on terror (estimated at 1.5 trillion) how does the sub-prime mess let the bogeyman of inflation/deflation (depending on who you listen to) out of pandora’s box?
I’m not saying that the global war on terror is a waste as it is a required insurance policy. No reaction to 9/11 would have evaporated 40-100 billion in global market equity in a matter of moments.
I just don’t see the long term impact of the sub-prime mess. It clearly is something that needs to be addressed but I just don’t see this as the advent of the next great depression.
November 2nd, 2007 at 6:14 pm
I get numbers higher than that: Most people agree that there are 7 million sub-prime mortgages in the USA, and that they have an average value of $200k. That’s $1400 Billion, or $1.4 Trillion.
Of that, perhaps 3 million are going to default, which is to say, $600B. It is likely that 90% of the value of these securities will eventually be recovered in foreclosure proceedings, which means that the net loss is likely to be around $60B.
This is the nominal set of numbers.
The problem is that the $600B (and the other $800B which look scary but are not going to default) are mixed into CDO pools and various other complex investments. Many of these pools have been leveraged in such a way that relatively small losses in the underlying asset pool will cause very large percent changes in the value of the resulting securities. Adverse changes in value, such as “you lose your shirt”.
Given that hardly anybody knows exactly what is going on, sensible people are refusing to buy bonds of any description.
That is the problem, and, yes, it could cause another Depression.
November 6th, 2007 at 10:49 am
Dave,
Please elaborate. I don’t care if some highly leveraged speculator loses his rear.
Being a regular guy with not a nickel in those speculative instruments, how are government or other bonds (non-junk from companies with real assets and markets) affected? GE still makes engines and light bulbs and sells them for real money. People who hold their bonds get paid.
This whole mortgage fiasco is puzzling to me. I’ve got a regular mortgage, for approximately half the value of my house. I have no reason to sell. If the value of my house falls, I still have a place to live. It’s not an investment. If I lived in California and bought a house at the market peak with an interest only, variable rate loan, I have no doubt the old saying about a fool and his money would apply.
If a bank or a brokerage goes under, I suppose some index fund in my 401K would lose a fraction of a percent of its value. There would be a lot of unemployed guys in New York City. Beyond that, how are regular people affected?