From: G Simmons
Sent: Thursday, November 01, 2007 9:53 AM
Subject: ANSWER THIS: IS THIS OR ANY/ALL PARTS OF IT TRUE ???
Like watching horror movies, i cant ever stop reading this type stuff, but that said i am asking a pretty diverse group in this email to hear IF anyone thinks there is any truth to this becasue it would be REALLY bad IF true...
The Bear's Lair: Level 3 Decimation?
By Martin Hutchinson
October 29, 2007
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005)
-- details can be found on the Web site www.greatconservatives.com
There's a mystery on Wall Street. Merrill Lynch last week wrote off $8.4 billion
in its subprime mortgage business, a figure revised up from $4.9 billion, yet
Goldman Sachs reported an excellent quarter and didn't feel the need for any
write-offs. The real secret of the difference is likely to be in the details of
their accounting, and in particular in the murky world, shortly to be revealed,
of their "Level 3" asset portfolios.
Both Merrill and Goldman have Harvard chairmen - Merrill's Stan O'Neal from
Harvard Business School and Goldman's Lloyd Blankfein from Harvard College and
Harvard Law School. Thus it's pretty unlikely their approaches to business are
significantly different - or is a Harvard MBA really worth minus $8.4 billion
compared with a law degree? (The special case of George W. Bush may be
disregarded in answering that question!)
We may be about to find out. From November 15, we will have a new tool for
figuring out how much toxic waste is in investment banks' balance sheets. The
new accounting rule SFAS157 requires banks to divide their tradable assets into
three "levels" according to how easy it is to get a market price for them.
Level 1 assets have quoted prices in active markets. At the other extreme Level
3 assets have only unobservable inputs to measure value and are thus valued by
reference to the banks' own models.
Goldman Sachs has disclosed its Level 3 assets, two quarters before it would be
compelled to do so in the period ending February 29, 2008. Their total was $72
billion, which at first sight looks reasonable because it is only 8% of total
assets. However the problem becomes more serious when you realize that $72
billion is twice Goldman's capital of $36 billion. In an extreme situation
therefore, Goldman's entire existence rests on the value of its Level 3 assets.
The same presumably applies to other major investment banks - since they employ
traders and risk managers with similar educations, operating in a similar
culture, they probably have Level 3 assets of around twice capital. The former
commercial banks Citigroup, J.P. Morgan Chase and Bank of America may have less
since their culture is different; before 1999 those institutions were pure
commercial banks and a substantial part of their business still lies in retail
commercial banking, an area in which the investment banks are not represented
and Level 3 assets are scarce.
There has been no rush to disclose Level 3 assets in advance of the first
quarter in which it becomes compulsory, probably that ending in February or
March 2008. Figures that have been disclosed show Lehman with $22 billion in
Level 3 assets, 100% of capital, Bear Stearns with $20 billion, 155% of capital
and J.P. Morgan Chase with about $60 billion, 50% of capital. However those
figures are almost certainly low; the border between Level 2 and Level 3 is a
fuzzy one and it is unquestionably in the interest of banks to classify as many
of their assets as possible as Level 2, where analysts won't worry about them,
rather than Level 3, where analyst concern is likely.
The reason analysts should worry is that not only are Level 3 assets subject to
eccentric valuation by the institution holding them, but the ability to write up
their value in good times and get paid bonuses based on their capital uplift
brings a temptation that few on Wall Street appear capable of resisting. Both
Goldman Sachs and Merrill Lynch are reported to have made profits of more than
$1 billion on their holdings of Level 3 assets in the first half of 2007, for
example, profits on which bonuses will no doubt be paid at the end of their
fiscal years. Given that we have had five good years on Wall Street, years in
which nobody has known the amount of Level 3 assets on banks' balance sheets,
and no significant media waves have been made questioning their valuation
methodologies, it would not be surprising if many banks' Level 3 assets had
become seriously overstated, even without any downturn having occurred.
When Nomura Securities sold its mortgage portfolio and exited the US mortgage
business in this quarter, it took a write-off of 28% of the portfolio's value,
slightly above the 27% of the portfolio that was represented by subprime
mortgage assets. Were Goldman Sachs's Level 3 assets similarly value-impaired,
it would result in a $20 billion write-off, more than half Goldman's capital,
leaving the bank severely damaged albeit probably still in existence.
Defenders of Goldman Sachs and the rest of Wall Street will insist that less
than 27% of their level 3 assets are represented by subprime mortgages yet that
is hardly the point. Subprime mortgages, estimated to cause losses of $400-500
billion to the market as a whole, though only a fraction of that to Wall Street,
have been only the first of the Level 3 asset disasters to surface. There is
huge potential for further losses among assets whose value has never been
solidly based. These would include the following:
Mortgages other than subprime mortgages. With the decline in house prices
accelerating, the assumptions on which even prime mortgages were made are being
exposed as fallacious. As house prices decline, debt to equity ratios increase,
and for mortgages with an original loan-to-value ratio of 90% or more quickly
pass the 100% at which a mortgage becomes uncovered. If the value of
conventional mortgages decline many securities related to them, currently
classed as Level 1 or 2 assets, will become un-marketable and descend into Level 3
Securitized credit card obligations. $915 billion of credit card debt is
currently outstanding, the majority of it securitized, and its default rate is
likely to soar as the full effects of the home mortgage market's crack-up spread
to the credit card area. The risks in Level 3 portfolios derived from this
asset class arise particularly in the areas of complex derivatives and
manufactured assets based on credit card debt pools.
Leveraged buyout bridge loans. After a hiccup in August, the market in these has
reopened recently, although around $250 billion of them still remains on banks'
balance sheets. The value of a leveraged buyout bridge loan that has failed to
find a pier to support the other end of the bridge is very dubious indeed, even
though these loans are being carried in the books at or close to par. As the
value of underlying assets declines and the cash flow fails to match debt
payments, the deterioration in credit quality of these loans will accelerate.
Asset backed commercial paper. The amount of asset backed commercial paper
outstanding has dropped from $1.2 trillion to $900 billion in the last three
months. This financing structure was always unsound; it was basically a means of
removing the assets backing the commercial paper from bank balance sheets, and
always faced the problem of a severe mismatch between asset and liability
duration. The $100 billion vehicle intended to rescue this market has found a
mixed reception to say the least. It is likely that as credit conditions
deteriorate, the assets underlying ABCP vehicles will increasingly find
themselves on bank balance sheets, where they will prove to be almost completely
Complex derivatives contracts. Even simple interest rate swaps and currency
swaps caused large losses in the last significant credit tightening in 1994,
although most of those losses were suffered by Wall Street's customers rather
than Wall Street itself. The more complex transactions that have been devised
during the last twelve giddy years are much more likely to prove impossible
either to sell or to hedge. Goldman Sachs reported that in the third quarter of
2007 its profits on derivatives used for hedging more or less matched its losses
on subprime mortgages. It is likely in reality that the bulk of those profits
were incurred through model-based write-ups of value on contracts that were
within the Level 3 category - after all, Goldman's Level 3 assets increased by a
third during the quarter. It's not much good shorting to match a long position
you don't like if your hedging shorts prove to be impossible to close out.
Credit Default Swaps, the global outstanding value of which in June 2007 was
$2.4 trillion, according to the Bank for International Settlements. These are a
relatively new instrument, the efficacy of which has not been tested in a
downturn. It appears likely that the value in banks' books of their Level 3
credit derivatives contracts bears no relation whatever to reality. As discussed
above, the incentives have been all in favor of inflating it.
The capital underlying Wall Street, at the top, is not all that large - a matter
of a few hundred billion. Given the piling of risk upon risk that has been
engaged in over the last few years, and the size of the losses in the mortgage
market alone that seem probable - my own estimate last spring of $980 billion
looks increasingly likely to be somewhat below the final figure - it appears
almost inevitable that in a bear market in which liquidity dries up and
investors become skeptical, Wall Street's capital will be wiped out. Only the
commercial banks like Wachovia and Bank of America whose investment banking
ambitions have been largely thwarted and portfolios of Level 3 rubbish are
correspondingly lower are less likely to disappear.
Given the size of the overall figures involved and the excessive earnings that
Wall Street's participants have enjoyed over the last decade, a taxpayer-funded
bailout of Wall Street's titans would seem politically impossible, however loud
the lobbyists scream for it.
In the long run, that is probably a blessing for the US and world economies.