How Many More Shoes Will Drop?

02/21/2008 12:00 am EST


Howard Gold

Founder & President, GoldenEgg Investing

The stock market has been holding up pretty well as investors expect more rate cuts and hope the economy may not be quite as bad as everyone says it is.

But there's no sign of relief in the debt markets, where last summer's financial panic has morphed into chronic, drawn-out agony.

Every week-sometimes every day-another bank or investment firm announces an unexpected loss. (On Thursday Germany's Dresdner Bank announced a $19-billion bailout of a structured investment vehicle.)

Markets nobody ever heard of-the latest is auction-rate securities-suddenly seize up, sending shudders through the system.

Meanwhile, risk premiums on all kinds of debt instruments are at multiyear highs, discounting much higher levels of default than we've seen in ages.

So, how bad could it get? And how long will it last?

In this column, I'll take my best shot at sorting it out. But be warned: I don't really know. And neither does anyone else, especially the Wall Street geniuses who created this mess.

Here's what we do know right now. The credit crisis, which began last July with the collapse of two Bear Stearns hedge funds that made leveraged bets on securities backed by subprime mortgages, has now spread to the furthest reaches of the debt markets. 

Major US and European banks and investment firms have sustained losses of roughly $120 billion to date, most of that tied to subprime mortgages.

Subprime mortgages, mortgages extended to the least creditworthy borrowers, exploded in 2006 as real estate mania peaked.  The big banks and investment firms packaged those mortgages into securities, which they then sold to clients and in some cases bought themselves. Ratings agencies gave AAA ratings to many of the securities and the vehicles that held them, called collateralized debt obligations (CDOs). That allowed a wide variety of institutions to snap up these high-yielding instruments.

But when boom turned to bust, buyers for the securities disappeared, and their value plummeted. Rating agencies dutifully downgraded the paper, and big institutions had no choice but to "mark to market" or write down the value of the subprime securities and the CDOs that they held. Hence, the $120 billion in losses.

So, how much will it ultimately cost? Ratings agency Standard & Poor's recently estimated losses from subprime-linked securities alone could eventually top $265 billion. The new wave of losses, S&P said, "may descend on regional US banks, Asian banks, and some large European banks."   In other words, we don't know where the next landmines will go off.

Here's what's not included in S&P's estimate: securities tied to Alt-A and Alt-B mortgages (whose borrowers are only slightly more creditworthy than those who get subprime loans); leveraged loans, especially to companies involved in private equity buyouts; consumer loans (auto, student, and credit cards), and anything connected with commercial property.

That means if the economy stays weak (or moves into recession) and credit markets remain frozen, we can expect to see big losses pop up in these areas, too.
As The New York Times reported this week, UBS predicted that "the world's leading banks could ultimately take $123 billion to $203 billion in additional write-downs" on all the various debt securities. Goldman Sachs predicts commercial real estate loan losses alone will reach $180 billion.

And The Wall Street Journal reported that "analysts and investors are bracing for as much as $15 billion in leveraged-loan related write-downs at commercial and investment banks in the first quarter."

I've seen estimates of the ultimate cost ranging from $500 billion to the uberbear Nouriel Roubini's prediction of over $1 trillion in losses.
That's a big number-a lot bigger than earlier estimates-but it's less than 2% of the total value of the US stock, bond, and residential real estate markets (between $55 trillion and $60 trillion). And it comes only with Roubini's projected financial catastrophe.

To look deeper at the impact the crisis might have, I examined recent financial statements and presentations by Merrill Lynch and Citigroup, two of the Big Three losers so far. (Swiss bank UBS is the other.)

Merrill, remember, ousted its chief executive officer Stanley O'Neal after big subprime losses started popping up last fall. New CEO John Thain, a Goldman alum and former CEO of NYSE Euronext, vowed to clean up Merrill's act.

And indeed Merrill has written down its portfolio by more than $20 billion. But as of December 28th, it still had $4.2 billion in subprime residential mortgage-backed securities (MBS), $7.1 billion in Alt-A MBS, and $43.6 billion in total exposure to residential mortgages on its books.

Merrill also had $18 billion in leveraged finance commitments and another $18 billion in exposure to commercial real estate at the end of last year, too. Clearly, barring big rebounds in the markets and the economy, there could be more write downs in Merrill's future. A Merrill spokesperson did not respond by deadline to e-mailed questions.

Citigroup, too, dumped its CEO, Charles Prince, and took big subprime-related write downs of over $17 billion. But as of mid-January, its total exposure to subprime securities was $37.3 billion. (Full disclosure: My wife owns Citigroup shares.)

In a conference call last month, new CEO Vikram Pandit and chief financial officer Gary Crittenden painstakingly walked investors through the steps they had taken to stress-test and bullet-proof their portfolio. Its models, Crittenden explained, assume US housing prices will fall by up to 7% this year and next.

Citigroup also issued $2 billion in securities and raised $12.5 billion in capital from sovereign wealth funds and other investors to boost its key capital ratios above its targets by midyear 2008. So, my best guess is Citi will probably hold the line through the second quarter.

And beyond that? Well, Citi took an additional write down of $5 billion to cover actual and anticipated losses from its mammoth US consumer-lending business amid huge spikes in credit losses and mortgage defaults since last year's third quarter.

And that may be only beginning, Crittenden acknowledged.

"Our expectation is that consumer credit in the US will continue to deteriorate," he said.

Meanwhile, Citi also has $43 billion in highly leveraged loans on its books. One analyst estimated it might have to write off 10% of that total.

"We don't comment on speculation," a Citigroup spokesperson replied.

Citi's new CEO Pandit told investors, "I'm not going to make any promises."

And indeed he shouldn't. Nor should the rest of us, given the palpable risks that remain.  If you hear anybody tell you otherwise, don't believe it.

This isn't going away any time soon.

Howard R. Gold is executive editor of The opinions expressed here are his own and are not necessarily the views of InterShow.

Related Video

More: How Wall Street Created the Subprime Mess 

S&P's Sam Stovall: Subprime Spurs Recession & Bear Market in 2008

Jim Stack: When Will Subprime Effects Finally Wear Off?

Related Articles on MARKETS