Thursday, October 18, 2007

"The Losses Have to Be Taken"

The quote above is from the article in Market Watch that discusses the bailout fund being set up by Citibank, JP Morgan and B of A and some of the associated problems. The article makes an important point the losses from the mortgage meltdown must be taken.

Having had a front row seat for the demise of Continental Bank in the mid-1980s and a bleacher seat for the S&L crisis of the early 1990s I can assure you that after everything is said the losses must be taken. Unfortunately, some institutions cannot take all the losses at one time, they can't afford it. So delaying tactics will be employed in the hopes that the losses can be taken over time so the institution can survive. Note one thing, losses are going to be taken for a while. Although the housing slump has been occurring in earnest since late 2006, the banks are just beginning to take losses in the third quarter, which means the losses need to catch up. I would note be surprised to see the banks taking losses on this portfolio through 2008. (Also I like the football in the house analogy. We used to do that when I was a kid, except we used to turn over the furniture too.) The text in bold is my emphasis.

Today's credit crisis has the feel of kids playing football in the house. Everyone is having a good time until the ball goes through the window.

It almost doesn't matter who threw the ball -- subprime borrowers or lenders, big banks, the leveraged-buyout guys, ratings agencies -- everyone was doing something they shouldn't have.

What's interesting is how all of the players are reacting. Some . . . . banks, who don't have these bad debts on the books, are pretending they don't need to clean it up.

and Treasury Secretary Henry Paulson, who may have left Goldman Sachs but still seems to live on Wall Street, are hell-bent on fixing the window.

These are the kids who think they can cover up the damage.

The fixers want to create up to a $100 billion fund to buy good assets from bad structured investment vehicles, or SIVs.

Here's one problem with this plan: If you follow the money, it doesn't make much sense. Start with a mortgage. It gets packaged by an investment bank into a collateralized debt obligation. That CDO is then sold to an SIV. The SIV is funded by a bank, investment bank or another industry lender. It could be the same bank through the whole process. At the minimum, it's a limited group of players.

Now, our original loan and others have gone bad, which means the CDOs have gone bad, which means the SIVs are in trouble. The industry's answer to this is to create yet another investment company to buy the good assets from the SIVs.

Detect a pattern?

Reaction to the plan has been lukewarm. Banks may be learning, just as the Fed did after its whopping rate cut last month, that it's hard to inject confidence into the market by panicking.

It's unlikely government or business leaders such as Paulson and Citigroup's Charles Prince would panic. It's even less likely Bank of America's Ken Lewis and J.P. Morgan's Jamie Dimon would rush in to prop up a competitor, since they didn't have much involvement in the SIV business.

That suggests there's a fire. Banks and other financial institutions, including Fidelity Investments, are reluctantly stepping forward in the effort even if they're in the camp that didn't set up SIVs or don't have a load of CDOs on the balance sheet. This mega-fund is not only the plan of the moment; it also appears to also be the best plan out there. Unfortunately, it won't stop the losses. Even if SIVs can fetch top dollar by selling good assets, the junk that was bought on borrowed money is still worthless.

"To properly solve the liquidity problem, the sponsors of the SIVs are still going to have to take losses," said Gerard Cassidy, an analyst with RBC Capital Markets. "To try to get out of this by papering over the losses is not going to work."

Analysts are becoming more convinced that the recent write-downs on Wall Street are the first in what will be a series of charges that banks will take during the next few quarters. Morgan Stanley's vice chairman suggested Monday that the profits made from the buyout boom will be washed away in the fallout.

The stakes are huge. There are 30 SIVs with $400 billion in assets. And even though asset-backed security issuance is down 17% from last year, underwriters have packaged 1,304 deals worth a combined $775.4 billion in 2007. CDOs, the danger piece of the pie, are about one-third, of that total, according to the research firm of Dealogic.

"We don't know how big it (the bad debt is)," Cassidy said, but it is clear some of "that stuff is toxic."

And does it matter who broke the window? Citigroup is the biggest issuer of asset-backed debt, with about a 9.5% market share. It's also estimated to have the most off-balance-sheet SIVs.
Going back to that broken window, the children have taken a deep breath. They have looked around the room. And in the calm, they realize there's broken things everywhere -- a vase, a hanging picture and spilled drinks. They stand before their mother.

"Some can't afford to take the losses," Cassidy said. "People can dicker over whether Paulson should have gotten involved or not, but the point is, they're trying to solve the problem with liquidity. Losses have to be taken."

The damage is done. Now everyone has to clean up, and someone has to pay.

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