Financials: Worse than they look?

On Tuesday, we wondered aloud what the S&P500 might have looked like had the true nature of the Financial sector’s true risk-adjusted earnings been known (S&P500 ex-Risk ?).

We questioned how the Financials looked historically, now that they wiped out so much profitability from the past few years.

One of the more interesting emails came from a person who wanted to
know how $100 in defaulted sub-prime mortgages could do so much
damage. The short answer is that its not merely the mortgages, but the entire derivative house of cards built on the backs of the sub-primes. Mortgages got repackages into residential mortgage-backed securities (“RMBS”).  These were in turn repackaged into collateralised debt obligations (“CDOs”). These  were re-repackaged in part as credit default swaps (“CDS”).

This entire derivative pile was based upon the explicit assumption that default rates would stay within the range of historic averages. That turned out to be a false assumption. So as the Mortgages increasingly enter delinquency, default and foreclosure, the highly leveraged alphabet soup on top of them took a giant hit. (See the graphics here for a visual explanation).

The situation may be even uglier than we previously believed:

“When it comes to working out the impact on banks, the task becomes even harder. For in recent years, banks have not simply been acquiring subprime loans, they have been repackaging them into complex “asset-backed securities” (ABS) that can be difficult to value. The Bank of England, for example, suggests that on the basis of industry data some $700bn-worth of bonds backed by subprime loans are now in circulation in the world’s financial system, with another $600bn of bonds backed by so-called “Alt A” loans, or those with slightly better credit quality.

Moreover, these bonds have then been used to create even more complex securities backed by diversified pools of debt, known as collateralised debt obligations (CDOs). According to the Bank’s calculations, for example, some $390bn of CDOs containing a proportion of mortgage debt were issued last year – though the precise level of the subprime component varies.

The multi-layered nature of these complex financial flows means it is hard to assess how defaults by homeowners will affect the value of related securities.”

We’ve all heard those numbers bandied about — but what do they actually mean to the various banks and brokers?  Consider the Level 3 assets. Marketwatch describes these as follows:  “Some assets are so esoteric and trade so infrequently that investment banks have to value them based on mathematical models, rather than the market prices of similar or related securities.”

In other words, these are the least traded, most estimated, hardest-to-accurately-value-because-there-is-a-dearth-of-buyers paper.

Here’s the truly ugly side of this:  When valuing these assets (derivatives, private-equity investments, CDOs and mortgage-servicing rights) the mark-to-model techniques are applied to an unhealthy slice of these holdings. According to Brad Hintz, an analyst at Bernstein Research (he was formerly Lehman Bros’  CFO), a huge amount of this stuff is still improperly priced:

% Level 3 trading inventory valued using mark-to-model techniques
Goldman Sachs    15%
Morgan Stanley    13%
Lehman Brothers    8%
Bear Stearns    7%
Merrill Lynch    2%

Source: Bernstein Research

I am not sure of the precise amount of Level 3 assets currently held, but it is substantial.

The next tier, Level 2, are described as those assets that may not trade much, but that can be theoretically valued by checking market prices of  similar securities and making assumptions about variables such as interest rates (MBS, some corporate bonds and CDOs).

According to Dick Bove of Punk Ziegel, the five largest U.S. brokers and banks — Citigroup, J.P. Morgan Chase and Bank of America — have $4.1 trillion of these Level 2 assets on their balance sheets.

That’s almost 10 times their shareholder equity.

When the final coda of this era is written, wiping out 5 years or so of earnings is going to look like a bargain . . .




What’s the subprime damage to banks?
Gillian Tett and Paul J Davies
FT, November 4 2007 18:08

Wall Street’s stress test
Alistair Barr
MarketWatch, 7:57 PM ET Sep 7, 2007

Banks Face $100 Billion of Writedowns on Level 3 Rule
John Glover
Bloomberg, Nov. 7 2007

Risk of securities fire sale mounts
David Wighton and Saskia Scholtes in New York and Gillian Tett in London
FT, November 6 20

2007 Global CDO and Credit Derivatives Outlook
Fitch, 13 December 2006

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What's been said:

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  1. Ted commented on Nov 8

    This doesn’t sound good, Barry. And more bad news — The NYT says this morning that falling home values may slow down consumer spending. Now, why haven’t you ever mentioned an important thing like that? (yuk yuk)

  2. Greg0658 commented on Nov 8

    Enron was repackaged where? Was subprime allowed as cover? Or a fixup.

  3. SINGER commented on Nov 8

    If the HUGE banks hold so much of these derivatives…Can’t they theoretically agree to simply cancel or modify these OTC Contracts… If two of these banks are counterparties on a deal where Bank A loses $100 billion and counterparties on a deal where Bank B loses $100 billion then can’t banks A and b just say, You forgive my losses and I’ll forgive your losses, so NET we are even so we really lost nothing…Isn’t the real issue the NET exposure of these banks…

    Also if everyone is losing money on these instrument who is making money on their decline who were the counterparties and to what degree???

    Another thing no one mentions…what about the derivatives contracts based on different currencies…Considering the huge moves in the dollar and other currencies versus the dollar i would think alot of players got burned hard on those…

  4. Greg0658 commented on Nov 8

    Singer – who is making money?

    Not sure who is making money on these loses (look at those instruments on regional house’g solvency)

    You know this, just a reminder:
    who made money? the initial lenders, the building product manufacturers, the builders, the laborers, the community, the government thru taxes, the home and apartment renters.

    Thank you investors for helping commerce. Sorry if you got burned.

  5. Greg0658 commented on Nov 8

    For real … I’m sorry if ya got burned … really

  6. Unsympathetic commented on Nov 8

    I’m just wondering how the permabulls are going to spin the fact that the past 5 years of financial earnings have been a fraud the likes of which we haven’t seen since…

    The tech bubble
    LTCM (and so on)

    Well, I guess I should end that sentence with “since the last bubble burst.”

    Greenspan is a wrinkled bag of wind. Paulson should be fired as CEO of Sachs for exposing them to this dreck – or leading the Treasury, one of the two.

    But good times!

  7. Greg0658 commented on Nov 8

    ps – its sad but true
    who else lost – areas that didn’t go for the ride above

  8. W.Edwards commented on Nov 8

    October same store sales flooding in. Generally speaking, it appears to be very weak. Walmart at +0.7% when you include gas/food prices! Not a good showing at all. A lot of other discretionary stores way down. I wonder how Wall Street will spin this? Probably will be discounted as people are looking towards the Christmas sales period.

  9. Salomon commented on Nov 8

    “If the HUGE banks hold so much of these derivatives…Can’t they theoretically agree to simply cancel or modify these OTC Contracts…”

    Singer, unfortunately it doesn’t quite work that way. Banks use the money of their depositors (people like you and me, and other institutions) to fund purchases of assets of this sort – the old borrow short and lend long game. So unless you’re ok with them coming to you and telling you that the money you deposited in the bank is now worth significantly less than it was when you originally deposited it, just canceling obligations like that is likely not a viable solution.

  10. Jaosn G. commented on Nov 8

    Noriel Roubini’s blog had a recent post that breaks down the Level 3 assets at the big boys…

    If it’s accurate… these are the Level 3 amounts:

    GS – $72b
    C – $135b
    MS – $88b
    BSC – $20b
    LEH – $35b
    MER – $16b

    There’s also some math to put these numbers as a % of equity capital base. Fascinating and frightening.

  11. Alan Greenspend commented on Nov 8

    As mentioned in Dr. Roubini’s blog and earlier elsewhere, the SFAS157 rule will play an interesting disclosure effect on these highly leveraged derivatives. Morgan Stanley is in big trouble, the insurers are in big trouble, etc.

    ” Nov 15 the SFAS157 rule goes into effect, as i think i mentioned, it “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.”
    Here is the Level 3 assets to equity ratio summary:

    Citigroup 105%

    Goldman Sachs 185%

    Morgan Stanley 251% Morgan Stanley: $88 billion in Level 3, equity base is $35 billion.

    Bear Stearns 154%

    Lehman Brothers 159%

    Merrill Lynch 38%

  12. Old Ari commented on Nov 8

    How much of these problems, is caused by the severe financial imbalance of the governments, state and federal?

  13. Loren Steffy commented on Nov 8

    BizLinks | 11.8.07

    Oil resumes march to $100 Restaurant giant Landry’s reports $3.2 million loss Valero says to spend $1.4B to expand Louisiana refinery capacity Unseasonably Higher, Gas Prices Add to Strain on U.S. Consumers What Economic Slowdown? Small Businesses Gro…

  14. michael schumacher commented on Nov 8

    IT has been caused by nothing more than greed, greed and still more greed.

    Case in point…..the people at Citigroup actually thought that they could roll over all that crap debt (well they did’nt think it was crap while they bought it)each and every month and then collect the spreads on them to make the profit margin.

    These are people that make millions of dollars a year and have years of experience and all they could come up with is hold and hope. Well now that’s ALL they have. THE CFO of C even said as much

    “we’ll continue to hold these and wait for a calmer market”

    I bet you will….

    Hold and Hope…….works for major banks but not you…..


  15. dblwyo commented on Nov 8

    Barry – when do you sleep ? Excellent post with a lot of work in it but 0608 ? Sheesh – you must have started at 0400 at least. But as long as you don’t sleep and can still work a couple of questions for your next depth post, if you don’t mind:

    1. Could you walk thru the leverage multiples as they build up across the chain. Seen some complex versions of that but not sure my simple mind got it. Nonetheless by the time you walked across the chain leverage multiples on original equity went from 10X to 70X.

    2. Have you thought about what happens if this same structural breakdown applies to other asset classes ? Corporate debt, EM Bonds, etc.

    For example:
    Next Fear: Corporate Debt ( )
    Fitch Ratings says downgrades of corporate bonds rose in the third quarter to $92.1 billion, their highest level in two years, a potential sign of rising distress.

    Took my pass at it as well but high-finance ain’t my field:
    Next Shoe Drops:

    Appreciate it.

  16. michael schumacher commented on Nov 8

    here comes Benny to rescue the markets with his speech…..

    Watch the market ignore anything bad and totally focus on whatever sunshine comes out of his ass.

    Where is Ron Paul when you need him??-LOL


  17. michael schumacher commented on Nov 8

    BTW the LTCM problem is such small potatoes in contrast to what we have going on now.

    LTCM took about $4.7 billion and leveraged it up to a little over $130 billion.

    Obviously we have the LTCM situation on steroids…….


  18. The Financial Philosopher commented on Nov 8

    What I find interesting is that simple common sense could see all of this coming without the use of economic statistics, fundamental analysis, chart analysis, or any kind of quantitative consideration whatsoever…

  19. Ralph commented on Nov 8

    The problem feeds itself, creating a pernicious downward spiral.

    Many of these institutions own the same or similar bonds. So, when one writes down a bond that reverberates through all the others.

    Which then lowers the value of all similar bonds etc. etc.

  20. UrbanDigs commented on Nov 8

    We must also consider:

    1. How classification adjustments will change what is now considered Level 3 once the new accouting rule kicks in.

    2. Ratings downgrades effecting what is considered level 3?

    3. Whether there will be another hideout somewhere on the books for these companies OR if this new accounting change will really make untradable holdings more transparent?

    With AAA ABX index plunging yesterday, this problem is far from contained. You will be hearing more about this as months pass.

    Ben may have to do an inter-meeting cut, even with oil near $100 and commodities so high as this credit problem is quickly turning out to be the worst threat we have seen in a long time.

  21. michael schumacher commented on Nov 8


    I gather that they all knew it was coming but when you get record profits (and bonus’) the motivation to correct it is less and less. Just like the CDO/SIV trader that Barry had posting here a month or two ago. He saw it, participated in it, enriched himself from it and ONLY NOW is apologetic about the whole process. Just like the banks and brokers are now.

    we are a nation of apologists…….


  22. a guy called john commented on Nov 8

    Haven’t see it discussed here, but here’s Jay-Z’s new video, rather than waste time with benjamins, he flips through a massive stack of 500 Euro notes:

    Check around the 50 second mark for those of you who don’t wanna sit through it.

  23. ron commented on Nov 8

    How about the SIV part of this package. Most are not part of the normal books, rather Enron style Cayman Island record keeping. No discussion in the financial press about these SIV’s and what of anything they are worth.

  24. pclema commented on Nov 8

    Seems to me the problem is much worse than just the sum of subprime and Alt-A mortgages of questionable value. Due to packaging these loans into other derivatives like CDOs they mixed questionable loans into assortments of other “good” loans. Now that the default assumptions have turned out to be faulty, instead of this arrangement protecting the performance of the weak loans it has impaired the performance of the good loans as well. Kind of like making hamburger using one e-coli tainted cow and a thousand good ones — the whole lot is now headed to the dumpster.

  25. zao commented on Nov 8

    just cut overnight rates to 2% now and put everyone out of their misery. It will also let us move on past the continued inane speculation of Fed cuts and onto what is actually happening. Inflation and dollar be damned.

  26. Groty commented on Nov 8

    As long as the Level 3 assets are being valued each quarter as a function of how the securities are cash flowing, what’s the problem?

    I’m thinking about private equity. Their portfolios are composed substantially of illiquid assets and somehow they manage to mark those portfolios (and accrue fat fees for themselves) that passes both investor and auditor scrutiny. Presumably they use some framework based on how the assets are cash flowing.

  27. Joe Klein’s conscience commented on Nov 8

    Ron Paul is on CNBC now. The Joint Banking Committee. He’s grilling Helicopter Ben something good.

  28. Joe Klein’s conscience commented on Nov 8

    Look at Helicopter Ben’s smirk!! Ron Paul just ripped him a new one and Ben knows it. He’s a charlatan.

  29. David Price commented on Nov 8

    Hi Barry, I am a little surprised no one has commented on Jim Cramers antics last night. Stabbing the picture of a model and public official on TV last night balming them for the fall of the dollar and loss of up to 200 pts. on the market. Like his buddies in the big financial institutions have no blame!

  30. Joe Klein’s conscience commented on Nov 8

    What public official? I think we all can figure out what model Crazy Cramer was skewering.

  31. VJ commented on Nov 8


    (CNN) – Luxury home builder Toll Brothers reported that overall revenue was down 36 percent in its fiscal fourth quarter, which ended Oct. 31, while net signed contracts, which reflects new contracts less canceled orders, fell 35 percent, while the value of those new contracts plunged 48 percent.

    Hovnanian Enterprises released its own preliminary figures that showed cancelations amounted to 40 percent of gross contracts in its fiscal fourth quarter. Pulte Homes reported a much bigger than expected loss in the most recent quarter at the end of October. Rival Centex disclosed it had cut prices on some homes by 15 to 20 percent in order to try to maintain sales, and had cut staff by more than 40 percent. The day before Centex had reported a large second-quarter loss. D.R. Horton reported in late October that its fiscal fourth-quarter orders fell 39 percent, while the value of those orders plunged 48 percent.

    Credit rating agency Moody’s downgraded the debt of Pulte, Centex, and Lennar (the nation’s No. 1 builder in terms of revenue) to junk bond status.

  32. hpov2000 commented on Nov 8

    Financial Philosopher,

    That’s where the greater fool theory comes into play. Every one thinks that they are smart enough to get out before the sh*t hits the fan.

    BTW, I like your blog too for sensible articles and trend analysis.

  33. adam commented on Nov 8

    when you combine the size of this hit (when the banks finally take the full amount), the savings and loan losses of the 80s and 90s and the Latin American debt crisis, are banks even profitable, cumulatively?

  34. tinhat commented on Nov 8

    I think something that gets overlooked with the housing mess is all the cutbacks at local and state governments. A lot of 5 and 10 percent cuts across the country leaves a few people out of a job and a lot more with no raises. Plus whatever they do waste our tax money on is obviously getting cut back which is not going to boost someone else’s profit.

  35. michael schumacher commented on Nov 8

    Look at the issuance of permits for existing construction…….people who work in those offices in any City Planning Office are going to be walking the job line soon.


  36. Ron commented on Nov 8

    Is the Fed’s funds infusion new stuff or just rolling over repos?

  37. dark1p commented on Nov 8

    Oh, that Cramer. Made a pile of money in the biggest bull market in history and had to manipulate information on CNBC to pump and dump in order to succeed as well as he did.

    Not a stupid man, but not the friend of the common man he might think he is. And not very good at picking stocks when the market is more complex than straight up, either.

    God bless ‘im, the little Jiminy Cricket.

  38. The Financial Philosopher commented on Nov 8

    MS & hpov2000:

    I agree with you both and will add that “common sense” can “see” things coming but just does not know HOW they will occur. Common sense also “knows” that the attempt in trying to determine how things will occur is almost always futile and, therefore, not worth the time and effort spent…

    Meanwhile, it certainly is entertaining and educational to read TBP and what insights the readers will offer in the comments…

  39. Unsympathetic commented on Nov 8

    Barry – What will it take for Congress to fire Bernanke and Paulson? We need to have capable men in those positions, not the shills that have been there since 2000.

    He should have been raising rates and hosting the resignation parties of every I-bank CEO.

  40. BR’s buddy commented on Nov 8

    Urban Digs;
    You might be referring to me as BR and I shared extensive notes on this topic several months ago. If so, I gotta tell you; I’m not sorry that as a fixed income sales person I helped CDO managers locate the securities they asked for as collateral for the structured products they issued. Most of these guys have lots of three-letter acronyms after their names telling us how smart they really are. If CFA’s, PhD’s, MBA’s, want to buy securities that I wouldn’t, I figured they knew what they were doing. And, if any professional investor, to include a CDO manager or a asset manager investing in CDO’s on behalf of others, claims to not understand the risks, they should be banned from the industry, and possibly, Earth.

  41. BR’s buddy commented on Nov 8

    Urban Digs;
    You might be referring to me as BR and I shared extensive notes on this topic several months ago. If so, I gotta tell you; I’m not sorry that as a fixed income sales person I helped CDO managers locate the securities they asked for as collateral for the structured products they issued. Most of these guys have lots of three-letter acronyms after their names telling us how smart they really are. If CFA’s, PhD’s, MBA’s, want to buy securities that I wouldn’t, I figured they knew what they were doing. And, if any professional investor, to include a CDO manager or a asset manager investing in CDO’s on behalf of others, claims to not understand the risks, they should be banned from the industry, and possibly, Earth.

  42. Greg0658 commented on Nov 8

    Please explain differently – I don’t understand this as is.

    Here is the Level 3 assets to equity ratio summary:
    Citigroup 105%
    Goldman Sachs 185%
    Bear Stearns 154%
    Lehman Brothers 159%
    Merrill Lynch 38%
    Morgan Stanley 251%
    Morgan Stanley: $88 billion in Level 3, equity base is $35 billion.

    Is Morgan Stanley the example I seek.
    35 x 2.51 = 87.85

    Equity = cash on hand?
    Equity = Level 1 and 2 collaterals plus cash on hand?

    If so – how can Merrill be below 100? How can you be negative Level 3 exposure?

  43. Bud Hovell commented on Nov 8

    “That’s almost 10 times their shareholder equity.”

    So are these stocks actually marked to market, or are they not also implicitly marked to model? Except on speculation of finding a greater fool, it’s a bit amazing anyone sane would hold these stocks unless bought with somebody else’s money.

  44. Jimmy commented on Nov 8

    just this spring i had interviews at Countrywide’s HQ. all these hotshots with their CFAs (certified financial analysis) didn’t hire me because i told them ‘common sense’ said mortgage loans and MBSs will get burned once rates moved back up and home values stopped appreciating. they were just greedy and didn’t want to know the truth or hire someone who really have ‘experience’ and not just a certificate.

  45. plantseeds commented on Nov 8

    Help me out here, say I was employed at one of the aformentioned large financial institutions and say “management” was suddenly recommending that client managers suggest to their clients, to bring their cash balances to the FDIC side – from the non-FDIC side – of their combined bank/brokerage accounts. What might be the reason for this? If it were to happen of course. Any ideas?

  46. Noah commented on Nov 8

    there are three problems that I see that could have been included in your discussion, or for future ones if you can do more research on it.

    1. The FASB 157 accounting change will adjust how Level 3 assets are classified and how they get disclosed to investors. This is a major problem. What used to be able to be classified as tier 2, may now need to be adjusted to tier 3. Needless to say, banks & brokerages used this gray area to underestimate the exposure of assets considered under level 3 accounting disclosures.

    2. the problem is no longer contained to subprime. The plunge in AAA ABX is consistent with what my sources were telling me for past 10 days or so. Investors are buying credit protection for alt a and prime mbs holdings. Im waiting for one of my sources who is right in the middle of this action, to put my post up that should have went up 2 days ago. The plunge in AAA ABX occurred yesterday. Sucks, cause I try to get this stuff out early. You can imagine the worry if its no longer just a subprime illness. Of course there were problems making AAA paper from subprime junk, but what if this spreads to higher quality paper before its securitized?

    3. ratings downgrades will have a two pronged effect. First, it will restrict who can buy the distressed assets as many pensions accounts and even hedge funds have restrictions on junk purchases. Second, level 3 accounting adjustments due to downgrades of holdings to markets that are untradable?

  47. Juan commented on Nov 9

    Thanks Noah,

    You know, there seems quite a bit of confusion around SFAS 157 (and 159), with many apparently taking these to be more than they are rather than an attempt towards a ‘fair value’ framework, which does not do away with use of unobservables or create a strict mark-to-market regime.

  48. rickrude commented on Nov 9

    , J.P. Morgan Chase and Bank of America — have $4.1 trillion of these Level 2 assets on their balance sheets.

    That’s almost 10 times their shareholder equity………………..

    2 solutions.. either the banks write them off
    as a loss (as there is no market for them) or Bernanke bails the banks out.

    If there is no market for them , then value = 0. Unless Bernanke creates a demand for them himself.

  49. sol commented on Nov 9

    “These were re-repackaged in part as credit default swaps (‘CDS’).”

    BR, I’m not so sure the above is true. Credit Default Swaps (CDS) are merely protection against underlying credit instruments. There is no packaging involved.

    Also, I think you are falsely overestimating the danger of level two assets. Many level two assets include municipal bonds, restricted stock, OTC CCY swaps and many other assets that are not directly tied to the subprime market.

  50. Greg0658 commented on Nov 9

    rickrude – why do they have to move on the loan write downs now?

    Ratio:Cash is cash shy at this new hype value? Untradeable stock market vehicle and folks want out? Some other benefit?

  51. Juan commented on Nov 9


    you’re correct though i believe CDSs are required for creation of synthetic CDOs and various ‘enhancements’, with CDS notionals having reached $45-50 TN range.

    other hand, a note in Securitization Conduit, Fall 2006, relates to ‘directly tied to…’,

    Notwithstanding greater risk diversification within the financial system through asset securitization, in the same way, the
    structural complexity arising from multi-layered security designs, diverse amortization schedules and possible state-
    contingent funding of synthetic credit risk transfer, however, might also obfuscate actual riskiness of these investments
    and inhibit provident investment. Moreover, numerous counterparty links established in the commoditization of
    securitized asset risk and derivative claims also create systemic dependence susceptible to contagion.

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