Two Weeks Past Halloween,
the Nightmare on Wall Street Continues
Today's comment is by Mike Burnick, The Sovereign Society's Senior Editor and Global Markets Analyst and editor of Market Shock Trader.
Dear A-Letter Reader,
In just the past few months, Wall Street's big banks and brokers went from dismissing the subprime credit crunch as "no big deal" to dropping billions in subprime related losses.
Specifically, the big banks and brokers have already taken some US$45 billion worth of losses and asset write-offs as a result of this debacle. And we may not have seen the worst of it yet.
Recent analysis from the Royal Bank of Scotland (RBS) reveals that Wall Street may be forced to write-off as much as US$100 billion before the year ends. These additional subprime related losses are all due to pending accounting rule changes that take effect this week.
Wary of another Enron-like collapse due to "aggressive" subprime accounting, the Financial Accounting Standards Board (FASB) moved to tighten the rules for valuing illiquid assets. They'll now be watching the assets carried both on and off banks' balance sheets. This makes it more difficult for banks and brokers to assign "fantasyland" pricing to hard-to-value securities known as Level 3 assets. Let me explain.
As Easy as Level 1, 2, 3...
Level 1 assets are easy to price using mark-to-market accounting. You have probably heard that term before. Mark to market is when an asset's worth is based on a real price. For instance, if you wanted to know IBM's price, you can check the quote on the NYSE - that's the "mark to market" price.
Level 2 assets use something called "mark-to-model," but I call it mark-to-maybe. This is where the accounting begins to get murky. Mark-to-model is only an estimate of a value based on "observable inputs." These "observable inputs" are used when no actual price quotes are available. An example might be a private transaction between two banks. Essentially, they're saying "Maybe this is what the asset is worth."
Then there are Level 3 asset values, which are based on "unobservable" prices. This is basically the banks' own "assumption" what the assets are worth. This is what's been called "Mark-to-Make-Believe" accounting - because it's all just fantasyland pricing.
It's really nothing more than an educated guess. And perhaps it's not a too well-educated guess at that. Firms use these educated guesses to price their own illiquid assets. Naturally, they're all looking to cover their butts with the most generous valuation they can dream up.
Is the Financial Day of Reckoning Close at Hand?
What's really driving the subprime problem at this stage of the game? There's been a total breakdown in confidence over what these assets are really worth...and we're talking a pile of toxic asset-backed subprime securities totaling nearly US$1.2 trillion here. And a whopping 30% to 40% of these securities may end up defaulting!
The day of reckoning may finally arrive later this week when the new and more stringent FASB accounting rules take affect. The US$45 billion in charges taken so far may only be the tip of the iceberg compared to what we'll see soon.
According to RBS, this "credit crunch may result in US$250 billion to US$500 billion of losses," once all is said and done. That's once more banks and brokers are forced to revalue a decent portion of these "mark-to-make believe" assets.
In fact, real world indexes that track deteriorating subprime bonds are showing dangerous "observable levels" (Level 2 pricing). These observable levels could actually wipe out ALL of the capital from several major Wall Street firms if these prices were used to value their Level 3 assets.
Wall Street's Equity Wipe-Out
Morgan Stanley still carries abut US$88 billion in Level 3 assets on its books. That's equal to 251% of its total equity capital, "making it the most vulnerable to write-downs," according to the RBS analysis.
This means that if the house of Morgan writes-off just half its Level 3 assets - its entire equity capital would be wiped out!
Goldman Sachs is following close behind in terms of risk with Level 3 assets worth 185% of capital. Meanwhile, Lehman Brothers has the equivalent of 159% of equity in Level 3 assets, and Bear Stearns with 154%. Citigroup, even after its announced US$11 billion write-down, still has Level 3 assets worth about 105% of equity.
Jim Grant, of Grant's Interest Rate Observer worries about the lurking danger posed by Level 3 assets, "the valuation of which is very subjective." According to Grant, "if one were to mark these Level 3 assets to zero, then many of our leading financial institutions would be broke."
Grant conceded that not all Level 3 assets may need to be written-down to such an extent. But the problem is that Wall Street hasn't been very forthcoming yet in disclosing the full extent of potential losses.
This leaves investors to speculate, and fear for the worse. This lack of disclosure may be a signal that even the Masters of the Universe on Wall Street simply do not know just how bad things may get out there. And that's the really scary part!
MIKE BURNICK, Senior Editor & Global Markets Analyst
EDITOR'S NOTE: Wall Street has gotten whacked this past week. As the country's largest brokers and bankers hold up their hands and cry "Uncle," Mike's Market Shock Trader subscribers are smiling all the way to the bank. Just last week, Mike put out a sell recommendation to grab gains of 130.8% and 106.5% on put options that capitalized on the blood bath happening in the financial sector. And with the way the market's heading, the next gains could be even bigger. Don't miss out. Test-drive Market Shock Trader today - and find out if options are for you.
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