Put the pistol down. Move away from the ledge. We can talk this through. The worst is all but over. Witness the title of the latest tome from Standard & Poor’s:
More Subprime Write-Downs To Come, But The End Is Now In Sight For Large Financial Institutions
Analysts at the rating agency reckon that while there might well be a bit more painful mark to market-ing to be done for Q1, the magnitude of write-downs taken by the big banks, brokers and insurers for 2007 — put, roughly, at $150bn – “is greater than any reasonable estimate of ultimate loss.”
Most of the write-downs have been on the so-called supersenior tranches of CDOs of subprime ABS. To date, banks have written down their unhedged supersenior CDOs of ABS by more than $65 billion. On an original exposure of about $160 billion, this represents about a 40% discount. However, that discount percentage varies tremendously from institution to institution.
In our view, some of the variation may be based on differences in the specific securities the institution owns, as the securities vary widely in their ultimate loss characteristics. Some of the variables that affect the valuation are whether the exposure was to so-called CDO-squared securities (CDOs that purchased tranches of CDOs) or to the supersenior tranches of high-grade CDOs or mezzanine CDOs; the proportion of the underlying loans that were of 2005 or earlier vintages; how many of the CDOs’ investments were in other CDOs and in subprime residential mortgage-backed securities (RMBS); and the levels of subordination in each structure.
Based on available information, we believe that the largest players can be seen as having undertaken a rigorous valuation methodology to come up with conservative valuations. Citigroup Inc. and Merrill Lynch & Co. Inc., for example, value their high-grade supersenior tranches at 52% and 68% discounts to original exposure, respectively. The broader range of banks values them at only a 30% discount. Similarly, Citi and Merrill value the supersenior tranches of the mezzanine CDOs at 63% and 73% discounts, respectively, whereas the broader range of banks values them at a 48% discount.
There are numerous other variables, such the issue of vintage of the underlying assets and there is still the uncertainty associated with those pesky monolines. But, as S&P sees it, intrinsic value should eventually begin to show through:
If they are held to maturity or if some of the risk premium for illiquidity and uncertainty goes out of market spreads, we believe the CDOs of subprime ABS may indeed see a recovery in value, although the amount is difficult to predict.
At which point the overly conservative approach adopted by the biggest institutions should begin to show dividends. Other market participants might as well jump now:
We believe that the difference between the $150 billion in losses from write-downs in market value disclosed to-date and our global estimate of $285 billion will come not just from additional write-downs at banks, where additional losses should be limited, but from write-downs at hedge funds, monoline insurers, other insurers, and other financial institutions.