Writing a full page analysis in Monday’s FT, Gillian Tett and Paul J Davies discuss why banks are still struggling to understand the extent of the losses they may realise in their portfolio of credit instruments. These losses may be greater than imagined for three reasons:
The policy response
While the pace of defaults on subprime mortgages has risen sharply in the past year, the scale of the losses are still hard to estimate due to the long lead-time in foreclosing on properties with delinquent loans. A further complication comes in the form of the policy response from the government. If the US government forces lenders to be lenient towards struggling homeowners, then the losses in the subprime sector could vary from a conservative $100bn, to several times that figure.
Not marking to market, but not marking to the ABX either
Banks that hold these mortgages - and credit instruments based on these mortgages - still do not know by how much they will have to write down their assets. Trading in subprime-mortgage-backed bonds has broken down, and this means nobody can find a current market price for the bonds. The ABX index, which tracks mortgage derivatives is being used as a next-best method to price mortgage-backed securities, but even this imperfect measure is not being embraced totally.
While the ABX indicates mid-ranked debt has fallen to trade at 40 cents in the dollar, Merrill Lynch has only written this debt down to 63 cents in the dollar, and UBS has only written it down to 90 cents in the dollar. A Merrill analyst says that if UBS marked its securities to the ABX, it would need to take another $8bn writedown.
Transparency
These opacities are all the more difficult to unpick due to the varying degrees of transparency in different institutions and jurisdictions. While a number of Taiwanese banks have been frank about their losses, banks in Japan have been less so, as it is widely accepted that these institutions typically hold their assets to maturity.
