The last few months of 2007 have presented both a unique problem, and the most misunderstood of crises. That crises occur periodically is to be expected; what is almost never accurately predicted is the exact timing and location of the next problem. No one predicted the Asian crisis of 1997. And 10 years on we remain in a risky old world.
There was a similar scenario in 1929. Banking and financial system losses led to a swift global tightening of interbank credit, a reappraisal of lending criteria and a withdrawal of credit to risky borrowers, including the Weimar Republic. In 1929 the Federal Reserve raised interest rates, prompting the Great Depression. Right now similar conditions have forced monetary easing. Ideally, at a time of surging oil prices and a slumping dollar, the US Federal Reserve does not want to lower interest rates, but it recognises it has to.
In some ways, the fact that the problem is US-based and involves financial institutions is predictable. The real economic damage will be the withdrawal of credit in the period Q3 2007 to H2 2008 — not just to risky borrowers, but to speculators driving up property prices, private equity and hedge funds, portfolio investors borrowing on margin, and banks themselves. It is not that money is too expensive in a credit crunch, it simply becomes unavailable.
Investors require transparency for Level 3... This costs money
The fact is that financial institutions take risks with shareholders’ money. Not all risks can be parcelled off to clients, or transited across to other banks. After all ‘you can’t make an omelette without breaking eggs’, or so the saying goes. Big institutions have to make upfront commitments, to win M&A work, to sell bonds or even just carry out the routine job of giving their salesmen a highly-priced IPO to sell. This is how Wall Street, the City of London, Frankfurt, Paris, Geneva, Tokyo, Singapore and Toronto all work. It is a game of musical chairs. But when the music stops, the bank is left holding the can. It has to wait for an upturn to realise what it cannot sell.
Banks, brokers and insurers are valued at between one and two times their book values or net assets. The book value approach roughly sums up its total assets and total liabilities. If assets rise faster than liabilities, the bank is creating shareholder value. But this is a blunt instrument for measuring value. It means $100 of one type of asset is arguably the same as $100 in cash. In the rush to blame and denigrate, investors are making the common assumption that the weakest, the Level 3 ‘available for sale’ assets, need to be valued according to realisable market value, and no other measure. This is unrealistic. Only Level 1 assets are valued according to the market. This is largely a function of the complexity of financial markets — banks and brokers are not central bankers, they do not hold vast reserves of gold bullion; it is not their commercial function to act as Fort Knox.
Merrill Lynch reported that even after its $8.4bn write-down it had a total of $21bn in Level 3 assets, including sub-prime mortgages, collateralised debt obligations (CDOs) and other exotic bonds. Other institutions, such as UBS and Citigroup, have much higher exposures. Investors have reasoned that these Level 3 assets are the problem, because their values cannot be ascertained. But not all liquid assets can be ascertained easily. Merrill Lynch owns 20% of Bloomberg. Bought in 1987, this is valued in the books at $0.7bn. However, even conservative valuations from Goldman Sachs value this stake at $5bn. It could be worth $10bn if Mike Bloomberg floated his company. Bank of America paid $3bn for a 9% stake in China Construction Bank, it is now worth around $30bn, but the Bank has yet to adjust its book valuation — and is in no hurry to do so. This is because until the asset is sold, the bank will not know its true worth, regardless of current market valuations 10 times its book value.
The fact is that Level 3 assets are, according to rule 157 of the Statements of Financial Accounting Standards, valued by ‘in-house computer models’. Wall Street has invested vast sums in IT programmers, quantitive analysts or ‘quants’ (i.e. maths boffins) in order for calculations to be made, that can credibly claim to value complex financial instruments, where there is no liquid market and often limited volumes. This works well as long as the models can make credible representations to a buyer, who then proceeds to buy. It also works well for investors who can ‘believe’ reported financial accounts that claim these estimates are real. The problem occurs when investors no longer believe they are being correctly valued. The bank then realises it needs to restore credibility by writing down these assets to a credible level.
Level 3 assets grow when delinquencies rise, down-shifting assets previously in other categories to Level 3. This is the real problem; the market has already priced in the losses from the visible Level 3; the issue is how much more in losses will be created as delinquencies rise.
A domestic analogy is fair
In a sense it is like replacement value. To draw on an everyday example, many people put very high valuations on their home contents for insurance purposes. But due to their age, or the fact they are second-hand, the realisable value of your insured personal possessions is likely to be lower than their insurance value. Further still, this value was often negotiated years ago, and is likely to be far higher than their equivalent replacement value now. In a sense, the real value of these items to the owner is the fact that they delay the replacement expense.
‘Value’ is very dependent on the owners’ intention and the purpose being served. If suddenly you had to obtain car-boot sale prices for domestic items then it would appear that you had lost a lot of money when compared to insurance or historic, book valuations. But this has little relevance unless you are in fact trying to sell all your personal items or trying to convince others you are right about their valuation (which is what banks and brokers are doing). It does not mean you are going bust by recognising these losses.
For companies, once these assets are on the balance sheet that is not in itself a problem. The problem occurs when you are asked to value these assets to the current market and apply standards not necessarily appropriate to these assets or the management’s intention. There is pressure to mark asset-backed securities (ABS) bonds to price references on the www.markit.com website which tracks illiquid investments such as asset-backed bonds and collateralised debt obligation. However, this is unlikely — the hit a bank’s book values will be too great. It could cause a panic if investors perceive the bank’s book value has been lost.
Step up the superfund buyer!
But none of these accounting complexities obscure the fact that any asset is determined by what ‘the next man will pay’ or what ‘the market will bear’. The institutions need to breathe life into the ABS market, because of the limits on lending funds from their own balance sheets. Hence the Wall Street $100bn ‘superfund’ initiative will create that buyer of last resort.
The issue raises the moot point of how to value a Wall Street brokerage or global institution. From 1990- 1993 investors paid well under book value on the grounds that these businesses involved loans to risky borrowers, who would eventually default. Post Basle II, the financial institutions convinced the public that separate income generating vehicles could be created to buy the institution’s financial products yet remain, from the bank’s viewpoint, a legally separate entity, limiting liability.
This theory was dealt a blow in September 1998 when Long Term Credit Management was rescued. A group of 15 global institutions were asked by the US Federal Reserve to inject $300m each into the rescue. The fact that the potential systemic failure losses were borne by the commercial banks and not by the Federal Reserve meant banks’ liabilities potentially could extend to parties who were not even clients. These days the rescues are much larger. The HSBC $35bn bail out of two structured investment vehicles has set a record. It is entirely possible that bank rescues will become more frequent and costly. The Abu Dhabi Authority’s $7bn capital injection into Citigroup is likely to be the first of many private cash calls by the US banks. The fact that it managed to extract an 11% coupon from the deal is a measure of just how desperate the credit situation is.
2008 will see new valuation methodologies evolving for banks and brokers. The least scathed will be the big franchises, Wells Fargo, Wachovia, Bank of America, etc., that had limited investment banking activities in the first place. In the second tier will be those that appear to have done a good job managing their exposure such as Barclays and Goldman Sachs. The rest... well, it looks like the sub-prime issue will roll on possibly for another six months. Be wary of financial instruments and institutions, but not scared.
