Royal Bank of Scotland estimated that investment banks will be forced to take $100 billion in writedowns as a result of the implementation of new accounting rules that restrict their latitude in valuing financial instruments that cannot be priced readily.
Citigroup alone has $135 billion in so-called Level 3 assets, and that number rose by $40 billion in the last quarter alone due to actions the bank took to shore up CDO vehicles that were not carried on its balance sheet. Bear Stearns similarly had to throw a much smaller lifeline to manage the orderly liquidation of its failed hedge funds. The RBS estimate is likely based on existing balance sheet exposures; God only knows how many non-contractual obligations (therefore not reflected in an readily apparent way in the financial statements) that these firms have that they will decide to honor, either out of a fear for their reputation, or of collateral damage due to resulting forced liquidations.
That’s a long-winded way of saying that even the grim RBS estimate could turn out to be low.
The story is just breaking that Morgan Stanley will be taking $3.7 billion in writedowns, according to the Wall Street Journal.
Prices on Citigroup credit default swaps tripled in the last three weeks. The swaps are trading as if the bank is rated at the lowest investment grade rating, Baa3, when Moody’s downgraded it to the vastly higher Aa2.
U.S. banks and brokers face as much as $100 billion of writedowns because of Level 3 accounting rules, in addition to the losses caused by the subprime credit slump, according to Royal Bank of Scotland Group Plc.
Morgan Stanley, the second-largest U.S. securities firm, fell for a fifth-straight day, dropping 6 percent to $51.19 in New York Stock Exchange composite trading. Lehman Brothers Holdings Inc. and Bear Stearns Cos., the No. 1 and No. 2 underwriters of U.S. mortgage bonds, each declined more than 5 percent. All three firms are based in New York.
The Financial Accounting Standards Board’s rule 157 makes it more difficult for companies to avoid putting market prices on their hardest-to-value securities, known as Level 3 assets, Royal Bank chief credit strategist Bob Janjuah wrote in a note today. While the rule hasn’t gone into effect yet, the biggest U.S. lenders and brokerages have already begun reporting their Level 3 holdings.
“This credit crisis, when all is out, will see $250 billion to $500 billion of losses,” said Janjuah, who’s based in London. “The heat is on and it is inevitable that more players will have to revalue at least a decent portion” of assets they currently value using “mark-to-make believe.”
Wall Street’s biggest firms have written down at least $40 billion as prices of mortgage-related assets dwindle because of record foreclosures. Morgan Stanley has 251 percent of its equity in Level 3 assets, making it the most vulnerable to writedowns, followed by Goldman Sachs Group Inc. at 185 percent, according to Janjuah. Goldman, the biggest U.S. securities firm, fell 4 percent in New York trading today.
Morgan Stanley may write down $6 billion of assets, David Trone, an analyst at Fox-Pitt Kelton Cochran Caronia Waller, said yesterday.
Citigroup Inc., which this week said losses from subprime assets may be $11 billion, has 105 percent of its equity in Level 3 assets, Janjuah wrote. The New York-based bank fell 4.8 percent to $33.41, a four-and-a-half year low.
Merrill Lynch & Co., which wrote down $8.4 billion of subprime mortgage debt and other debt securities, has Level 3 assets equal to 38 percent of its equity “and may well come out of all of this in the best health,” Janjuah said. Merrill, the world’s largest brokerage, fell 4.2 percent to $53.99.
“If you look at the writedowns just at Citi and Merrill already it’s about $20 billion, so $100 billion may be on the conservative side globally,” said Sajiv Vaid, who manages the equivalent of about $10.5 billion of corporate debt at Royal London Asset Management in London, a unit of the U.K.’s biggest customer-owned insurer.
The losses are likely to hurt shareholders more than bondholders because the banks may be forced to sell stock to raise additional capital, Vaid said.
Banks may be forced to write down as much as $64 billion on collateralized debt obligations of securities backed by subprime assets, from about $15 billion so far, Citigroup analysts led by Matt King in London wrote in a report e-mailed today. The data exclude Citigroup’s own projected writedowns.
Under FASB terminology, Level 1 means mark-to-market, where an asset’s worth is based on a real price. Level 2 is mark-to- model, an estimate based on observable inputs which is used when no quoted prices are available. Level 3 values are based on “unobservable” inputs reflecting companies’ “own assumptions” about the way assets would be priced.
ABX indexes, which investors use to track the subprime-bond market, are showing “observable levels” that would wipe out institutions’ capital if the benchmark’s prices were used to value their Level 3 assets, according to Janjuah.
The indexes have tumbled this year because investors expected rising numbers of borrowers to default on home loans, cutting the cash flowing to the bonds that package the mortgages.
Lehman has the equivalent of 159 percent of its equity in Level 3 assets, and Bear Stearns has 154 percent, according to Janjuah’s note, titled “Bob’s World: Feast and Famine.”