JP Morgan: Banks May Take $77 Billion in CDO Losses

Bloomberg reports that JP Morgan analysts forecast that large bank exposure to CDO-related losses could reach as high as $77 billion. Note that they have written off more than half that amount already. They also estimated aggregate losses at $260 billion. We have come up with larger back-of-the-envelope loss estimates, but that was based on a bigger CDO market size assumption.

Exposure to losses will vary considerably. Smart players like Goldman and Morgan Stanley reduced their exposures early in the credit market deterioration. Some firms stuck with large net long positions may have tried to hedge them, but the analysts note that those hedges aren’t always effective (as proven dramatically in the meltdown of the two Bear Stearns hedge funds, where both the positions and the hedges went south).

From Bloomberg:

Losses on collateralized debt obligations at the world’s biggest banks may double to $77 billion, JPMorgan Chase & Co. analysts predict.

Losses marketwide on CDOs linked to U.S. mortgages will reach about $260 billion, the New York-based JPMorgan analysts, led by Christopher Flanagan said in a report.

Merrill Lynch & Co., Citigroup Inc. and other banks that underwrote the so-called structured finance CDOs have already taken losses of at least $47.2 billion, a tally that also includes other holdings aside from CDOs. Questions about the extent of writedowns have caused investors to flee bank stocks and bonds and has kept interbank lending rates from matching declines in yields on short-term U.S. government debt.

“One of the benefits of securitization is the offloading and global distribution of risk,” the JPMorgan analysts wrote. “Ironically, this is now a capital markets hazard, since no one is sure where subprime losses lurk.”

Structured finance CDOs repackage asset-backed debt including subprime-mortgage bonds and other CDOs into new securities with varying risks. CDO sellers including Merrill, Citigroup, UBS AG and Deutsche Bank AG are taking losses on the “super-senior,” or safest, pieces of the CDOs, according to JPMorgan. Writedowns on that debt should be between 20 and 80 percent, the analysts wrote.

The banks ended up holding so many super-senior classes of CDOs partly because they were forced to retain about two thirds of the securities when underwriting deals in 2006 and 2007 because of weak demand from other investors, the JPMorgan analysts wrote.

Other holdings came from promissory agreements and from banks seizing collateral on bad loans to hedge funds, the analysts said.

Some banks may have “successfully hedged” their exposure to CDOs, though the timing of the gains on the offsetting positions may not match the timing of losses, the analysts wrote.

JPMorgan’s team of CDO research analysts led by Flanagan and Kedran Garrison was voted the best of its field in a poll by Institutional Investor magazine this year.

The team’s CDO loss estimate is triple the $85 billion that UBS analysts led by Laurie Goodman said they expect in a Nov. 13 report. JPMorgan’s estimate includes about $60 billion in losses from CDOs’ holdings of other CDOs, which UBS excludes.

New York-based Merrill, which ousted Chief Executive Officer Stan O’Neal, last month may lose $13.3 billion, the analysts said. New York-based Citigroup, which removed CEO Charles O. Prince III this month, is likely to have losses of $10.6 billion in total, the report said. Shares of the banks, which announced mortgage- related writedowns of $12 billion and of $7.9 billion, are each down more than 40 percent this year.

Zurich-based UBS may lose $8.6 billion, Frankfurt-based Deutsche Bank may lose $5.1 billion, and New York-based Goldman Sachs Group Inc. may lose $5.1 billion, the report said.

Bond insurers including Ambac Financial Group Inc. and MBIA Inc., which have “taken few reserves,” own CDOs that have had $29 billion in losses, JPMorgan estimated.

Losses on all subprime mortgage assets may reach $300 billion to $400 billion worldwide, Deutsche Bank analysts said Nov. 12. Credit losses on subprime, Alt-A and second mortgages made in the past three years will rise to $394 billion, excluding the effect of CDOs and credit-default swaps linked to the loans, UBS said.

Collateralized loan obligations, which repackage buyout loans and other high-yield company debt, may have lost $45 billion of value, the report said. The losses aren’t “credit-driven,” the report said.

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