Is That S&P Forecast of Subprime "Bottom" Good News?

The market rallied on the news that S&P reported that the end was in sight for subprime writedowns, with the firm placing the total damage at $285 billion, with $150 billion realized so far.

The need to believe is stronger than I realized. “End is sight” is not the same as “end is nigh” but that it what the market chose to hear.

Let’s just look at the forecast presented. Commercial and investment banks have taken $150 billion in subprime writedowns. S&P says the big banks will take few further hits; it will be other players, such as hedge funds, will take another $135 billion (reader James caught an error in my earlier version). That means they have to almost as much in additional losses as they have already taken.

How can this possibly be good news? Look at the damage the financial system has sustained in getting this far. We have Countrywide, which should be permitted to fail, surviving solely by virtue of the pending Bank of America acquisition, Wamu rumored to be on the hunt for cash, Bear Stearns allegedly at risk of going belly up, and Citigroup in wobbly shape.

And due to the damage they’ve sustained thus far, they are contracting their balance sheets, with catastrophic knock-on effects. The auction rate securities crisis, which has wreaked havoc with many a municipality’s budget, was a direct result of bank writedowns. They have neither the capacity nor the willingness to take much in the way of gambles these days.

Consider additional collateral damage thus far. Banks have cut way way back on writing mortgages. Home buyers with good credit are reportedly having trouble getting a loan. The disruption in the credit default swaps market means that highly-rated borrowers are facing relatively high costs of funding. Banks have increased margin requirements for hedge funds, which puts the highly leveraged ones on perilous footing.

And this happened even thought the large banks and investment banks had considerable success in replenishing their capital thanks to cooperative sovereign wealth funds.

So we are already at the point where the losses are painful. But the next wave of losses will allegedly be concentrated not at the center of the financial system, but among players that are supposedly more peripheral.

Don’t count on that assumption. The losses to AIG and the monolines thus far have led to a reduction in CDS writing capacaity (the protection writer is the one who takes the risk of default). With a big demand/supply imbalance, CDS spreads are skyrocketing, which is making it costly for even AAA borrowers like GE to issue bonds. Hedge funds are the second most important class of CDS writer (I’ve seen estimates that they provide over 37% of the protection). Hedge fund losses might not only lead to ever further imbalances in CDS prices; if any hedge funds who wrote protection were to fail, it could lead to panic about counterparty risk in the CDS market, and to cascading losses, as positions once thought to be hedged were revealed not to be as one side of the trade turned out to have failed.

Similarly, S&P blandly comments that the monolines will take further hits, but does not acknowledge that they could be downgraded. I’ve seen another presentation by a hedge fund that is short the monolines (not Pershing this time), and it makes a persuasive case that we are early in the housing mess; the peak in defaults is probably more that a year away, and we wont’ know the loss severities until we are further along in this process (we are so far outside any historical pattern as to make estimating difficult). And witness LTCM, a large hedge fund failure (or a series of medium sized ones that add up to similar numbers) has the potential to inflict considerable damage on its bank creditors.

More disturbing, the presentation goes through some of the CDOs that the monolines own (that list was provided by Ackman). It takes one as an illustration, and peels the onion to demonstrate that the losses in some of the layers have gotten to be great enough that it is a certainty that Ambac will have to pay out. Yet Ambac has taken no reserves against this deal. I suspect this is the issue that led Dinallo to decide that there might be something to what Ackman was saying and get on the bond insurers’ case.

So I am skeptical that losses will be neatly contained to hedge funds and insurers. Any additional losses to the big financial intermediaries will result in proportionately much greater pain. Why? First, capital to fill in the holes created by losses will be much harder to come by. The sovereign wealth funds have already indicated privately that they aren’t terribly interested in stumping up more cash, given the losses they’ve taken already. The next round will come with considerable dilution, and if domestic players cannot fill the gap, the Federal government many have to do a lot of pleading overseas on the banks’ behalf.

And if the replacement capital does not come quickly, the financial firms will have to shrink their balance sheets proportionately more than they did the first time.

Second, we’ve already passed the point at which the banks are merely undoing excesses of the boom; they are now reducing intermediation and credit capacities that customers find important for their own well being. Further losses will lead them to cut further into muscle, to the detriment of the real economy.

Third, these losses come when the banks are now being hit on other fronts: leveraged loan losses, commercial real estate writedowns, possible losses from hedge fund failures and credit default swaps dislocations.

Separately, I suspect S&P’s estimate will be proven wrong. A meaningful proportion of subprime loans are well outside any historical precedent, in terms of how weak the borrower was and how little equity was put down. And we have no data on what loss severity is like in a falling home price environment.

And S&P has been complicit, ever favoring the issuers over the investors. Its conduct with the monolines was shameful. Depite its fanfare of reviewing and downgrading CDOs, it has failed to re-rate many AAA tranches (where the vast majority of the value of a deal lies) even in the face of evidence that the instruments now fail to meet the published standards. And noter they have stayed completely away from re-rating the CDOs in the Markit ABX index, even though some of those are on the dodgy list.

Moreover, this report comes suspiciously close to earnings reporting season. Starting with the third quarter last year, the market has taken false comfort that each time, the banks were taking writedowns deep enough to put their problems behind them. Given the possibility that investors might have wised up by now, S&Ps, reassurance is no doubt very handy.

This crisis is far from its peak. The high month for subprime resets is August, and they continue at a high level for the balance of 2008. Default increase sharply after resets, and foreclosures average 15 months after default. The worst will come mid 2009 or even later, which is a long way away. I am not certain that the market has discounted how bad things might get.

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  1. James I. Hymas

    S&P says they will take another $135 billion.

    No it doesn’t. S&P says Standard & Poor’s Ratings Services believes that the bulk of the write-downs of subprime securities may be behind the banks and brokers that have already announced their results for full-year 2007. There may be some additional marks to market as market indicators have shown deterioration in the first quarter. However, when we dissect the percentage of write-downs taken against various types of exposures, in our opinion the magnitude of some write-downs is greater than any reasonable estimate of ultimate losses….
    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

  2. Yves Smith


    I’ll rejigger the post, although their earlier $265 billion estimate was for banks, although they thought it would be distributed more among the smaller banks.

    Losses to insurers and believe it or not, hedge fund, are also losses to intermediation capacity. Hedge funds have been the second-biggest writers of CDS. Lack of protection writers is the big reason that market is out of whack. And if the monolines are damaged badly enough (which I believe is a certainty), it will lead to further losses at the big banks.

  3. Anonymous

    S&P did a great job in “calling” the subprime meltdown and the spilover — even as they remained in denial for the past 6 months (not including the 5 year bubble) thus, I’d say this is a heck of a great call going forward!

    S&P also did a great job of calling Enron’s top and bottom and they continue to have a fine track record for playing these bets which are based on models that remain as valuable as discarded lotto stubs. Three cheers for S&P and the very best of luck on this call, even though it seems a few hundred billion short of reality!! Hi hip hooray!

  4. Francois



    Aren’t these folks the same dangerously dimwitted dudes that downgraded Pfizer to AA and kept Ambac at AAA despite Pfizer pristine balance sheet and Ambac unmitigated disaster? Hmmmm?

    Banks don’t want to lend to each other because they can’t know for certain how toxic are their holdings but S&P does know? Far out man!

    And the “market” choose to believe these clowns?

    That is indeed very good news. Time to short the hell of the market part II.

  5. Anonymous

    I am not an economist or mortgage banker, and have just been following the sub-prime/credit market debacle on this site out of recreational interest you might say.

    But it seems to me, the fraud and professional incompetence surrounding this entire affair is mind-boggling to say the least.

    I’ve got to ask. How can some of these so-called mortgage banking professionals be so confident in projecting the future depth and scope of what remains ahead as far as booking the present value of estimated defaults? Isn’t it a little late in they game for them to demonstrate their extraordinary mastery of the credit markets?

    Or to put it another way, just how much confidence do they think “john q. public” should place in the rating agencies’, bond insurers’, and mortgage bankers’ opinions and projections of future defaults, in light of our current crisis?

    This goes ditto for the regulators and auditors too.

  6. Anonymous

    So that’s what Baghdad Bob’s been doing since 2003 — writing commentary and analysis for S&P.

  7. Jay

    If the majority of additional subprime losses is taken by hedge funds, wouldn’t that me even more destabilizing, since hedgefunds:

    -have no access to a last-resort-lender;
    -have high leverage.

    And who funds these funds:
    -investment banks.
    With what collateral:
    -subprime paper perhaps?

    So who will be stuck with this paper and bad loans, if hedge funds fail: investment banks.

  8. firsttopanic

    Your writing skill and knowledge is awesome. I wish I can write as well as you do.

    Keep up the good work.


  9. Ivan Kitov

    ANy time is good to test quantitative predictions against observations. More important is to assure quantmodels to be more useful than judgements. The latter usually fill all possible spectrum of predcitions. In this case S&P against naked capitalism (and many others). I am on the side of S&P with my model for SP500 returns

    Several months to wait, although.

  10. Max

    The latter usually fill all possible spectrum of predcitions.

    On the other hand, the quant models are usually complacent and fill only one line of the spectrum. Many angels will fall because all of them bet in the past that (a) real estate always goes up, and (b) low risk-premium environment will stay here forever.

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