The Impact of the Securitization Crisis on the Broker/Dealers and the Capital Banks
OECD estimates that the major broker/dealers, and capital banks hold around $750 billion in structured CDOs, or 25% of the $3 trillion market.
To get a sense of the problem, we make a very general estimate of the losses to these firms of subprime mortgages, their derivatives, and loans. We derive our estimate mainly from economic factors, rather than from the behavior of the market.
Subprime Mortgages ($420 billion OECD estimate)
Subprime mortgages are mortgages granted to less than credit worthy borrowers for the purposes of residential purchase or, unfortunately, for speculative residential real estate investment. Such loans typically carry high loan/value ratios > 80% and high borrower debt service/income ratios > 45% 1.
Using 2006 data, the Federal Reserve Bank of San Francisco plots an inverse relationship between changes in house prices and the 60 day mortgage delinquency rate in Figure 1. We extrapolate this data assuming a total negative change in house prices of 10%, this year and next 2, in a moderate recession. We estimate a 2007-2008 delinquency rate on these mortgages to be 35%, compared to 15% as of 7/07. Assuming this 35% delinquency rate equals the foreclosure rate and that the loss on these loans averages 45%, according to the Fed, this implies a 15.8% loan writeoff rate 3. Estimated subprime loan losses at the ten largest banks and broker/dealers will total $66 billion this year and the next.
This figure is extremely difficult to determine, even by the owners of these portfolios. The ABX index is a major subprime derivative. We simply assume, from a Deutsche Bank estimate, that derivative writeoffs will be 60% of subprime losses, or $40 billion 4.
Leveraged Loans ($330 billion OECD estimate)
A leveraged loan is a bank loan that has a 5-8 year maturity, and a below investment grade rating. Emery and Cantor (2005) estimated that the three year cumulative default rate for these loans (historical experience is probably somewhat more relevant for these loans, than for subprime mortgages), was 17.3%. There was a 41% loss on loans in a recessionary environment once there has been a default. This implies a 7.1% loan writeoff rate 5, or in this case, $24 billion in loan losses. The banks are reducing the outstanding amount of these loans, and bringing them onto their balance sheets. The losses will remain regardless.
Assuming a 10% drop in home prices and a moderate recession, the total writeoff of these assets could be $130 billion, or 24% of the industry’s $550 billion book capital in August, 2007.
1 That fact alone should have set off all sorts of warning bells. The financial engineers did not look at the underlying risks to the mortgage cash flows.
2 During the Great Depression of the 1930s, housing prices fell 30%.
3 There are about $1.2 trillion in subprime mortgages outstanding. This writeoff rate results in a calculated loss of $190 billion, slightly below the $200 billion generally estimated.
4 Our average industry subprime writeoff estimate, including derivatives, is 26.2%.
As of 1/08, Merrill Lynch has announced total third and fourth quarter writeoffs of $19.6 billion against $42.7 billion of direct subprime loans, structured CDOs, and their associated derivatives - a 46% writeoff. This totaled more than 43% of the firm’s $45 billion in Tier 1 capital (August, 07), capital that it had raised and accumulated since its founding in 1915.
Curious readers might find out what happened to the riskiest ABX-BBB- 07-1 derivative index, that tracks the values of specific subprime mortgage tranches.
When buying the stock of a financial company, you are buying into its credit or investment culture. Since these companies are typically leveraged 10 or 20:1, a slippage in credit standards can quickly result in massive losses. What would have prevented this debacle was some skepticism: at the underwriters, at the credit rating agencies, and by investors.
5 In the Journal of Banking and Finance 29 (2005), Emery and Cantor estimate that loans to speculative borrowers had a 17.3% cumulative three year default rate between 1995 and 2005. The 41% capital writeoff factor (Emery and Cantor, Moody’s 2006 Syndicated Bank Loan Default Review) was the factor in January of 2003, after the last recession. We therefore assume a 7.1% loan writeoff rate; the realized figure will probably be greater.