Monday, September 22, 2008

America leads on the back nine

Today, caught reading the FT at a coffee shop, I was asked by a pensioner about the news. But all he wanted to know was who won the Ryder Cup? If the first year of the credit crunch may be called the outward nine, the second year is the back nine, and America is firmly in the lead with its $50bn, $180bn and now plus $700bn stroke-play!
Let's try some back of the fag packet calculations. Mortgage assets in the US are about $12tn at face value. Some commentators say about $3tn is toxic. By this they mean that the returns over the period to maturity will be negative. Why, because there could be up to about 20-25% defaults that translate into gross loss of 50-80% before half of this is recovered through property repossessions and firesales plus other monies recovered net of costs of recovery including lost loan interest (in the periods between loans defaulting and final write-off).
On this rough reckoning the eventual loss over time (finally realised say 2-3 years from now) could be $300bn (compared to current writedowns in the US of about $425-500bn). Some analysts (as reported by the FT)believe that the US Treasury when buying in $700bn of mortgage (and other) assets (including derivatives of these) should achieve a further $500bn discount (via reverse auction or whatever other current npv model valuations). This means buying in about $1.2tn of assets at current book value (at fair value some way above current mark to market value). Assuming these assets have been already discounted by 15-20%, the nominal face value of what may be bought in could be up to about $1.5tn paying a 4-5% interest before management charges (less 10-20% management fees of the underlying assets that will continue to be earned by the originators, banks and mortgage brokers, say $10bn a year).
The sellers of assets to the US Treasury (paid for with Federal bonds) will have to book $500bn in realised losses, but these have mostly been written off already and the loss may be carried forward against tax less the ongoing management fees i.e. about $490bn immediately that moderates slightly over the next few years by about the same as the target LIBOR margin of 2.5%?
The US Treasury has the option to hold the asets to maturity or to sell them off once a system of governance is firmly in place for doing so and the assets have been re-rated and restructured to be standardised (plain vanilla bonds). Assuming that the original risk ratings hold over the full credit cycle, then the US Treasury may be looking at a 90% profit if all assets are held to maturity. It is unlikely that the original risk ratings will hold over the cycle or that even most assets will be held to maturity, but the eventual margin could nevertheless be generously profitable. This was the thinking of the vulture funds (hedge funds and macro funds) that had been hoping to be in the position the US treasury now occupies of buying distressed assets for double digit medium term profit.
There are many contingency issues involved here. The banks have to take a view as to whether it might be better to hold on to the assets longer given that current mark to market values are subjective. Even the ratings agencies' recent downgrades are arguably short termist and subjective. The first consideration of the banks is to complete their economic capital model and how their options as to hold or sell will impact their own risk ratings, and if they hold what they will need to restructure and some forecast of how and when asset revaluations will arrive over the rest of the credit cycle. The writedowns have wiped out about half of banks' own capital, and more than this in those cases where banks' share values dropped steeply. As bank shares recover, the prospect of adding Treasuries to capital reserves will remain attractive for some time. A full recession should require the banks to replace half of their own capital again!
The US Treasury, meanwhile, has made a major commitment that is restoring market confidence. It may take some time to sort out the governance of how the buying in of distressed assets will operate, perhaps 6 months? The assets are now effectively quarantined whether on the banks' books or when sold to the Treasury. A further $160bn or so of writedowns by the banks on toxic mortgage assets of various kinds may now not be required? The mark to market value of these assets hould also marginally improve, though this is subject to whether recession becomes official and is deemed yo be especially deep and persistent or not, a V, U or L-shaped recession? The Treasury by taking its time may save on cash-flow, and if banks restructure their structured products and credit assets efficiently, the amount of " radioactive toxic waste" (The Sunday Times depiction) that is eventiually bought in may turn out to be considerably less than currently allowed for.

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