Shell Game is over this Thursday

Discussion in 'Financial Cents' started by melbo, Nov 12, 2007.

  1. melbo

    melbo Hunter Gatherer Administrator Founding Member

    Thanks MN

    We have heard about sub-prime mortgages; we have heard about collateralised debt obligations (CDOs); we have heard about banks writing down their assets; we have heard about global bankers resigning; we have heard about Northern Rock and the first run on a British bank in 140 years.

    The risk of a worldwide banking crisis – one that is particularly damaging to mortgages, private equity, hedge funds and the banks themselves – is higher than it was a month ago, and the storm is rising.

    This is still an emerging story. It was not until last Wednesday that The Financial Times led on the legal provision that CDOs can be liquidated by the senior holders when they go into default. That could lead to a fire sale of CDOs and still larger defaults.

    Yet this, as important as it could be, is not the biggest threat. Few non-bankers have heard of FAS 157 and 159, yet these are the regulations that will set the terms on which the banks will value their assets. The trouble with FAS 157 and 159 is that they are perfectly reasonable regulations in themselves which could have disastrous, though unintended, consequences.

    What are FAS 157 and 159? They are the new United States (Federal) accounting standards that have been introduced to regulate the valuation of bank assets. These valuations are of crucial importance because they are the basis of all bank lending: no assets, no lending; no lending, no bank. According to an informative article in The Financial Times, the new standards will apply fully from Thursday. Many US banks have adopted them already. All US quoted banks will have to publish asset figures in conformity with FAS 157 by next spring.

    The new rules divide bank assets into three “levels”, according to the freedom with with which they can be bought or sold. Level-one assets, which are easy to value or trade, have to have quoted prices in active markets such as US government bonds or gold bullion. Level two is an intermediate stage; these assets are not as fully marketable as level one, but still sufficiently tradeable to have a definite value.

    Level-three assets – usually artificial financial instruments – are the problem. They do not have quoted prices in active markets. They have to be valued by reference to the bank’s own models. According to the analyst Martin Hutchinson, who had analysed some of the US banks, the holdings of level-three assets are substantial. Lehman has $22 billion; Bear Stearns $20 billion; JP Morgan Chase $60 billion. Even these figures may be understated, since the banks have themselves decided whether assets belong to level three or the more acceptable level two, and they have an interest in placing as little in level three and as much in level two as they reasonably can.

    Martin Hutchinson has also analysed the assets of Goldman Sachs. The bank has disclosed $72 billion of level-three assets, out of total assets of $900 billion. That seems reasonable enough, but it compares with Goldman Sachs’s capital of $36 billion. Any substantial write off of level-three assets would impact on Goldman Sachs net asset value.

    One cannot say that FAS 157 is only an American regulation and the banks of other countries would not therefore be affected. Most global banks already have a listing in the United States that would therefore be subject to US accounting standards. Those that do not will be judged by FAS 157 as the international standard. From now on all major banks will have to declare their assets in the FAS 157 form with its division into different levels by marketability.

    No doubt this is the reform that should have been introduced years ago; that would have saved a great deal of agony and some abuse. But FAS 157 is coming into effect at a most inconvenient time. The sub-prime mortgage defaults have already undermined confidence in mortgage banked securities. These form a significant part – perhaps about a quarter – of all level-three assets. Level three also includes higher-quality mortgages and leveraged bridged loans for buyouts.

    The global banking system now faces the risk of a general flight towards cash and liquid level one assets on a scale that has not been seen since the early 1930s. Already British banks are showing signs of near panic. I hear of London banks going back on recently agreed loans to parties of good credit, presumably on orders from head office.

    There have also been cancellations of offers of credit cards that had already been approved. One need have little sympathy for the US investment banks; they found it profitable to make speculative loans, and now they are paying the price.

    Even if ordinary mortgages do continue to be offered – and they are bound to be restricted – sub-prime mortgages will no longer be available for first-time buyers. Yet the housing market depends on people being able to sell their first houses when they trade up to their second. If all banks are anxious to protect their cash reserves, and to reduce their level-three assets, that will make ordinary borrowing difficult and level-three borrowing impossible. Probably the downturn will spread into stock markets, even though it did not originate in stock market speculation.

    It is far too late to cancel FAS 157 and 159, even if that were desirable. The concept of different levels for bank assets has been introduced to the banking system and the defaults on sub-prime mortgages have lowered the acceptability of all level-three assets. No one knows what they are worth and hardly anyone wants them.

    Commercial banking, with its large customer base, is in better shape than investment banking, but will also be affected. FAS 157 may prove an historic regulatory blunder.
  2. AlterEgo

    AlterEgo Monkey+++

    Good snag melbo. Somehow I missed that one today.

  3. Bear

    Bear Monkey+++ Founding Member Iron Monkey

    This has been brewing but somehow not talked about much... it may hit the markets as soon as this Wednesday....

    Expect the commodities and oil to go down some... maybe alot by some standards... and the market to soar as high as 20000.... then watch out below.... JHMO....

    Party on![beer]
  4. Jonas Parker

    Jonas Parker Hooligan

    Thanks for the good read, Melbo. Somehow I don't feel like I'm on the RMS Titanic anymore. The Titanic stayed afloat for a couple of hours before it sank. I feel like I'm on the Edmund Fitzgerald... it just disappeared from the radar scope with no warning and no survivors...
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