The neighbour was again leaning over the fence to resume our yarn about the debt crisis.
‘Have the banks declared all their mortgage losses to clean out the stable, or is it still piling up,’ said the neighbour.
‘No, there are still more defaults to come. The Goldman Sachs’ banking analyst William Tanona is estimating that Citibank incurred an additional writedown of US$ 18.7 billion for the fourth quarter of 2007. The bank is maintaining silence on the issue.
‘Adding to the problem are two new American financial accounting standards (FAS). These are FAS 157 and FAS 159 relating to valuation of financial assets and liabilities, which came into operation in November 2007. Level one assets are those traded on an international market, and so easily determined.
‘Level two assets aren’t very actively traded, but there is some pricing data available to permit a reasonably reliable estimate of the asset’s value. The devil of the piece is in valuing level three assets, which was formerly estimated by the financial institution
and its auditor. But in the new brave world of revealing everything, level three assets now have to be valued on a mark to market basis, although there is no real market to measure them.
‘Level three assets include CDOs, mortgages, mortgage backed and other asset backed securities, such as credit card and auto loan receivables. These assets will always be in dispute as to what is their real value. In today’s market, all these assets would be severely marked down, worth on a generous valuation 30 cents or less in the dollar.
‘For subprime debt, Alan Abelson who writes the Up and Down Wall Street column in Barron’s reports that E Trade recently sold its entire portfolio of subprime debt at 17 cents in the dollar.
‘The chief credit strategist of RBS, UK’s second largest banking group, Bob Janjuah has described level three assets as “marked to make-believe.”
‘For many banks who were more than enthusiastic in the recent past indulging in a credit binge, with a lot of potentially toxic derivatives, including leveraged loans for private equity groups, and complicated buy back deals with hedge funds and the like, exposure time makes for one hell of a nervous time.
The neighbour said: ‘Don’t tell me there is more. Banks make me nervous at any time, and the fees they slap on are outrageous. But if you need them as I do at the moment, you grin and bear it, much as you mutter sotto voice, the’re daylight robbers.’
‘I can understand your concerns. Well apart from the valuation nightmare, there is the potential blow up in the leveraged corporate debt market. The talented Gillian Tett reported in the Financial Times some worrying details about the coming disaster in leveraged corporate defaults.
‘Last year, the default rate was 1.3 per cent. The Citibank credit assessment is that the default rate will have blown out to 5.5 per cent by January 2009, so that out of $100 of debt, $5.50 will turn sour. The 5.5 per cent is based on no recession occurring in America. As Citibank was itself involved in large quantities of leveraged corporate defaults, the credit analysts would have some knowledge to fall back upon.
‘As recession is already beginning in the States, the default rate will be much higher.
But that’s a story for another day. A news item from Bloomberg (January 3 2008) reports that the Carlyle Group, one of the larger private equity groups is being punished by investors, who have lost heavily by buying high yield high risk loans. It’s now payback time.
‘Creditors are making borrowers from Carlyle’s Life Care Holdings increase the interest on their debt by an average 0.83 percentage point to change the terms of their loans. The penalty rate increase is four times higher than six months ago, and the highest in 10 years according to the rating agency Standard & Poor’s.’
‘Let’s stop now and if you agree, we’ll continue on later,’ said the neighbour.
‘That’s a very good idea,’
