Saturday, August 18, 2007

The REALLY Troublesome Thing about the Subprime Mess

According to data form the Office of the Comptroller of the Currency (OCC), there was $10 trillion in outstanding mortgage debt at the end of 2006. Of this, subprime loans accounted for $1.4 trillion. Of that amount, about $1.08 trillion was packaged into securities that, according to the OCC, are not being held by banks, thrifts, credit unions or finance companies. Which means that $1.08 trillion in securitized subprime loan exposure is out there somewhere, on the balance sheets of hedge funds, mutual funds, insurance companies, investment banks, residential mortgage REITs, pension funds and God knows where else.

All of those mortgage-backed securities are being carried on their owners’ balance sheet at valuations based on some accounting convention. If current marketplace conditions persist, the relation between those balance sheet valuations and the actual realizable value of these assets could prove to be highly strained. For any company forced to sell those assets because of liquidity constraints (such as, for example, for a hedge fund or mutual fund, a heightened rate of redemptions), the amount realized could be far different than the current balance sheet valuation.

Even companies facing no immediate liquidation pressure face scrutiny, disclosure challenges, and potential turbulence in the financial marketplace. The sequence of events this past week involving Scottish Re Group illustrates just how volatile current circumstances are for any company holding material amounts of subprime mortgage-backed securities. In connection with its quarterly earnings release (here), Scottish Re provided information relating to its investment holdings in mortgage-backed securities. In supplemental disclosures (here) detailing its mortgage-backed securities investments, Scottish Re disclosed that within its $11 billion investment portfolio (amortized cost valuation), it holds subprime asset backed securities valued at $2.1 billion (about 19.1% of its investment assets) and another $1 billion (or 9.3% of investment assets) in Alt-A loans. (Alt-A loans are designed for borrowers with cleaner credit records, but with other issues that mean the borrowers provided fewer documents.)

In its quarterly earnings release, the company said that the market for these mortgage-backed securities has become “increasingly illiquid and unbalanced with an absence of buyers, causing prices to be well below what we and our third-party managers regard as their true fundamental value.” The financial market’s reaction to the disclosure of the company’s mortgage investment risk was sharp and harsh – the company’s share price dropped 28% in one day. (On Friday, the company's share price did recover 9.45%.)

So – if there are $1.08 trillion in mortgage backed securities out there, there are numerous other entities whose balance sheets, like that of Scottish Re, carry a substantial mortgage investment risk. A senior official at one of the federal regulatory agencies told me that the process of trying to figure out where that risk is like a “very complicated game of ‘Where’s Waldo?’.” There will be other companies making other disclosures like that of Scottish Re, but there will also be other companies who will quietly bump along, carrying the asset at the acquisition cost and counting on the marketplace for mortgage backed securities to reach some sort of equilibrium before the moment of truth. Either way, there is risk , but those companies that are not forthcoming or that soft-pedal the information face an unknown risk of greater hazards down the road.

These concerns are even more complex than may immediately meet the eye, as the balance sheet valuation issue is not limited to just asset-backed securities themselves. For example, insurance giant American International Group found itself providing extensive explanations (see the August 13. 2007 Wall Street Journal article here) of its exposure to certain kinds of insurance contracts called credit default swaps the company has issued to insure pools of collateralized debt obligations (CDOs) backed by mortgages. AIG apparently has written $465 billion in credit default swaps since 1998, about $64 billion of which is linked to multisector CDOs containing subprime debt. Accounting for these derivative instruments requires AIG to mark these instruments to market. The company says it has not changed the value of these instruments on their books since the first quarter of this year.

The problem for the holders of these securities and derivative investments is that in the final analysis the value of these instruments is linked to the performance of the underlying mortgages. Recent headlines have shown that default rates are rising, but the larger risk is that it will get worse. According to analysts at Bank of America Corp. (refer here), homeowners on about $515 billion in adjustable rate mortgages will pay more this year, and another $680 billion worth of mortgages will reset next year. More than 70 percent of the total was granted to subprime borrowers. As these mortgages reset, and some borrowers are unable to make the higher payments or refinance, the default rate will increase. The valuation of the instruments into which these mortgages are securitized will be affected accordingly.

The dilemma for any entity holding the subprime mortgage-backed or subprime mortgage-linked securities is not just that the current marketplace for these investments is illiquid and unbalanced; it is that the situation could well deteriorate further. This puts an enormous pressure on the balance sheets of any entity that has material exposure to these investments. It also creates an enormous disclosure dilemma -- how much should (or must) a company say about the value at which these assets are carried given the uncertainty in the financial marketplace?

For analysts, investors, D&O insurance underwriters, and anyone else who must assess companies’ accounting and financial risk, all of these concerns create a serious problem. It is relatively easy in this environment to understand that mortgage lenders themselves are facing significant challenges. But the question of which other companies are exposed to mortgage investment risk is far more difficult to discern. The $1.08 trillion in subprime mortgage backed securities is distributed on many other balance sheets. Exposures to derivative investments like AIG’s credit default swaps are also spread around the credit and financial marketplace. All of these financial and credit exposures represent significant imbedded risk. More companies will be making disclosures about their exposure to this risk. But the companies that are not disclosing, or that are soft-pedaling the disclosure, may represent the biggest problem.

That is why the SEC, according to the August 10, 2007 Wall Street Journal (here), is "checking the books at top Wall Street brokerage firms and banks to make sure they aren't hiding losses in the subprime-mortgage meltdown." According to the Journal article, the SEC is looking at "whether Wall Street brokers are using consistent methods to calculate the value of subprime-mortgage assets in their own inventory, as well as assets held for customers such as hedge funds." While the large investment banks are definitely a good place to start, beyond the investment banks there is still a world of asset valuation risk that remains out there --unexamined, beyond scrutiny from outsiders, but fraught with malevolent potential.

And that is what is really troublesome about the subprime mortgage mess.

Because I hate to sound alarmist, and so as to close on a more reassuring note, I should add that on August 17, Fitch’s announced (here) that it had completed a review of the investment holdings of U.S. life insurers and concluded that the “direct exposure” to investments in mortgage backed securities is “relatively limited in the aggregate and largely concentrated in the high investment-grade securities with significant structural protection.” Of course, these securities are called “investment grade” based on the ratings they carry from the rating agencies….
UPDATE: In his August 20, 2007 column in Fortune magazine (here), Fortune columnist and PIMCO founder Bill Gross notes that "the bond and stock market problem is the same one puzzle player confront during a game of 'Where's Waldo' -- Waldo in this case being the bad loans and defaulting subprime paper of the U.S. mortgage market. While market analysts can estimate how many Waldos might actually show their faces over the next few years - $100 billion to $200 billion seems a reasonable estimate -- no one really knows where they are hidden....Many institutions, including pension funds and insurance companies, argue that accounting rules allow them to mark subprime derivatives at cost. Default exposure, therefore, can hibernate for many months before its true value is revealed to investors....Proper disclosure is, in effect, the key to the current crisis...."
This all has a familiar ring to me. Great minds with but a single thought. Apparently Waldo is on a lot of people's minds these days.
Another Subprime Related Securities Lawsuit: Shareholders have filed a purported securities class action lawsuit against IMPAC Mortgage Holdings and certain of its directors and officers (press release here). The complaint relates to "Impac's representations concerning its Alt-A loans are alleged to be patently untrue, with the Alt-A loans actually being sold to less creditworthy borrowers, so that the loan portfolio was experiencing the same risks and discounts in securitization as sub-prime mortgages. At the same time, Impac overstated its financial results by failing to write down the value of its loan portfolio, thus falsely inflating the prices investors paid for Impac securities."
With the addition of the IMPAC Mortgage lawsuit, the number of subprime mortgage-related securities class action lawsuits now stands at 11, according to the running tally of subprime related lawsuits I am maintaining here.


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