The REALLY Troublesome Thing about the Subprime Mess
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.