Rate Cuts, Trusts, Banks and the Summer of 2001

Lack of Confidence is Clouding Ne= ar-Term Economic Prospects

A year has passed since the subprime crisis hit the world’s financial markets, and yet it continues to roil. Equity marke= ts hit new lows in mid-July 2008 as eddies of fear built on the failure of a regional US bank (Indy Mac) after depositors withdrew $1.3 billion over 11 = days following a senior US Senator’s release to the press on 26 June of a letter he had written to the regulators suggesting that this bank "cou= ld face a collapse". It could not have been but well-known that a large proportion of assets held by many state and regional banks were mortgage assets, some of it surely subprime, and that given the extant conditions, t= hese banks had to be under pressure. Finger pointing in such a situation is downright dangerous. The acuteness of the US subprime credit problem appear= s to have been accentuated by the curious reactions of the regulators. Would it = be unreasonable to expect that a regulator would step in when there was a run = on the bank? Especially when it would appear that a public charge from a senior law maker set off the run? How many banks, in such gloomy conditions, would= in any case, survive such a sustained withdrawal of deposits?

The manner in which this bank was allowed to fail = has raised serious concerns about the vulnerability of other banks and financial institutions. Recently, Kenneth Rogoff, professor at Harvard and once Chief Economist at the IMF, speaking at a conference in Singapore, was reported by the media to have said that, “We’re not just going to see mid-s= ized banks go under in the next few months, we’re going to see a whopper, we’re going to see a big one – one of the big investment banks = or big banks”. Was it a comment in the tradition of academia of the “possible”, or a warning to the regulators, or more cries of “fire” in a crowded theatre? We do not know. But it was certain= ly reflective of the mood in the market: Very gloomy.

The gloom is at once familiar and new. When the cr= isis broke the initial estimates of total losses were of the order of $ 250 to $= 400 billion. A year later, bar the IMF, most estimates placed it between $ 400 = and $ 500 billion. The IMF has a trillion dollar story, but most informed peopl= e do not take this seriously, suspecting that the Fund, or rather John Lipsky (t= he No. 2), of principally looking for an enlarged role for the IMF. The stability = of the loss estimates (bar again the IMF) should be comforting, for it would suggest that things have not got worse than expected. However, it turns out= that this comfort has little substance and the reason why, is precisely the grou= nd on which the IMF has built its estimates of “aggregate potential loss= es” of $ 945 billion.

On the one side are the individual home loans and = on the other, are the packaged CDO (collateralised debt obligations) and other= paper held by banks, financial institutions, savings funds, insurance companies a= nd other investors. It is impossible for a particular investor to decompose his CDO assets into the underlying individual loans and build up his likely loan loss from the ground up. It is also very hard to figure out what the eventu= al loss can be on subprime loans, since there are few historical yardsticks to= go by, whether on delinquency or recovery rates. The estimation of losses have revolved around using the total of subprime (and Alt-A) issuance and try simulate what the losses would be for a range of values for delinquency and recovery rates, under certain assumptions about home prices.

The problem with this estimation method is that ev= en if it turns out to have been reasonably accurate for the system as a whole, individual CDO assets may perform worse than the average – and nobody knows which ones they may be or who owns them. Further, the assumptions on delinquency and recovery rates may turn out to have been not severe enough.= What are the implications? Big, it turns out. Suppose we adopt an estimate of $ = 500 billion. Now, the total write-downs and reserves set aside, towards subprime losses by banks and financial institutions were estimated in May 2008 to ha= ve been $ 379 billion. Some more losses have been recognised since then, and we can perhaps safely round the number off to $400 billion. Which means at most another $100 billion of losses to be recognised and that may take place over the next 12 to 24 months. However, if we were to start with the IMF’s estimate of $945 billion, the yet unrecognised losses would come to $545 billion.

While, the truth may well lie between the two, it = is an extremely discomfiting thought that maybe half as much of the pain is ye= t to come: Which is what is weighing so heavily on the markets today.=

Some broad numbers recently made available by the = US Federal Reserve provide data on a state-wise list of 5.25 million subprime = and Alt-A loans aggregating $1.2 trillion. Of the sub-prime loans, 58% are stil= l current, 24% overdue and 17% in foreclosure or REO (with the originator after failed foreclosure auction). The total does not include loans that have been successfully foreclosed, the implication being that the “current̶= 1; portion of loans originated is quite a bit lower than 58%. Of the Alt-A loa= ns, a much higher ratio are current at 82%, but the downside is that there is a much larger proportion of interest rate resets yet left, but then again, mo= st of them are 24 months or more into the future.

For the loss to increase towards $1 trillion, about half of the presently current loans have to go bad. Since about half the st= ock of sub-prime loans is already sour, the future losses must come mostly from Alt-A loans. It may be argued that while this is possible, it is not probab= le. There is a view, backed by arcane computations too complex to be narrated here, t= hat argue that losses are being over-estimated, but this is a view which is yet to fi= nd traction. Overall the uncertainty about the extent of losses yet to be foun= d (and where) and the reaction of regulators and other authorities are pinching out the prospects of a recovery in confidence. And without that, broader econom= ic prospects can only remain under a cloud.

(The author is Economic Advisor, ICRA)

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The Economic Times: Friday, August 29, 2008

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