Sunday, February 1, 2009

Toxic Assets -- Where's Waldo?

The New York Times has an article discussing just how difficult it can be to value a CDO, which is representative of what the "bad bank" proposal is up against.  
The financial institution that owns the bond calculates the value at 97 cents on the dollar, or a mere 3 percent loss. But S.& P. estimates it is worth 87 cents, based on the current loan-default rate, and could be worth 53 cents under a bleaker situation that contemplates a doubling of defaults. But even that might be optimistic, because the bond traded recently for just 38 cents on the dollar, reflecting the even gloomier outlook of investors.
The bond is backed by 9,000 second mortgages used by borrowers who put down little or no money to buy homes. Nearly a quarter of the loans are delinquent, and losses on defaulted mortgages are averaging 40 percent. The security once had a top rating, triple-A.
The article does a good job picking an asset that is truly difficult to value. Note that no one is saying that normal, whole loans are toxic. They are either good, bad, or somewhere in between -- but everyone understands what they are. The banks segregate non performing loans, and show the provision for loan losses. Everyone thinks these are optimistic, but there is an element of transparency, since it is possible to fairly easily superimpose an alternative judgment. Loan losses lag economic declines, and the reserves will not be adequate until the economy bottoms.

I took a look at the big banks.  We now have 4 -- C, BAC, JPM, and WFC.  Wells is now Wells plus Wachovia.  BAC will include Merrill Lynch and Countrywide.  JPM has hoovered up Bear Stearns and Washington Mutual.  Total assets for these banks is over $7 trillion dollars.  

I pulled figures from the September 10-Q's.  I can't find over $100 billion in toxic assets.  However, they don't make it easy -- and skimming hundreds of pages of dense SEC filings on a laptop screen isn't a great way to really dig in and do a rigorous analysis.  However, this was the general thought process:

1.  C is a basket case and already has guarantees for something like $60 billions in assets.  They are also splitting themselves up into a good bank/bad bank.  They are effectively nationalized and.

2.  BAC also has the guarantees for about the same, based on MER's 4Q blowup.  In addition, MER already wrote down most of their CDO's in 3Q.

3.  JPM says they don't need any money.  Most of the Bear assets have a government guarantee.

4.  WFC also says they don't need any more money or help.  They are showing maybe $20 billion in CDO's.  Both Wells and WB were functioning more like traditional banks, so they don't have all the capital markets residue of the others.

Here is a spreadsheet with some summary data.  It isn't totally consistent, but is roughly correct.  

Major observations -- with $7 trillion in assets, this is a big chunk of the entire banking system.  However, there is only $350 billion in tangible equity backing these assets (mostly excluding preferred stock).  Now some of the assets are cash or government guaranteed securities, and capital ratios exclude that.  Still, there is a lot of goodwill, and not a lot of capital for the assets given the overall uncertainty.

If you exclude C's off balance sheet stuff, there simply isn't the quantity of toxic assets that people are talking about.  Bad assets aren't toxic assets.  The defining quality of toxic assets is uncertainty.  

Excluding  C and JPM, I only found $70 billion.  Some of the $70 aren't toxic, and I am sure that I missed a lot.  If whole loans are excluded, I don't see how anyone could get over $150 billion if you exclude the $120 already hived off in C and BAC.  It simply isn't visible to me.

Someone needs to lay out exactly where these assets are on the balance sheets of these four companies.  Or come up with a different story.  They simply aren't there.    

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