Wednesday, October 10, 2007

Another sleight of hand

It is interesting to glean the global financial news daily from various sources on the web and how the media present the numbers to their target audience on satellite TV.

The concerned central bankers of UK and Europe fire off warnings about the risk of inflation, huge budget deficits of the US and the great trade surplus of China, the turmoil created by the US subprime mortgage crisis and related derivatives (collateralized debt obligations), the subsequent credit crunch which are still simmering to date, while being pressurized by their respective governments and the US Fed recent easing of its monetary policy to reduce their respective banks’ lending interest rates. So far the professionalism shown by the UK, the European and the Japanese Central Banks is still holding. For how long more is anyone’s guess.

Gleaning from the financial news reports over the past few weeks, one found the desired information. The US mortgage market amounts to 16 trillion US dollars.

The recent write offs by the high street banks and the investment banks amounted to USD 20 Billion – big losses, but they only represent a miniscule 0.125% of the US mortgage market. The write offs include losses arising from mortgage loan defaults, related CDOs and financing leveraged buyouts. What remained hidden were these banks’ exposure and how the provisions or write offs were made – meaning the adequacy of the write offs or the provisions. Since we read daily of the fall in the US house prices, house repossessions, and the high defaults in subprime loans.

What may interest readers could be how the global banks and investment banks provide for the write offs. According to a news article on the web this is what they do:

‘Banks this year classified securities on their balance sheets into three groups.

Level 1 the most liquid, or mark-to-market level.

Level 2 or mark-to-model, the next level, includes collateralized debt obligations (CDOs) and other securities that trade rarely and require computer models to value.

Level 3 – the most illiquid of the group, includes investments in private equity, mortgage servicing rights and other assets that have no apparent market value. Because it is difficult to value and understand, they have been dubbed “mark-to-make believe”.’

Since the advent of the defaults in subprime loans and the consequent fear of high risk bets, the previous huge appetite for CDOs, other derivatives and junk bonds including the financing of leveraged buyouts have quickly dried up. Therefore their trade is almost non existent, which explains the recent credit crunch.

Provisions for Level 1 debts would be adequate as they are marked-to-market. But provisions for the other two levels – the ‘mark-to-model’ and the ‘mark-to-make believe’ is suspect. Why?

When it is marked-to-model, we do not need a financial or computer whiz to tell that any twitching to a model can yield better numbers. Since the Level 3 debts are marked-to-make believe, only those who want to be willingly misled will buy these debts. The global banks probably know it too well to fall for these two levels of debts which probably explained why they desist from inter-bank lending.

With a 16 trillion dollars US mortgage market, it would be made believed that a total write off of USD 20 billion by high street and investment banks is near sufficient or prudent.

It paints a rosy picture that the subprime loans and related CDOs have been mostly hived off to the ‘old fools’ banks in Europe and elsewhere – remember the recent USD 20 billion bailout of a German state bank? I have my doubts because of the huge amount of outstanding subprime mortgages and their doubling or threefold value in CDOs repackaging.

The Asian moms and pops – mainly from South Korea and Japan – are probably punting the US stock markets and the Yen Carry trades like there is no tomorrow. Otherwise it is difficult to understand why when these banks announced losses or much lower profits warnings, their share prices go up, while the value of the Yen keeps falling. Probably the punters have long forgotten about the Information Technology bubble of seven years ago where many Korean day traders, via their fast broadband networks, were burnt when the IT bubble burst. So did a few big hedge funds. Hard core gamblers seldom learn or listen.

All this while, according to news reports, the large institutional investors are particularly risk adverse and have been staying on the sidelines guarding their trillions of dollars. Perhaps these investors and the European central banks know something that small fries like us do not?

Meanwhile the ‘sleight of hand’ goes up another notch. Gloss.

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