Tuesday, September 23, 2008

How to minimise RMBS writedowns?

Perception of mortgage risk differs in all countries. Between the US and Europe there is the major difference in that in the US a borrower finding that the house is worth less than the mortgage may choose to walk away and the only redress by the lender is to repossess and sell at or below the market value, while in Europe the balance of the loan continues to stick to the borrower; borrowers cannot hand in the keys and walk away.
There are other variations among European countries to do with the rights of protection of borrowers and tenants in their own homes. There are also some similar rights that can vary among US states. This is one reaon why bundling up mortgage loans from different jurisdictions into asset backed bonds is a mistake.
The FT’s LEX state that a “house insured for more than its value is always considered a fire risk. But home insurance is regulated and arson is a criminal offence. That keeps most people honest, most of the time. The same cannot be said of the credit default swap industry. The private, over-the-counter market allowing two parties to bet on the likelihood of a company defaulting on its debt had, by the end of 2007, grown to at least $62,000bn in notional amounts insured – more than all the credit outstanding worldwide. Contracts, however, are registered nowhere but in the books of the partners. Nobody really knows the real volume of trading, the method(s) of prices discovery or, in President George W. Bush’s phrase, the “interlinks” of risk. CDS, of course, cannot be blamed for the excessive leverage in the system, or for the lack of visibility into the quality of credits bundled up into complex structured products. But the pressure to hedge has led the most liquid contracts to overshoot, in effect pricing in absurd default risks and recovery rates. These same prices are then used as supposedly objective indicators to value the securities the CDS contracts were designed to hedge – hence the spiral of over-hedging and overstated marked-to-market losses. David Paterson, governor of New York, seems convinced that bringing parts of the sector under the control of insurance supervisors will make things better. He is wrong – dealers could easily circumvent the requirement to hold an insurance licence by trading from a different jurisdiction. The priority, rather, should be to move trades on to already regulated exchanges. That would mean buyers and sellers of protection were matched more efficiently and transparently. A central clearing house would reduce counterparty risk and enforce bigger margin requirements. This would also price out some of the chancers. Standardising decades-long bespoke contracts would not be easy. But the great deleveraging and asset price correction is already painful enough. That this vast, opaque market underpins everything is not helping.”
I agree, but the problem is now global. Most, or about half, of the US retail mortgage backed securitized bonds (RMBS) including the sub-prime paper has been sold to foreign investors. There is some curiosity and concern about how these are valued in Europe and Asia leading to the question why European and Asian financial firms are not declaring similar writedowns as banks and others in the US? The answer is probably similar in both regions, though I suspect that in Asia the hiding of losses may be more entrenched and less complex than in Europe.
European banks issued RMBS etc. primarily in countries with a credit boom economy (UK, Ireland, Spain, Holland, Denmark, Greece). UK banks issued never less than 50% of all of Europe and Ireland about 5-10%. When they also bought securitized US RMBS for trading or investment (prime and sub-prime) it was senior tranches that do not have to bear first loss provisions. Some UK banks via their US branches had major roles e.g. RBS Greenwich Capital underwrote about $1tn in bottom feeding quality ABS. Lloyds TSB financed US SPE conduits. Small players bought low grade ABS e.g. Bradford & Bingley in a 3 year deal with GE Capital.
There are various options to comply with accounting treatment and regulatory pressure to bring off balance sheet exposures on balance sheet and/or from trading book to banking book:
1. deem toxic assets to be held to maturity, therefore no longer for sale at any time (note that maturity on CDS may be quite a short period e.g. up to 90 days) and either keeping them in the trading book with a fair value valuation, or transferring to the banking book for a combination of historical book plus cash-flow forecasts, and only writing down in proportion to any fall in interest.
2. re-class writedowns as adjustments for market turbulence and reduce writedowns by maintaining a high expectation of collateral and CDS cover e.g. some banks that have not managed to process collateral in their risk accounting!
3. apply fair value based on internal models and discount market prices in view of the markets perceived inefficiency, disorderliness, subjectivity etc. and do not adjust speedily when ratings agencies issue downgtrades. Note that some banks’ accounting systems are incompetent in adjusting for monoline insurers’ risk gradings!
4. put toxic assets into clients' investment funds e.g. BNP Paribas and UBS, which are not then written down against the banks’ own capital.
5. gaming on valuation dates and fudging what is “exposure” and what is “writedown” e.g. Bayerische Landesbank (with €40bn exposure and €1.8bn writedown at Dec 31 accidentally reported the writedown as the exposure in April ‘08).
The banks are less afraid of their regulators than US banks are of the Fed and SEC. European banks would also be more sensitive to the pricing of their toxic assets if they were offering these to the central banks as collateral to the extent that this is happening in the US and the UK. ECB and continental central bank liquidity injections are straight into the money markets.
The questions about whether regulation and accounting rules on the Continent force companies to accurately and fully disclose enough are valid concerns and possibly one reason why the IASB is insisting on marking to market. But the market is OTC and informal like syndicated loans. Purchases of sub-prime or other toxic ABS and CDOs have been treated by banks like syndicated corporate loans.
They are valued, but not priced. There are market prices that could be used as benchmarks, but in reality, given the variety of conduit contracts and standards and legal issue disputes, they treat these as unique valuations not necessarily applying to their holdings. UBS came clean earliest for several reasons to do with internal politics and other serious reputational risk issues facing the bank in the USA.
While regulators in the United States are examining the balance sheets of Wall Street securities firms to check they are not hiding subprime-related losses, regulators in Europe are far more concerned with Basel II ICAAP audits. And when they find discrepancies they give the banks 6 months to a year to find the right answers – or they will face financial penalties and higher reserve requirements, which is preferable for some compared to coming clean on writedowns. Banks are keen to say they have no “direct exposure” to US sub-prime assets and will not re-price their non-US RMBS according to US sub-prime valuations.
BNP Paribas suspended investors’ ability to remove money from three funds that had invested in American mortgage securities saying in March ’08, “We aim to ensure that there is equal treatment of investors, and have sought assurances from banks that any suspension of funds (interest or first loss provisions?) will only be provisional.”
Some European regulators refuse to comment or make statements on the subject when market confidence is very volatile. In general, there is a failure insofar as there is no official source for knowing how much in US sub-prime assets were purchased by foreigners, not just in Europe but perhaps more importantly in Asia? Probably more was sold to foreign investors than is currently held in the USA.
Most European banks and insurance companies have in their quarterly earnings reports told investors that their exposure to US sub-prime assets and vehicles is very low or immaterial (from a Basel II reporting aspect). But, investors are not convinced by these assurances, hence, for example, the steep falls in Irish banks’ shares, and especially after the failure of IKB Deutsche Industriebank. It disclosed subprime writedowns and was bailed out with government-backing just days after the bank said it is unaffected by US mortgage losses.
European banks with important US subsidiaries are most likely to come clean on writedowns. Accounting standards, which are similar to those in the United States, started to apply in 2005 but rules and enforcement can vary. The rules do identify direct or indirect investments in subprime lending and when held via a fund or CDOs, there is even less transparency. Companies are obliged to disclose total assets under management and the revenue they generate from managing them, but additional information, for instance what the funds invest in, needs to be supplied only to the investors of those funds, not to shareholders. Investment fundss are “off-balance sheet,” meaning the risk of losses at an investment fund lies with its investors and not with the financial firms managing it.
The challenge in the accounting is measuring the values of assets and liabilities under stress, and this is the subject of IFRS-7. But, European banks are only in early stages of fully complying with the complex treatment required. They almost all have intractable problems in designing and implementing economic capital models and relating these to credit and economic cycles.
Public disclosures required by current regulation is in Pillar II of Basel II, but the prescription is more principle than rule-based. Some banks do report “extreme stress tests” on portfolios as part of earnings presentations, e.g. KBC Group, Belgium’s second-biggest financial firm after Fortis reports. But, in most cases the extreme tests are not nearly extreme enough. Recession scenarios, if fully modeled would wipe out the majority of banks’ regulatory capital. Instead, they tend to apply only moderate stress values taken directly from central bank examples that were worked in the years before the current credit crunch.
In the case of German Banks, S&P states “we consider that credit risk in the German banking sector from U.S. subprime mortgage exposures is limited as it is generally concentrated in the 'AAA' and 'AA' rated tranches and we consider the potential market valuation effects to be manageable.” This view is caveated by the fact that many German banks do not yet apply IFRS and that German banks will report regulatory capital ratios under Basel II only in 2008 when potential negative impact on Tier 1 capital would be mitigated by a reduced level of RWA, and that accuracy in the EU is only required by the CRD in 2008 to be 90% of all assets. In fact, even when it is less than this, banks merely obtain more time from regulators to do better! S&P estimated sub-prime exposure to be less than 20% of German banks’ Tier 1 capital. Dresdner’s, via its London branch, was proportionately the largest, one reason why it was taken over by, or consolidated into, Allianz's Commerzbank.
German banks’ exposure to US sub-prime assets and conduits is at least €200bn, but they are claimed to be all AAA, AA+ or AA-? In the EU as a whole the gross figure would be at least $2tn or more than double all banks’ regulatory Tier 1 capital. Banks, some banks, may place their toxic assets into a so-called revaluation reserve, or if for some reason their general ledger or risk accounting system cannot cope with the precise accounting definitions required, the toxic assets may be lost in a general estimate of gaps and corrections. This is virtual or gap-estimated accounting for securities for which valuation losses are considered temporary and short term recoverable, or medium term recoverable if deemed to be held to maturity. Although the risks associated with the investments placed into this reserve are confirmed, and may be covered by a CP or loan reserve, they do not affect the bank's results. But, all items in this quasi-separate account must be sold or properly written off within a year. If these investments are virtually unmarketable a write-off will happen and a concomitant reduction in profits, but maybe not for another year? The truth is that many banks use trading book and front office accounting tricks to roll over and conceal losses, which it is hoped can be worked through in time?

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