Credit Crisis Part Deux: The Noise in the Housing Attic.

June 7, 2008

I think the best way to discuss the “reemergence” of the credit crisis is to remember a childhood story. Remember that time your family was throwing a party and you were concerned about crazy grandma going off on her usual rants? You thought carefully about what you were going to do since you wanted to have a pleasant evening but you also wanted to be cognizant of lovely grandma’s feelings. And suddenly a light bulb ignited over your head with the solution. Lock grandma up in the attic. Sure she wouldn’t be happy for a few hours but the guest will have a great time!

During the evening, the guests hear faint sounds emanating from upstairs. You quickly turn up the music and chatter louder to drown out the noise. The guests slowly ignore the sound yet you can still hear the noise because you know what lurks in the attic. As the guests leave, they are oblivious to the situation and leave with a grand smile on their faces. You run up stairs and open the attic door to be confronted by a furious grandma. This was expected and you knew once the party was over that reality would need to be confronted. Good times.

Well given what is going on with the current credit market, it is safe to say that we’ve locked up our own credit grandma in the attic trying to enjoy the party while ignoring the faint sounds in the background. Grandma not only is angry but has been training in mixed martial arts while being in the attic and is going to open up a can once we let her out on the first unsuspecting soul that opens the door.

Ever since we locked Bear Stearns away in the attic, a collective sigh of relief was heard across all the financial markets. It seemed as if the Fed some how found the panacea to this credit debacle. Unfortunately all it did was prolong the misery that would need to be confronted. If we really want to see what is in the attic let us take a look at some of the Level 2 and Level 3 assets of the largest financial firms:

Level 3 Assets

*Hat tip to Anon Reader

From this list we can see the attic of debt still not accurately being reflect on the balance sheets of many companies. The fact of the matter with the Bear Stearns deal is that essentially this problematic debt was shifted from one institution to another; except it had a back stop by our own Federal Reserve. We saw similar problems hit the BofA and Countrywide deal when BofA mentioned they may not back up some of Countrywide’s debt:

“(Bloomberg) Bank of America Corp., the second- biggest U.S. bank, said it may not guarantee $38.1 billion of Countrywide Financial Corp.’s debt after taking over the mortgage lender, fueling speculation that Countrywide’s bondholders face renewed risk of default.

“There is no assurance that any such debt would be redeemed, assumed or guaranteed,” the Charlotte, North Carolina- based bank said in an April 30 regulatory filing, adding that no decision has been reached….

Countrywide’s $1 billion of 6.25 percent notes maturing in 2016 traded at 90.25 cents on the dollar yesterday with a yield of about 7.9 percent, according to Bloomberg data. The debt traded as low as 46 cents in January, with a yield of 20 percent, just before Bank of America announced the purchase.”

From what we are seeing we can expect to see many of these shotgun weddings in the next year with the unique caveat of firms picking the meat from the carcass while the U.S. Taxpayer is relegated to the role of being a vulture with only bones and guts to devour once the best parts are gone. Either way, the rules from FASB 157 or the fair value measurements is also putting pressure on the market. This is part of where we get the entire mark-to-market idea but there is a slight issue here as well:

“This Statement clarifies that market participant assumptions include assumptions about risk, for example, the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique. A fair value measurement should include an adjustment for risk if market participants would include one in pricing the related asset or liability, even if the adjustment is difficult to determine. Therefore, a measurement (for example, a “mark-to-model” measurement) that does not include an adjustment for risk would not represent a fair value measurement if market participants would include one in pricing the related asset or liability.

This Statement clarifies that market participant assumptions also include assumptions about the effect of a restriction on the sale or use of an asset. A fair value measurement for a restricted asset should consider the effect of the restriction if market participants would consider the effect of the restriction in pricing the asset. That guidance applies for stock with restrictions on sale that terminate within one year that is measured at fair value under FASB Statements No. 115, Accounting for Certain Investments in Debt and Equity Securities, and No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations.”

The problem with using fair market risk assessments or valuation is that these institutions actually have to have an idea of the fair market value of their assets. Are you kidding me? These are the folks that bought up all the asset backed crap and now we want them to accurately asses a Real Home of Genius in East Los Angeles? Well we already know that we are witnessing the steepest housing correction ever, even worse than the Great Depression in terms of its speed of severity. We can only take a wild guess at what is lurking in those off balance sheet accounts but I think we can all hear that faint echo in the attic of what we can expect.

Many experts are expecting $400 to $1 trillion in credit market writedowns before this thing is over. As of April of 2008, we’ve had a total of $231 billion in credit writedowns (a bit higher given the additional writedowns in the past few months). Since people are now liking this thing to a baseball game, I see it more like game 1 of the NBA Finals. We’ve finally narrowed the field from 16 teams to 2. Now we find out that only one can stand and it isn’t going to be debt. Here is the list of writedowns as of April and all figures are in billions:

Firm	Writedown	Credit Loss (a)	Total
UBS	38		38
Merrill Lynch	25.1		25.1
Citigroup	21.4	2.5	23.9
HSBC	3	9.4	12.4
Morgan Stanley	11.7		11.7
IKB Deutsche	9		9
Bank of America	7.3	0.9	8.2
Deutsche Bank	7.4		7.4
Credit Agricole	6.5		6.5
Credit Suisse	6.3		6.3
Washington Mutual	0.3	5.5	5.8
JPMorgan Chase	2.9	2.1	5
Wachovia	2.9	2	4.9
Canadian Imperial (CIBC)	4		4
Societe Generale	3.8		3.8
Mizuho Financial Group	3.4		3.4
Lehman Brothers	3.3		3.3
Barclays	3.2		3.2
Royal Bank of Scotland	3.1		3.1
Goldman Sachs	3		3
Dresdner	2.7		2.7
Bear Stearns	2.6		2.6
ABN Amro	2.4		2.4
Fortis	2.3		2.3
Natixis	1.9		1.9
HSH Nordbank	1.7		1.7
Wells Fargo	0.3	1.4	1.7
BNP Paribas	1.3	0.3	1.6
DZ Bank	1.5		1.5
National City	0.4	1	1.4
Bank of China	1.3		1.3
Bayerische Landesbank	1.3		1.3
Caisse d`Epargne	1.3		1.3
LB Baden-Wuerttemberg	1.3		1.3
Nomura Holdings	1		1
Sumitomo Mitsui	1		1
Gulf International	1		1
European banks not listed above (b)	8.4		8.4
Asian banks not listed above ©	4	0.7	4.7
Canadian banks excluding CIBC (d)	2.4	0.1	2.5
Totals	206	25.8	231.8

So as we look at the amount of off balance sheet debt, the magnitude of the contraction in housing, and finally the faltering impotence of the Fed we now know that reality is setting in for our summer superhero Joe six pack (J6P). We are now seeing the inevitable consequence of locking up grandma U.S. Dollar for too long in the attic; now we are seeing the vengeance on energy prices, money destruction with writedowns, and the overall general malaise in our markets. But fear not! Unemployment and inflation is under perfect control according to government data. Pay no attention to rising fuel, higher grocery bills, ever more expensive healthcare, and a steadily increasing education bill.

Seems like our government has their own method of putting things off the books. If you hear that creaking door sound you may need to look up because grandma debt just got out of the attic and the party is still going on.

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