“The problem with designing something completely foolproof is to underestimate the ingenuity of a complete fool.”

I could never get my FDIC supervisors to listen to my suggestion that we begin tracking in 2007 the credit default swap index to detect any sign of problems in the subprime mortgage market. They never thought it would be a worthwhile exercise. The rest is history.

From: Haskins, Dwight J.
Sent: Friday, August 21, 2009 5:55 PM
To: Corston, John H.; Hirsch, Pete D.
Subject: Genesis of the crisis as it related to a little known LIDI suggestion

Most economists agree that the financial crisis began right around July 2007. It so happens that I was following the ABX securities on a routine basis back then. Not long after the crisis got going, I suggested that “the index be one more data element worth tracking in the LIDI (large insured depository institutions) database and LIDI Dashboard.” As I stated in October 2007, “I thought the ABX swap index was the best barometer we had to project loss exposure in subprime loan portfolios.”

It turns out this would have been a good practice to have adopted to get a good perspective on rising risks confronting the industry. Yes, the fall began with subprime assets but as we see today, the prime loans are now a big problem with one of eight mortgage loans delinquent. And as it turned out the derivatives contracts written by AIG, Lehman Brothers and Bear Stearns led to their eventual collapse due to the liquidity squeeze brought about by uncertainty of collateral values. As current prices stand today on the AAA ABX-HE and BBB ABX-HE, an investor would have lost 72% and 97% of their investment if purchased at origination back in mid-2007 and sold today.

As I pointed out in my other analyses, significant unrealized losses on financial assets remain today with several of the largest banks, with fair values below book balances buried in the financial statement footnotes.

One can see more clearly the genesis of the financial crisis by going to Securitized Banking and the Run on Repo, where Gorton and Metrick (what a great economist name) go over the basic idea of how repo haircuts relate to a bank run. The economists note the crisis started in July 2007, just when several AAA ABX-HE (subprime housing) tranches started trading below par. At that point people realized these assets were not merely a normal bump in default rates, because anytime a large AAA CDO trades below par, you basically have a catastrophe alert. The failure of informationally insensitive assets caused every informationally insensitive asset to trade as if a junk bond. At about that time beginning in July 2007, investors changed from taking any AAA rated securities as a given, to going over all the things that could go wrong, by using the minimax principle, which generated really low prices.

So, when the AAA subprime securities went bad, all AAA ABS was suspect, haircuts rose, and through the mechanism described by Gorton, a reduction in the monetary base occurred similar to as if customers withdrew deposits from a bank. A modern bank run via repo haircuts occurred. The paper identifies the hit due to increases in repo haircuts. Another key factor was changes to the funding spread. The business model of many structured finance vehicles, including SIVs depended on a stable LIBOR rate, otherwise it wasn’t safe to lever up the AAA securities. Once LIBOR started going wild, the funding costs for the SIVs exceeded the coupons on their investments, so the business model was unsustainable, and investors stopped supporting the SIVs, the real Achilles heal of investment banks such as Citigroup, JP Morgan and Bank of America. As it were, both sides of the balance sheet were squeezed.

Combine this situation in the financial crisis where the margin spiral was declining with the fact that banks were shedding assets, often at fire-sale prices, and that they were hoarding liquidity out of fear of a run, you had all the makings of a catastrophe in the making. Liquidity was squeezed as it was necessary to stop the run and assets were being shed either to window dress the balance sheet and enable the large banks to claim that they had no asset-backed securities, or because they were trying to stay above the run threshold and away from the thundering (selling) herd.

Dwight

From: Haskins, Dwight J.
Sent: Thursday, October 25, 2007 2:51 PM
To: Corston, John H.; Hirsch, Pete D.
Subject: More Data showing CDO and Subprime Exposure probably resides in Other Large Banks

John/Pete, I should have had this bit of news when I sent you the email earlier. Here’s a bit more context why the ABX swaps appear to likely show fairly significant declines in subprime mortgage values subsequent to September 30. Banks had to cut-off valuations naturally on Sept 27, 28 at the latest to make their 3Q financial statement deadlines. Values have declined significantly since September 30. My take is some 20 to 30% decline since the end of September so obviously there is little investor interest in this segment which could worsen any credit crunch for subprime borrowers. Also, Merrill Lynch and other large banks must still be sitting on losses for the fourth quarter. I think the ABX swap index is the best barometer we have to project loss exposure in subprime loan portfolios.

It is one more data element worth tracking in the LIDI database and LIDI Dashboard.

October 23, 2007

Housing Derivatives – ABX Subprime Mortgage Index 07-1 Series Making Steepest Decline

The ABX Index is a series of credit-default swaps based on 20 bonds that consist of subprime mortgages. ABX contracts are commonly used by investors to speculate on or to hedge against the risk that the underling mortgage securities are not repaid as expected. The ABX swaps offer protection if the securities are not repaid as expected, in return for regular insurance-like premiums. A decline in the ABX Index signifies investor sentiment that subprime mortgage holders will suffer increased financial losses from those investments. Likewise, an increase in the ABX Index signifies investor sentiment looking for subprime mortgage holdings to perform better as investments.

So far this week, the 07-1 series is settling its trading on its lifetime lows for all but the AAA tranche. The BBB and BBB- tranches are about to break the 20% level. The 07-1 tranche cover 20 subprime mortgage bonds issued in the second half of 2006, coinciding with the high in the national real estate market. Source: Markit. http://housingderivatives.typepad.com/housing_derivatives/abx_index/index.html

From: Haskins, Dwight J.
Sent: Thursday, October 25, 2007 11:33 AM
To: Corston, John H.; Hirsch, Pete D.
Subject: More CDO and Subprime Exposure probably resides in Other Large Banks

As we can see, it appears that we will need to find a good way to capture analytical commentary by Dedicated Examiners/Case Managers relating in the LIDI Assess Database. We will have to experiment with it and see how best to make it work. It may be tricky to capture embedded charts, as shown below. Below are my comments on Merrill Lynch and why we can expect further earnings problems still coming in the fourth quarter.

It would appear that credit risk management practices let Merrill Lynch down, leading to staggering market losses and loss of confidence by the rating agencies. Getting a handle on losses has to be extremely difficult as shown by the rapid deceleration in market values the past 30 days (see chart). Therefore, it is likely that more losses are headed for fourth quarter earnings.

• Merrill Lynch missed Earnings Estimates reporting $2.3 billion in losses due to CDO/Subprime Exposure
• Write-downs for CDOs and subprime were staggering $7.9 billion, +75% worse than estimates
• Shows dependence on structured products and importance of Risk Culture
• S&P, Moody’s and Fitch downgraded to high-A with Negative outlooks

One can use the ABX HE BBB index as a barometer of market valuations for Subprime Mortgages. Note it is currently trading at 25 and is down nearly 30% over the past 30 days so that there should be even more losses in the Subprime and CDO portfolio. Using the Index as proxy, one can anticipate that other large banks likely still have losses in their CDO/Subprime Mortgage security investments to show up during their next quarter’s reported earnings.

The exposure should not be limited to Merrill Lynch, especially when looking at who the constituent parties shows other large bank participants to the Structured Index. Most of the large big banks (Citigroup, JP Morgan, Morgan Stanley, Washington Mutual, Bear Stearns) have securities represented in the Index and thus have exposure.

Dwight

source: LinkedIN

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