Summary
There are more write-downs to come. Balance sheets are weak due to capital not being replaced, while new government requirements for underlying capital limit financials’ ability to conduct business as usual. And, is the size of the program sufficient for the amount of toxic assets out there?
Will the bad bank pay enough for the toxic debt?
According to the Paulson plan the new bad bank will not only buy mortgage-related assets, as first expected, but all kinds of “toxic debt” including student loans, consumer credit card debt, car leases and so on. For most of these loans there are no current market prices as trading has dried out and banks are struggling to sell them to shore up their liquidity. At least the new bad bank offers a buyer which will transform illiquid assets into cash – undoubtedly positive for financials. But if the selling price of the debt is below the current book value it could trigger further write-downs.
First indications are the bad bank wants a reverse action where it would only buy the cheapest toxic assets. Any financial carrying a hefty load of toxic assets with liquidity issues will have to offer its debt cheap to be sure the bad bank will buy them. And hence the write-downs…
Beware that the whole Paulson plan is still not approved by the congress.
Weak balance sheets and new capital requirements limit future earnings potential.
According to Bloomberg, financial firms have written down $522 billion and raised new capital of $370 billion since the beginning of the subprime crisis (see the table below). The difference of $152 billion is no longer available as working capital. If we assume a conservative return on capital of 10% to 15%, we are talking about $20 billion of missing company earnings worldwide. Also, increased capital requirements will draw on the financials’ working capital, having a negative leverage effect on margins and earnings.
 Source: Bloomberg
Another point about Bloomberg’s estimated write-downs is the low figure for Asia relative to the amount of investment assets held there. It would be a surprise if some of the world’s biggest investors had not bought any mortgage-related products…
A $700 billion snowball in hell
The value of toxic debt on bank and insurance company balance sheets exceeds the $700 billion in financial resources the new bad bank will have access to. If toxic debt is defined as level 3 assets (no market price - only internal model valuations), the US financials had $500 billion on their balance sheets at the end of June. Add student loans or consumer credit and the possible total debt exceeds the resource available.
This would be exacerbated if recent announcements hold up and foreign companies are allowed to sell to the bad bank if they have a significant part of their business in the US. And it is still not clear if everybody else can sell their problem credits to the bad bank via a US bank as intermediate. Paulson may have invited other governments and central banks to take part in the exercise, but turnout will be muted.
Expectations for global debt that could possibly be sold to the bad bank fluctuate between $1 and $5 trillion. At Saxo, we believe this amount could be up to $2 trillion - or roughly 3-4% of World GDP, mostly emanating from the US.
The concept of the investment bank has failed.
Pure investment banks are the biggest losers. Lehman Brothers is bankrupt; Bear Stearns and Merrill Lynch were forced into takeovers by JPMorgan and Bank of America respectively. The last “surviving investment banks”, Goldman Sachs and Morgan Stanley, have morphed into a normal commercial banks, giving them access to the momentarily all-important cheap liquidity from the Fed. Both banks are likely shore up capital and purchase new assets, with small and medium-sized regional banks being possible targets.
It’s ironic that investment banks were brought to their knees by their own “brilliant ideas”. The repacking of mortgage loans and the excessive short-selling of stocks was invented largely by investment banks – with each owning at least one hedge fund.
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