Standard & Poor's Ratings Services believes that the bulk of the write-downs of subprime securities may be behind the banks and brokers that have already announced their results for full-year 2007. There may be some additional marks to market as market indicators have shown deterioration in the first quarter. However, when we dissect the percentage of write-downs taken against various types of exposures, in our opinion the magnitude of some write-downs is greater than any reasonable estimate of ultimate losses.
The write-downs of collateralized debt obligations (CDOs) of subprime asset-backed securities (ABS) by large banks and investment banks (referred to as banks) in North America and Europe to-date total approximately $110 billion. To this amount we add approximately $40 billion in write-downs of insurers (financial guarantors and other insurers) and banks in the Gulf States and Asia to arrive at a rough estimate of $150 billion in global disclosed write-downs to-date.
Most of the write-downs have been on the so-called supersenior tranches of CDOs of subprime ABS. To date, banks have written down their unhedged supersenior CDOs of ABS by more than $65 billion. On an original exposure of about $160 billion, this represents about a 40% discount. However, that discount percentage varies tremendously from institution to institution.
In our view, some of the variation may be based on differences in the specific securities the institution owns, as the securities vary widely in their ultimate loss characteristics. Some of the variables that affect the valuation are whether the exposure was to so-called CDO-squared securities (CDOs that purchased tranches of CDOs) or to the supersenior tranches of high-grade CDOs or mezzanine CDOs; the proportion of the underlying loans that were of 2005 or earlier vintages; how many of the CDOs' investments were in other CDOs and in subprime residential mortgage-backed securities (RMBS); and the levels of subordination in each structure.
Based on available information, we believe that the largest players can be seen as having undertaken a rigorous valuation methodology to come up with conservative valuations. Citigroup Inc. and Merrill Lynch & Co. Inc., for example, value their high-grade supersenior tranches at 52% and 68% discounts to original exposure, respectively. The broader range of banks values them at only a 30% discount. Similarly, Citi and Merrill value the supersenior tranches of the mezzanine CDOs at 63% and 73% discounts, respectively, whereas the broader range of banks values them at a 48% discount.
CDO Discount Valuations Differ
Markdown (%)
High grade
Mezzanine
CDO^2
Total super senior
Bank of America Corp.
19
40
42
33
Barclays Bank PLC
N.A.
N.A.
N.A.
23
Canadian Imperial Bank of Commerce
N.A.
64
100
89
Citigroup Inc.*
52
63
100
34
Credit Agricole S.A.
26
45
N.A.
33
Fortis Bank SA/NV
45
60
N.A.
47
Merrill Lynch & Co. Inc.
68
72
76
70
Morgan Stanley
N.A.
62
50
62
Royal Bank of Scotland Group PLC (incl. ABN AMRO)
16
30
N.A.
20
Societe Generale
36
20
N.A.
26
UBS
28
47
71
42
Total of universal banks (includes banks not listed above)
30
48
56
40
*Excludes data for ABCP conduit exposure to CDOs. N.A.-Not available.
In our view, much, though not all of the differences in valuations may be attributed to differences in vintages of exposures and other deal-specific characteristics. Banks that have taken relatively lighter write-downs on securities often have much higher proportions of 2005 or older vintages of securities. This is true for Societe Generale and Barclays Bank PLC for example. We do not expect these vintages to have the same level of ultimate losses as the newer ones.
Some of the difference, however, may also have to do with the modeling methodology. There appears to be general consistency among banks on certain assumptions, such as projected cumulative losses for the subprime loans underlying CDOs of ABS. Nonetheless, within a model framework that effectively frontloads the losses versus one that spreads them out over a longer time, those assumptions can produce different results. Other valuation models rely more on the ABX indices. The decline in those indices could produce more write-downs in the first quarter. Yet other methodologies combined a mark-to-market methodology with one focused on ultimate recovery, depending on the likelihood of actually having to liquidate the investment. In addition, banks have adjusted their models to reflect cash flow assumptions based on specific characteristics of individual loans.
We believe Citi and Merrill in particular have taken conservative views in this regard, and have built in liquidity premiums. This would not preclude further write-downs, but in our estimation, these would not be anything like those to date. Even if others take more substantial additional write-downs, we do not expect them to be as great as those taken in fourth-quarter 2007.
The market value write-downs are a separate issue from intrinsic value. If they are held to maturity or if some of the risk premium for illiquidity and uncertainty goes out of market spreads, we believe the CDOs of subprime ABS may indeed see a recovery in value, although the amount is difficult to predict.
Reserves For Monoline Hedges Still A Moving Target
Further write-downs could occur in the portions of bank portfolios that are hedged by monolines. Banks collectively have taken about $12 billion of losses to-date as reserves against the counterparty risk of the monoline insurers that have provided hedges on, or guaranteed, a further $125 billion (notional amount) of supersenior CDO exposures. The hedged CDO exposure is marked to market using the same models as for the unhedged CDOs, but is offset by the value of the hedges. However, banks must take a mark that is essentially like a credit reserve deemed appropriate for the counterparty risk represented by the monolines. More than $6 billion of the $13 billion in reserves against monoline counterparty risk was to entirely write off the value of the ACA Assurance hedges after we downgraded ACA to 'CCC'. The potential losses on the remaining hedged exposure could be substantial in our view. The value of the hedges is the value of the CDOs being hedged. Banks have reserved an average 13% of their currently calculated hedge values for the non-ACA-related hedges provided by monolines at year-end 2007. This reflects a perceived weakening in the creditworthiness of the monolines, which is also reflected in the widening of their CDS spreads.
If the banks' own internal credit departments downgrade the monolines, reserves will be raised. In addition, if the value of the hedges increases (because the value of the CDO declines), the reserves will need to be increased again, even if there is no change in monoline creditworthiness. The banks' internal ratings falling below investment grade would call into question the hedge's effectiveness. The banks would then likely write down the full value of the hedge.
The potential losses can be estimated as follows. Hedge values are running at about 30% of the notionals (the par amount of CDOs being hedged), or about $38 billion. That is low compared to the valuation of the unhedged supersenior CDOs. In our view, this is largely because the monolines tended to insure relatively higher quality deals. Assuming that those valuations are correct, if all monolines' creditworthiness were to deteriorate to the noninvestment-grade range, the value of the hedges they provide would no longer be deemed effective, so banks would have to write down the value of the hedges by $38 billion, as if the hedges did not exist. That is $26 billion in addition to the $12 billion of reserves taken already. We estimate that for every rating category of downgrades for the monolines, reserves would need to be raised by 30% of the hedge values. In that fashion, the reserves would get to 100% of the hedge value in equal increments if the monoline ratings fell to noninvestment grade.
As we have observed, the likelihood of further downgrades will depend partly on the success of various capital-raising plans under consideration. In addition, breaking certain monolines into two companies--one dedicated to the municipal bond business and another to the structured finance business--could lead to downgrades, especially of the companies insuring structured finance.
Markdowns On Other Subprime Securities
Large banks and investment banks also took about $34 billion of write-downs against a variety of other types of subprime exposures. These included a relatively small amount of lower rated tranches of CDOs, as well as loans or RMBS held in warehouses pending securitization. We believe that the difference between the $150 billion in losses from write-downs in market value disclosed to-date and our global estimate of $285 billion will come not just from additional write-downs at banks, where additional losses should be limited, but from write-downs at hedge funds, monoline insurers, other insurers, and other financial institutions (see "Subprime Write-Downs Could Reach $285 Billion, But Are Likely Past The Halfway Mark," published March 13, 2008, on RatingsDirect).
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