Wall Street Hides Losses, Fights Reforms

The investment banks are writing down billions but still setting up Enron-esque deals to postpone the acknowledgment of subprime-related losses.

Despite billions in writedowns (devaluations) of subprime mortgage-related securities, experts say that much more is on the way from the big investment banks. Several of the banks are reportedly moving bad assets off their books temporarily, in order to postpone the acknowledgment of subprime-related losses. Late last summer, Citigroup was revealed to have massive off-balance sheet subprime exposure in “structured investment vehicles.” The Treasury Department came to its aid in October to help organize a super fund that would buy up its assets. Meanwhile, Wall Street firms successfully took the teeth out of a bill that would have held them liable for buying predatory loans.

A. BILLIONS IN WRITEDOWNS, BUT EXPERTS SAY MORE IS ON THE WAY

Though investment banks unloaded much of the bad subprime-related bonds, most had held on to billions of dollars worth of subprime-related securities. The securities have plummeted in value after this summer’s meltdown in the subprime market: no one trusts the models that had been used to value the securities, and few investors are willing to pay any significant price for them. These financial instruments are widely viewed as black boxes in the wake of the subprime boom – it’s hard to know what’s inside, so why take the risk on the underlying assets?

The following is a list of some of the writedowns so far, which total about $50 billion at the major investment banks:

• Merrill Lynch: $8.4 billion.^[1]
• Citigroup: $11 billion.
• Morgan Stanley: $3.7 billion.
• Bear Stearns: $1.2 billion.

Much more is on the way, according to some estimates. For instance, a Goldman Sachs analyst recently lowered his rating of Citigroup to “sell” after estimating that the bank would write down $15 billion in mortgage-related losses in the next two quarters.^[2] According to one trader quoted in The Wall Street Journal, "the overwhelming sentiment on the floor is, things are much worse than people fear (in credit markets) and that we're still not getting a straight scoop from banks and investors."^[3]

A recent estimate from the Organization for Economic Cooperation and Development predicts losses in the mortgage sector will total $300 billion, of which only $50 billion has been accounted for by major banks.^[4]

Furthermore, the next wave of losses may hit institutional investors such as pension funds that are generally risk-averse, but had been dipping into the subprime trough to boost returns in recent years. A Bloomberg article recently reported that municipal investment fund managers in Florida had invested money in the structured investment vehicles which invested heavily in subprime paper, and may be facing losses in the near-future.^[5]

B. ENRON-STYLE OFF-BALANCE SHEET ACCOUNTING TACTICS COMING TO LIGHT

Murky accounting methods similar to those that inflated the value of the energy-trading Goliath – and eventually spelled its end – have been employed by the banking giants in the area of subprime mortgage-backed securities.^[6]

Over the past few months, several forms of complex off-balance sheet structures and transactions have come to light, adding to concerns that the banks are more exposed to subprime risk than previously thought. It also appears that the investment banks are using these methods to postpone acknowledgment of losses:

Liquidity Puts

Citigroup, in particular, forged these agreements with investors purchasing CDOs backed in part by subprime mortgage assets. The agreements granted investors the option to sell the CDOs back to the bank in the event of financial difficulty. Citigroup moved the CDOs off its balance sheet without accounting for the fact that it could be required to re-purchase the assets at some point in the future. The legality of this is unclear:

Floyd Norris, New York Times: “With such a put in existence, I don’t understand how the banks could get the original loans off their balance sheets. How could they claim they had sold something if they could be forced to buy it back? It will be interesting to see if the Securities and Exchange Commission challenges the accounting.”^[7]

This summer, when the subprime market tanked, Citigroup was forced to buy back $25 billion in CDOs that were suffering dramatic declines in value.

It is unclear which other investment banks also entered into these agreements. According to FT Alphaville, the Financial Times blog, Bank of America entered into similar agreements that forced them to buy back $12 billion in off-balance sheet CDOs.^[8]

Structured Investment Vehicles (SIVs)

Structured Investment Vehicles have been constructed in such a way that they can collapse very quickly and infect the balance sheet of the investment bank that set them up. A stagnant market for the SIVs’ short-term asset-backed commercial paper paper may lead to a “fire sale” of the SIVs’ long term mortgage-backed assets, many of which are subprime-related. Though SIVs are set up to be independent from the investment banks that create them, the investment banks essentially have to stand behind them when they suffer losses, and let these transfer to their balance sheets (much as the profits from these SIVs had been transferred).^[9]

Hedge fund agreements

Some Wall Street firms have allegedly begun delaying losses by transferring mortgage-backed securities to hedge funds in recent months. The Wall Street Journal reported on November 2 that Merrill Lynch was quietly entering into agreements with hedge funds through which they moved billions in mortgage-backed assets off of their books.^[10] In a typical deal, a hedge fund purchased $1 billion in commercial assets, some of which was backed by mortgages, from Merrill Lynch. The agreements reportedly stipulate that Merrill Lynch will buy back the assets for a minimum price after a period of a year if the hedge fund is unable to unload them. The tactic allows the banks to delay accounting for losses associated with writing down the value of the assets.

Merrill Lynch has denied forging these agreements.

C. THE TREASURY UNITES WITH SEVERAL BANKS TO BAIL OUT SIVs

Though the Treasury Department has no clear plan in place to aid struggling homeowners, it moved very quickly to come to the aid of investment banks with massive exposure to the off-balance sheet SIVs described above.

Treasury-led discussions with Citigroup, JP Morgan, and Banc of America Securities in September and October resulted in the planned creation of a $80 billion “super SIV” that is intended to stave off fire-sales of SIV mortgage-backed assets by purchasing them from the SIVs. Secretary Henry Paulson’s justification for his intervention – which does not involve putting up financial resources for the fund – was that the fire-sale scenario could send shock waves through the credit markets and the broader economy.^[11]

The plan has been widely criticized as a bailout of Citigroup.^[12] Citigroup’s SIV assets account for 25% of the worldwide SIV total – around $80 billion. This makes the bank the leading SIV manager in the world, far ahead of most other investment banks, which haven’t developed the same affinity for the off-balance sheet financial structures. JP Morgan and Banc of America, the other two investment banks developing the super fund, reportedly have no SIVs.

It is also questionable that more re-packaging of subprime assets will make the situation any better. Warren Buffet waxed poetic on this point in an interview with the Financial Times:

Warren Buffet: “One of the lessons that investors seem to have to learn over and over again, and will again in the future, is that not only can you not turn a toad into a prince by kissing it, but you cannot turn a toad into a prince by repackaging it. But very imaginative people in the securities market try to do that. If you have bad mortgages they do not come better by repackaging them. To some extent the chickens are coming home to roost for the mortgage originators and securitisers.”^[13]

D. WALL STREET SUCCESSFULLY FIGHTS REFORMS OF THE MORTGAGE MARKET

Congressman Barney Frank’s lending law reform bill, HR 3915, recently passed the House. While the bill does institute some needed reforms of the mortgage market, it was the subject of significant criticism from consumer groups for failing to hold Wall Street accountable for loans purchased from predatory lenders. The New York Times editorial page also weighed in against any watering-down of the bill before it passed:

New York Times editorial: “The House will vote today on much needed legislation to curtail abusive mortgage lending. Last minute lobbying to weaken the bill is coming from all corners: from brokers who hawked the junk loans, lenders who advanced the cash and Wall Street banks that bought the loans and repackaged them into securities for sale to investors. Having profited so immensely during the mortgage bubble, they now want to keep the world safe for future financial excesses.”^[14] [emphasis added]

In the end, Wall Street won out: the bill shies away from implementing significant liability for the Wall Street firms that package predatory loans.^[15]

In a 2003 interview with American Banker, John Taylor, chief executive of the National Reinvestment Coalition, said “the role that Wall Street plays is the untapped universe on trying to impact predatory lenders. We need to use everything in our power – whether it's media review, government regulatory oversight, congressional hearings – to take the profit motive in predatory lending out of Wall Street."^[16]

Unfortunately, it appears that this is still the case in 2007.

Footnotes