Is That S&P Forecast of Subprime "Bottom" Good News?

The market rallied on the news that S&P reported that the end was in sight for subprime writedowns, with the firm placing the total damage at $285 billion, with $150 billion realized so far.

The need to believe is stronger than I realized. “End is sight” is not the same as “end is nigh” but that it what the market chose to hear.

Let’s just look at the forecast presented. Commercial and investment banks have taken $150 billion in subprime writedowns. S&P says the big banks will take few further hits; it will be other players, such as hedge funds, will take another $135 billion (reader James caught an error in my earlier version). That means they have to almost as much in additional losses as they have already taken.

How can this possibly be good news? Look at the damage the financial system has sustained in getting this far. We have Countrywide, which should be permitted to fail, surviving solely by virtue of the pending Bank of America acquisition, Wamu rumored to be on the hunt for cash, Bear Stearns allegedly at risk of going belly up, and Citigroup in wobbly shape.

And due to the damage they’ve sustained thus far, they are contracting their balance sheets, with catastrophic knock-on effects. The auction rate securities crisis, which has wreaked havoc with many a municipality’s budget, was a direct result of bank writedowns. They have neither the capacity nor the willingness to take much in the way of gambles these days.

Consider additional collateral damage thus far. Banks have cut way way back on writing mortgages. Home buyers with good credit are reportedly having trouble getting a loan. The disruption in the credit default swaps market means that highly-rated borrowers are facing relatively high costs of funding. Banks have increased margin requirements for hedge funds, which puts the highly leveraged ones on perilous footing.

And this happened even thought the large banks and investment banks had considerable success in replenishing their capital thanks to cooperative sovereign wealth funds.

So we are already at the point where the losses are painful. But the next wave of losses will allegedly be concentrated not at the center of the financial system, but among players that are supposedly more peripheral.

Don’t count on that assumption. The losses to AIG and the monolines thus far have led to a reduction in CDS writing capacaity (the protection writer is the one who takes the risk of default). With a big demand/supply imbalance, CDS spreads are skyrocketing, which is making it costly for even AAA borrowers like GE to issue bonds. Hedge funds are the second most important class of CDS writer (I’ve seen estimates that they provide over 37% of the protection). Hedge fund losses might not only lead to ever further imbalances in CDS prices; if any hedge funds who wrote protection were to fail, it could lead to panic about counterparty risk in the CDS market, and to cascading losses, as positions once thought to be hedged were revealed not to be as one side of the trade turned out to have failed.

Similarly, S&P blandly comments that the monolines will take further hits, but does not acknowledge that they could be downgraded. I’ve seen another presentation by a hedge fund that is short the monolines (not Pershing this time), and it makes a persuasive case that we are early in the housing mess; the peak in defaults is probably more that a year away, and we wont’ know the loss severities until we are further along in this process (we are so far outside any historical pattern as to make estimating difficult). And witness LTCM, a large hedge fund failure (or a series of medium sized ones that add up to similar numbers) has the potential to inflict considerable damage on its bank creditors.

More disturbing, the presentation goes through some of the CDOs that the monolines own (that list was provided by Ackman). It takes one as an illustration, and peels the onion to demonstrate that the losses in some of the layers have gotten to be great enough that it is a certainty that Ambac will have to pay out. Yet Ambac has taken no reserves against this deal. I suspect this is the issue that led Dinallo to decide that there might be something to what Ackman was saying and get on the bond insurers’ case.

So I am skeptical that losses will be neatly contained to hedge funds and insurers. Any additional losses to the big financial intermediaries will result in proportionately much greater pain. Why? First, capital to fill in the holes created by losses will be much harder to come by. The sovereign wealth funds have already indicated privately that they aren’t terribly interested in stumping up more cash, given the losses they’ve taken already. The next round will come with considerable dilution, and if domestic players cannot fill the gap, the Federal government many have to do a lot of pleading overseas on the banks’ behalf.

And if the replacement capital does not come quickly, the financial firms will have to shrink their balance sheets proportionately more than they did the first time.

Second, we’ve already passed the point at which the banks are merely undoing excesses of the boom; they are now reducing intermediation and credit capacities that customers find important for their own well being. Further losses will lead them to cut further into muscle, to the detriment of the real economy.

Third, these losses come when the banks are now being hit on other fronts: leveraged loan losses, commercial real estate writedowns, possible losses from hedge fund failures and credit default swaps dislocations.

Separately, I suspect S&P’s estimate will be proven wrong. A meaningful proportion of subprime loans are well outside any historical precedent, in terms of how weak the borrower was and how little equity was put down. And we have no data on what loss severity is like in a falling home price environment.

And S&P has been complicit, ever favoring the issuers over the investors. Its conduct with the monolines was shameful. Depite its fanfare of reviewing and downgrading CDOs, it has failed to re-rate many AAA tranches (where the vast majority of the value of a deal lies) even in the face of evidence that the instruments now fail to meet the published standards. And noter they have stayed completely away from re-rating the CDOs in the Markit ABX index, even though some of those are on the dodgy list.

Moreover, this report comes suspiciously close to earnings reporting season. Starting with the third quarter last year, the market has taken false comfort that each time, the banks were taking writedowns deep enough to put their problems behind them. Given the possibility that investors might have wised up by now, S&Ps, reassurance is no doubt very handy.

This crisis is far from its peak. The high month for subprime resets is August, and they continue at a high level for the balance of 2008. Default increase sharply after resets, and foreclosures average 15 months after default. The worst will come mid 2009 or even later, which is a long way away. I am not certain that the market has discounted how bad things might get.