Time for a "Contained" Hall of Shame?

For months, hordes of ill-informed, though frequently highly-paid policymakers and commentators have fallen over themselves in a rush to declare an early end to a still unfolding financial disaster.

Often clueless and with little shame, they threw around terms like "contained," "limited," and "irrelevant," to describe a dangerous situation they did not understand, nor knew how to rectify, though many pretended otherwise.

And yet, despite their wishful thinking and delusional happy-talk, the situation only seems to be getting worse, as the FT Alphaville blog notes in "Another Day, Another Subprime Victim: From State Street and Barclays to DBS,"

Now that the term “structured investment vehicle” is on its way to becoming the finance world’s version of a household phrase, every day brings fresh concerns about the fall-out from US subprime mortgage investments on banks and their off-balance sheet vehicles.

Tuesday’s crop is no exception, with reports in the The Times, Reuters and Bloomberg that banks including Barclays and State Street may be facing losses from the so-called conduits that invested in CDOs.

The Times says State Street has been identified as having $22bn of exposure to asset-backed commercial paper conduits. According to US regulatory filings, the Boston-based bank has credit lines to at least six conduits, which account for 17 per cent of its total assets, says The Times. That proportion makes State Street the most highly exposed bank to conduits among its European and US peers; IKB, of Germany, which was forced to accept emergency funding for its conduit last month, had credit lines worth 15 per cent of its total assets. Deutsche Bank and WestLB each have exposure of 6 per cent, notes The Times.

Meanwhile, the risk of owning Barclays debt rose last week, according to Bloomberg which cites traders of credit-default swaps. The resignation last week of Edward Cahill, head of Barclays Capital’s CDO operations in Europe, has only added to fears that banks may face as-yet undisclosed liabilities from conduits and related investment vehicles, notes The Times, while Bloomberg adds that two funds arranged by Barclays had credit ratings slashed to junk from AAA by S&P on August 22 after investors refused to buy their debt.

The FT, reports Tuesday that Barclays faces scrutiny over its links to Sachsen LB, the failed German public sector bank, after it emerged that Barclays had set up an SIV-lite on the German bank’s behalf less than three months before it collapsed.

And in Asia, DBS Group, Singapore’s largest bank, on Monday evening said it has more at risk from CDOs than it earlier revealed after market turmoil led a special-purpose vehicle to seek additional funds, reports Bloomberg. The bank has S$2.4bn ($1.6bn) of CDOs up from S$1.4bn declared on August 7, including S$1.1bn worth held by a so-called conduit, Red Orchid Secured Assets, or Rosa, DBS said. The bank’s shares dropped 1.5 per cent on Tuesday morning in Singapore.

In a note on Tuesday, however, Barclays Capital played down negative credit implications and said it believed any ensuing losses at DBS would be easily absorbed. Indeed, said BarCap, “DBS’s total CDO exposure of S$2.4bn is equivalent to around 1% of total assets and two-thirds of annualised pre-provision operating profit,” and that its Stable fundamental credit view and Marketweight recommendation for benchmarked investors are unchanged.

Reuters, meanwhile, reports that China Construction Bank, one of China’s big four state lenders, said Monday it held $1.06bn worth of CDOs at the end of June but expects the securities to have “limited impact” on its operating results for the year.

Analysts said the US subprime exposure to Construction Bank was manageable, because it only accounted for about 2.5 per cent of its equity, Reuters added.

However, as Lex noted last week when Bank of China announced it held nearly $10bn of US subprime mortgage-backed securities, the subprime exposure “looks less toxic when measured against the bank’s capital”:

BoC’s $10bn exposure represents a little more than 1 per cent of total assets and about one-fifth of shareholders’ equity. It is also relatively top-drawer paper. More than 75 per cent of the securities are AAA-rated while almost all the remainder are AA.

Industrial and Commercial Bank of China, the world’s biggest bank measured by its Shanghai-listed market capitalisation, also said it held $1.23bn - 4 per cent of its foreign exchange investment portfolio - in US mortgage-backed securities but had so far incurred no related losses.

But - and it is a “but” that grows bigger by the day - with bankers scrabbling to price subprime securities, “it would be naive to assume Bank of China’s $145m provisions mark an end to the story - particularly since Industrial & Commercial Bank of China also revealed exposure of $1.2bn,” warned Lex.

More worryingly, it added, “the fact that Chinese lenders are dabbling in such exotic instruments barely a year after transforming into partially privatised entities shows risks are spreading. Investors are accustomed to wobbles on the credit side: Chinese lenders are poor at pricing risk and the buoyant economy discourages caution”.

Actually, we could think of others - and they’re not Chinese banks - to which Lex’s words might apply.

As an aside, it's worth remembering that at the May 9th meeting of the Federal Open Market Committee, policymakers noted the following [italics mine]:

Recent developments were seen as supporting the Committee's view that maintaining the current target rate was likely to foster moderate economic growth and a gradual ebbing in core inflation. Members continued to view the risks to economic activity as weighted to the downside, although with turmoil in the subprime market appearing to have remained relatively well contained and business spending indicators suggesting a more encouraging outlook, these downside risks were judged to have diminished slightly. Members agreed that considerable uncertainty attended the prospects for inflation, and the risk that inflation would fail to moderate as desired remained the Committee's predominant concern.

According to the minutes, the following individuals were present at the meeting:

Mr. Bernanke, Chairman
Mr. Geithner, Vice Chairman
Mr. Hoenig
Mr. Kohn
Mr. Kroszner
Ms. Minehan
Mr. Mishkin
Mr. Moskow
Mr. Poole
Mr. Warsh   
Mr. Fisher, Ms. Pianalto, and Messrs. Plosser and Stern, Alternate Members of the Federal Open Market Committee

Messrs. Lacker and Lockhart, and Ms. Yellen, Presidents of the Federal Reserve Banks of Richmond, Atlanta, and San Francisco, respectively

Mr. Reinhart, Secretary and Economist
Ms. Danker, Deputy Secretary
Ms. Smith, Assistant Secretary
Mr. Skidmore, Assistant Secretary
Mr. Alvarez, General Counsel
Mr. Baxter, Deputy General Counsel
Ms. Johnson, Economist
Mr. Stockton, Economist

Messrs. Connors, Evans, Kamin, Madigan, Rasche, Slifman, Tracy, and Wilcox, Associate Economists

Mr. Dudley, Manager, System Open Market Account

Messrs. Clouse and English, Associate Directors, Division of Monetary Affairs, Board of Governors

Ms. Liang and Mr. Struckmeyer, Associate Directors, Division of Research and Statistics, Board of Governors

Messrs. Leahy and Wascher, Deputy Associate Directors, Divisions of International Finance and Research and Statistics, respectively

Mr. Dale, Senior Adviser, Division of Monetary Affairs

Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors

Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors

Mr. Luecke, Senior Financial Analyst, Division of Monetary Affairs, Board of Governors

Mr. Carlson, Economist, Division of Monetary Affairs, Board of Governors

Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors

Ms. Green, First Vice President, Federal Reserve Bank of Richmond

Mr. Rosenblum, Executive Vice President, Federal Reserve Bank of Dallas

Mr. Hakkio, Ms. Perelmuter, Messrs. Rolnick, Rudebusch, Sniderman, and Weinberg, Senior Vice Presidents, Federal Reserve Banks of Kansas City, New York, Minneapolis, San Francisco, Cleveland, and Richmond, respectively

Messrs. Dotsey, Tallman, and Tootell, Vice Presidents, Federal Reserve Banks of Philadelphia, Atlanta, and Boston, respectively

Maybe it's time for a "contained" hall of shame?

Comments

[Bruce Allen]

Mike,

I too wonder how much longer it will be before the wailing and gnashing of teeth starts. It's only a matter of time now. And if the U.S. decides to make a move on Iran(as has been increasingly mentioned by many), then watch the you-know-what hit the fan. The remaining 4 months left in this year are going to be VERY interesting. And we haven't seen any reports from Q3 yet. How much more money can the FEDS pump into this ponzi scheme? How long until we see the run on the banks? How many more billions of dollars will be needed to keep this three-ring show going???

Bruce.

[Alex Grey]

The "sub-prime crisis" can only get worse and spread across the housing market. The immediate problem that is causing the liquidiy problems is one of pricing - no one knows exactly how much sub-prime is in this broad range of potentially contaminated CDOs. However even when this problem is resolved the end result will be that interest rates on these CDOs will increase, the increase being larger the greater the solvency problems that sub-prime borrowers are facing. This rise in CDO interest rates will feed back into the market, forcing up interest rates on new mortgages. This is already starting to happen with "jumbo loans". A rise in interest rates will do wonders for a housing market where prices are already falling. Potentially worse than the sub-prime crisis is the fall in housing prices which is gradually eroding the security in CDOs. What will be the interest rate on CDOs that include mortgages where house prices are down 5-10% from their peak given that 75% of new mortgages were for 75% or more of the property's value (as of 2005)? I think what we are looking at therefore is a substantial tightening of lending in the housing market extending far beyond sub-prime, with the end result being a significant increase in the downpayment required. To the extent that the housing market is heavily dependent on the inflow of borrowed funds, the end result could be dire.

[Leon W. Fainstadt]

The sheep are running and the fat cats are waiting with knives drawn. I am disguisted by the national media's poor coverage of the current financial crisis. While millions will lose their homes strategies abound to find a way to make money off the losers. The business channels play cheerleaders to the transfixed "know-nothings" who sit waiting for tomorrow.
California takes money away from the homeless and mentally ill while reducing taxes on the wealthy yacht owners in the marina. If I did not read this I would not balieve it. "Let them eat cake" but perhaps they should beware of the ingredients. America could truely have been great. We are in for a major fall.
Depression - DEPRESSION! Brother can you spare a dime and the truth?