Phew! That was close. For a moment there, it looked like the collapse of the subprime mortgage market was going to wipe billions off financial earnings for years to come.
The bad debts were stacked up like poisoned berries gathered by a poison-crazed squirrel during the housing bubble of 2003-2006. Going bad fast in summer '07, they threatened to wipe out consumers, investors and businesses everywhere in a slow-motion replay of Japan's 'zombie' banking deflation.
At least, that's how the credit markets saw the subprime meltdown in August. Two subprime hedge funds at Bear Stearns had gone bust in June; Ben Bernanke, head of the Federal Reserve, said in July that total subprime losses could total $100 billion; private-sector economists put the total nearer to $150 billion. Now MacroMavens in New York thinks we're looking at $210 billion to $346 billion 'and that's assuming the situation doesn't get worse.'
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
These billions in bad debt would seep into the broader economy, investors feared, and kill the market in new lending dead.
But hey, panic over!
'They revealed all of it,' as a friend of mine now senior analyst at a leading mutual fund here in London told me over a beer or three late last week.
'Trust me, I've been through the disclosures. I was there for Deutsche Bank's results last week. They're writing down more than $3 billion...all the banks are clearly stating their subprime losses, too.
'Sorry Ade, but there's nothing left to hide. Nothing to see here...'
This happy, if not quite sober view of 'Subprime? So over!' is certainly what the banks announcing their Q3 numbers this month would like the world to believe. For all we know, they're sincere about it, too. And the write-downs sure look dramatic enough to mark the end of the crisis in subprime bad debt:
- Citigroup, the biggest bank in the US, reported a 57% drop in third-quarter earnings from a year earlier, due in no small part to bad mortgages;
- Bank of America, the second-largest US bank, just reported a 32% drop in earnings, led by a loss of $527 million in revenues at its structured products division;
- J.P.Morgan, the third biggest bank in the US, has marked down $186 million in bad mortgages plus $339 million in debt-derivatives for June-Sept.;
- National City Corp. of Cleveland the ninth-largest bank in the US according to Reuters now projects mortgage-book losses of $160 million for Q3, 'the high end of its previous forecast';
- The leading US savings and loan, Wamu, says it expects a 75% drop in profits, with a new set-aside of almost $1 billion to cover bad debts and a hit of $410 million to its current lending portfolio;
- Sovereign, the No.2 savings and loan firm, has raised its bad-debt provision three times over to $155 million, adding another $35 million in mortgage-loan charges and writedowns;
- Some 170 investment bankers are losing their jobs at Credit Suisse after it warned of a 29% drop in operating profits;
- Nomura, Japan's largest brokerage firm, says it expects to lose $621 million by shutting its US mortgage division after heavy losses taken over the summer;
- Merrill Lynch wrote down $5.5 billion in subprime and leveraged-loan losses for June to Sept., with around $4.5bn lost to bad home-loans alone.
In short, a litany of woe all round!
Still, thanks to the wailing and gnashing of teeth by hair-shirted banking chiefs this earnings season, it's clear to see that their subprime mistakes have now been settled in full.
Yes, subprime was a mess, but it's been cleared up and tidied away like the trash of beer bottles and bucket bongs after an 18th birthday party. The investment bankers' hangover is already starting to clear. Right?
Equity investors seem to believe so. Banking stocks have risen by nearly 13% from the bottom hit in August. And as proved by my night out at the John Snow pub on Broadwick Street last week (their beer, by the way, is shockingly cheap for London...and rightly so) professional analysts are happy to take the banking world at its word.
'Deutsche Bank joins a conga line of banks coming clean,' says FinancialWeek. 'Swiss bank exposes holes in Q3 results,' adds a French newswire, reporting that UBS, the world's biggest wealth manager, expects to lose $3.4 billion on its subprime mortgage book.
'Coming clean...exposing holes...' This is the language of honest men 'fessing up and moving on. 'While we're disappointed with our anticipated third-quarter results, we look forward to an improved fourth quarter,' says Kerry Killinger, chief of Wamu.
'While it is very early in the current quarter and despite continued challenges in structured finance, we are beginning to see signs of a return to more normal activity levels in a number of markets,' says Stan O'Neal, head of Merrills.
In short, 'we see substantial opportunities in investment banking after this period of correction,' as Josef Ackermann, head of Deutsche Bank, put it.
Indeed, the world's highest-ranking bankers have enjoyed what looks like a moment of clarity. From here on, their mortgage-backed losses of third-quarter 2007 will always serve to remind them: Don't lend to people with no income.
Only Goldman Sachs escaped the carnage and even then, it seems, only on paper. 'Common sense tells me that a lot of their losses were real and a lot of their gains were paper,' says Charles Peabody, head of research at Portales Partners in New York.
'The opaqueness of Goldman's balance sheet makes us immediately question how they made money in the [third] quarter.'
Goldman's stock still shot higher on its 'yah-boo' earnings report, however, gaining some 7% since the firm announced in stark contrast to everyone else a stellar quarter between June and Sept.
Trading revenues at GS rose 70% from the same period in 2006, a massive $8.2 billion all told, taking the group's net earnings to a new record for the year so far. Merrill Lynch and UBS, on the other hand, reported their first quarterly losses in more than four and a half years as the International Herald Tribune notes, adding that:
'Bear Stearns posted its biggest earnings drop in a decade.'
So how did Goldman 'increasingly perceived as the world's biggest hedge fund' according to the IHT succeed where everyone else failed? The bank made no secret of its success in its Q3 report of Sept. 20th:
'Net revenues in [trading] mortgages were...significantly higher, despite continued deterioration in the market environment. Significant losses on non-prime loans and securities were more than offset by gains on short mortgage positions.'
Put another way, Goldman Sachs cleaned up during this summer's collapse in subprime mortgage bonds...by selling the subprime mortgage-backed market short. And why not?
It's not like Goldman is barred from shorting the investment markets that it helps bring into being. Nor did it have any special insight; all of the big investment banks were busy creating and selling subprime junk in 2005-2006.
None of the other big banks, however, had the chutzpah to short the very market in junk they'd given birth to not yet, at least. And few banks seem to have created bonds quite as toxic as Goldman did.
Take last year's vintage, for example. In 2006, Goldman Sachs' mortgage-bond division Alternative Mortgage Products (known as GSAMP for short) issued 83 home-loan-backed bonds, valued at $44.5 billion. In the subprime sector, it grew its business by 59% from 2005, unloading some $12.9 billion on to unsuspecting, stupid and/or greedy investment fund managers who thought a bond under-pinned by home-buyers with no hope of repaying might be worth having.
According to Inside Mortgage Finance, that made GSAMP the 15th biggest issuer of subprime-backed bonds in 2006. And come the start of the third quarter this year, those securities were being downgraded by the credit ratings agencies faster than anyone else's.
Research from Citigroup, dated 22nd June, found that 'portions of Goldman's GSAMP-issued bonds, which include subprime loans from a variety of lenders, have been downgraded a combined 69 times by Standard & Poor's and Moody's Investors Service in the year through June 15,' as Reuters reported.
'Sixty of the GSAMP downgrades refer to classes from 2006 bonds,' Citigroup added, and one of Goldman's 2006 crop the GSAMP Trust 2006-S3 may actually be 'the worst deal...floated by a top-tier firm,' reckons Allan Sloane in the Washington Post.
In spring 2006, 'Goldman assembled 8,274 second-mortgage loans originated by Fremont Investment & Loan, Long Beach Mortgage, and assorted other players,' explains Sloane after studying the public record. 'More than one-third of the loans were in California, then a hot market. It was a run-of-the-mill deal [face-value $494 million], one of the 916 residential-mortgage-backed issues totaling $592 billion that were sold last year.
'The average equity [these] borrowers had in their homes was 0.71%...[meaning] the average loan-to-value of the issue's borrowers was 99.29%.
'It gets even hinkier,' Sloane goes on. 'Some 58% of the loans were no-documentation or low-documentation. This means that though 98% of the borrowers said they were occupying the homes they were borrowing on 'owner-occupied' loans are considered less risky than loans to speculators no one knows if that was true. And no one knows whether borrowers' incomes or assets bore any serious relationship to what they told the mortgage lenders.'
Whatever the truth, one in every six of the 8,274 mortgages bundled together in GSAMP Trust 2006-S3 was already in default 18 months later. Whoever bought the S3 bonds will have either taken a 100% loss, or they're now waiting and hoping against hope for some other schmuck to turn up and take this toxic waste off their hands at a very heavy discount.
Meantime at Goldman Sachs, the profits made by shorting the subprime market flipped Q3 '07 from 'significant losses' to 'significantly higher' net revenues. Goldman creamed it by selling 'em twice, in other words...first as an asset...and then as a tasty short.
You don't need to think this is more than ironic to wonder why anyone most especially your pension or fund manager would trust investment bankers to look out for your best interests. (More on that in Part II...)
Nor does it matter how Goldman went short of the subprime market. It may have sold derivatives against an asset-backed index such as the ABX (which now looks close to winding down, by the way, because 'securitizations have fallen so low, there may not be enough bonds to fill the series' says Markit, the index's developer). Alternatively, Goldman might have borrowed a fistful of mortgage-backed bonds and derivatives from poor, benighted investors...and dumped them into the market as it plunged between June and Sept.
Goldman may even have borrowed the bonds that it shorted from its own 2006 customers, but I guess it's unlikely. Yes, the sales team at GSAMP must own a Rolodex packed full of investors now looking to hide, bury or burn the 'toxic waste' they bought last year. But can you imagine the phonecall from GS?
'Hey...remember those mortgage bonds we sold you last year? Betchya can't forget them! But we don't think they've sunk far enough yet. So we wanna borrow a bunch and sell 'em short. Whaddya say?'
Back in the US housing market, meantime the source, remember, of all those defaults and delinquencies now hitting investment-bank profits the trouble looks to have barely begun:
- Construction of new homes plunged to its lowest level in 14 years last month, down more than 10% from August according to the Commerce Dept., swamping consensus forecasts of a 4.2% decline;
- US home foreclosures rose by 93% in the year to July said John Dugan, US Comptroller of the Currency, in recent testimony;
- Fitch the ratings agency has caught up with the junk it previously stamped as investment-grade, hiking its default forecast for one set of bonds by 50% this summer;
- More than $250 billion worth of US mortgages will reset to sharply higher interest rates in 2008 and 2009, and 'another $700 billion will do so in 2010 and beyond,' says a study from First American;
- Four months after issue, 6.3% of the home-loans bundled into mortgage-backed bonds during the first half of 2007 were 60 days late with repayments or more. 'The rate was 4.2% after four months for bonds created last year,' says research from Moody's.
'I foresee several million [foreclosures],' warns Bill Wheaton of MIT's Center for Real Estate studies. 'I think that we could easily see 2 to 3 million people lose their homes and go back to renting, basically.'
But would that scale of wipe-out on Main Street matter to Wall Street?
Well, if the investment banks were now home and dry, why would Citigroup, J.P.Morgan and Bank of America have agreed to back a $75 billion 'off-balance sheet' fund that will actively seek to support the value of US home-loan securities?
If the whole problem has been dealt with in one quarter, why would US Treasury Secretary Hank Paulson a former chief of Goldman Sachs, no less! want to bang heads on Wall Street and get this deal set up?
And if the trouble in subprime were over, why didn't Goldman Sachs step up to join Paulson's bail-out baby? Does GS plan to short the mortgage-bond market and keep shorting it as 2007 turns into 2008...?
'[The banks] may firmly believe this gets everything out of the way,' says one analyst of the mass confession given in Manhattan, Frankfurt and London this month. 'But I think there's going to be further reserve additions in future quarters.'
'I'm pretty bearish on the whole banking sector,' he adds. In our humble opinion, that sounds a fair call.
All told, the ongoing subprime crisis is just one more reason why we're sticking with gold, rather than paper promises.
Because there's more trouble to come in paper. Much more.
Adrian Ash is editor of Gold News and head of research at www.BullionVault.com
