December 2007

As history was for the Irish writer James Joyce, so the subprime-induced credit crisis has become a nightmare from which investors are trying to awake.

Those who had believed that banks' third-quarter earnings reports had disclosed every last cent of subprime-related losses have been disillusioned by subsequent, additional write-downs. In the absence of any regulatory obligation to reveal all losses, the bad news has been drip-fed to the investment community, resulting in a crisis of confidence that continues to exact a heavy toll on sentiment.
 
For banks, the ongoing credit squeeze is not just about the house-of-cards frailty of mortgage-backed securities: it has also brought to light their use of SIVs (structured investment vehicles). These are essentially funds that borrow money in the short-term commercial paper market to buy mortgages, bundle them into securities and sell them on to the bond markets. In theory, as the banks themselves do not own the underlying mortgages, SIVs carry no risk. However, given the dearth of liquidity in the commercial paper market, banks have been obliged to either fund SIV activities themselves or repurchase the underlying mortgages. One estimate puts banks' total SIV exposure at $340 billion. Plans, backed by the US Treasury, to sell $75 billion of the highest-rated debt to a "Super SIV" may help the banks in the near term, but will do little to restore investor confidence. That will only come with full - and credible - disclosure.
 
Can anything be done to avert future credit meltdowns? Enter FAS 157. Without much of a media fanfare, Statement 157 of the Financial Accounting Standards Board came into effect on 15 November. FAS 157 concerns the fair value measurement of assets and liabilities; one of its more interesting aspects is its insistence on valuing assets at "exit price" - the price a third party would reasonably pay. This is fine for liquid assets but rather difficult for illiquid ones. The absence until now of this convention has allowed banks to make hypothetical valuations for illiquid, "level 3" assets that are typically far above their realistic values; such assets have therefore been grossly overvalued in the books of the banks concerned. However, despite the complex calculations required, many banks have already adopted FAS 157 principles and have announced large write-downs (and some high-profile resignations).
 
Estimates of the ultimate cost of the subprime crisis have steadily increased. Some analysts now project potential total losses of up to $400 billion. Can things get worse? As long as disclosure of such losses is essentially voluntary, investors may worry that they will.