I Know What You Did Last Summer

Being in finance and investments, you have to keep learning new jargon. Six months ago many probably don't even know what CDOs were, many kept hearing it over the last 2 months and had a vague idea of what that is, but probably would find it hard to remember the actual definition in totality - man, where's our c-drive, no retention power, somebody defrag me... or just close all windows in my house and reboot!

Just when you thought it was safe to no longer mention "subprime"... hey all suddenly screamed "I know what you bloody banks did last summer!!!" You got me on HSBC, then Bear Stearns, the UBS joined the fray, jumped across to Northern Rock, now Merrill Lynch and the bigdawg Citigroup.

As I have said recently, the big banks waited for Paulson/Fed to come up with a US$100bn Superfund to help bail them out. That did not arrive, hence the revelation (just as scary as the one in the Good Book). Let's look at why so many investors are caught unawares on these shitty stuff. HSBC did the right thing, first to acknowledge that there is a problem, admit & write down the assets and control the exposure - that's why HSBC always trade at a premium in the eyes of Asian investors. The rest dragged their feet and evaded until it the cows actually rang the doorbell.

Many banks created Structured Investment Vehicles to carry a lot of these CDOs, and they did not show up on the balance sheets. Citigroup had the biggest OBS (off balance sheet) assets at US$222bn and their biggest SIV exposure was US$80bn, hence it would not be too far off to estimate that Citigroup may have to write off 50% of that in total or US$40bn. Bank of America staffers are probably the happiest as their banks have ZERO in SIVs and the OBS assets amount o only US$97bn. JP Morgan has US$128bn in OBS and has an exposure of over US$40bn to private equity firms. In total, Citigroup may have to write down US$21bn. That compares with potential losses of US$5.4 billion for Bank of America, the second-biggest U.S. bank, and US$4.1 billion for JPMorgan Chase. I think Bank of America is quietly sniggering that this debacle will close the gap between #1 and #2.

Merrill Lynch last month reported US$8.4 billion of writedowns in the third quarter and may be on the hook for another US$9.4 billion. However, the potential losses related to CDOs at the three major banks in absolute terms dwarf those of the largest brokers. Lehman Brothers, Bear Stearns, Goldman Sachs and Morgan Stanley, all stand to lose as much as a quarter of their equity. The announcement of Citigroup's potential losses and the exit of its CEO prompted Fitch Ratings to cut its rating to AA, three levels below the top, and say it may reduce the rating again. Standard & Poor's said it may lower its AA grade.

As bad as it sounds, the bad news seem to be a sigh of relief for the markets as more of the actual risks are now known. When you do not know the numbers, you worry more, now that you do - you can start to work off those numbers accordingly.