Easily the biggest financial story of 2007 still lingers as investor’s biggest concern in 2008… the sub-prime credit crunch and its impact on the banking sector – that is both the “real” AND the “shadow” banking systems!
In the past two weeks plans for a U.S. Treasury sponsored bail-out fund (aka the “super-SIV”) were officially buried, thanks to lack of participation. Citigroup, the super SIVs biggest proponent quietly decided to take $49 billion worth of off-balance-sheet investments in structured investment vehicles back onto its own balance sheet.
In addition Citi says it will guarantee $58 billion in additional debt from SIVs it manages in order to avoid a forced sale of these securities at less-than-attractive (fire sale) prices. This financial commitment is in addition to $17.4 billion in losses and asset write-offs already disclosed by Citi related to sub-prime and other mortgage investments gone bad. Speculation is rampant that the biggest U.S. bank may need to raise even more capital, similar to the $7.5 billion investment it accepted from Abu Dhabi.
Unfortunately, Citigroup is not alone in this modern-day accounting shell-game. In fact, this kind of off-balance sheet accounting got many banks and financial firms into trouble. The same off-balance sheet shell-game that resulted in the ruin of Enron and WorldCom not so long ago has run rampant in the financial sector – and amazingly – it’s been perfectly legal to get away with it!
This is what has been referred to as the “Shadow Banking System” – a largely unregulated, unsupervised extension of traditional banking that depends on increased leverage to boost a bank’s bottom line. In recent years, Wall Street’s banks and brokers worked overtime creating a surplus of derivative securities, all of which are devilishly difficult to understand, and even harder to value.
Now the complex shell-game of financial engineering has broken down, and the result has been a huge global credit crunch that’s still with us in the New Year. Banks and brokers have reported nearly $100 billion in sub-prime related losses in 2007, with a lot more to come this year.
Now, the Financial Accounting Standards Board (FASB), the supposed watch-dog for the industry, has imposed new rules requiring banks and brokers to more fully disclose their risky assets. The riskiest – and hardest to value – of these is termed “Level 3” assets.
The problem, as shown in the graph above, is that many leading Wall Street firms carry more of these highly-toxic L-3 assets on their balance sheet than they have equity capital. According to data from Royal Bank of Scotland, Morgan Stanley is at the most risk, because risky level 3 assets equal two and one-half times its equity capital.
This means that if Morgan were forced to write-off just 40% of its level 3 assets in the future – then its entire equity capital would be wiped out – and the House of Morgan would technically go broke!
According to a recent report by Merrill Lynch, Wall Street’s banks and brokers may face additional sub-prime related losses and asset write-offs of up to $500 billion between now and 2010!
Faced with a potential financial-sector crisis of this magnitude in 2008, it’s no wonder investors are still wary of banks and brokers in the New Year. But you know what the Chinese say: where there’s crisis, you usually find opportunity.
In spite of all this “doom and gloom” and all the uncertainty of year-end, so far at least the Financial Sector SPDR ETF (symbol: XLF) has held above its November lows. The iShares DJ U.S. Broker Dealer Index ETF remains above its low reached in August.
I smell potential upside profit opportunity, if these lows continue to hold – stay tuned!
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