02 November 2007

The costs of the credit crunch mount. There may be more pain to come

“THIS time it's different” are the four most expensive words in the English language, runs a saying among bankers. So it has proved at Merrill Lynch, an American investment bank which is ruing a stampede into collateralised-debt obligations (CDOs) and other subprime mortgage-linked nasties. Never mind that most of its CDOs were “super senior” and supposed to be relatively safe. On October 24th the Thundering Herd's senior bulls sheepishly announced write-downs of $7.9 billion on Merrill's mortgage holdings, $3.4 billion more than the bank had estimated only 19 days before. This tipped Merrill into loss. After a few days' testy deliberation, the board tipped its chairman and chief executive, Stan O'Neal, through the nearest window.

The $161.5m that Mr O'Neal grabbed on his way out will no doubt encourage would-be successors to step forward. But the new boss will be taking over at an unenviable time. The mortgage crisis has done more than $27 billion-worth of damage to capital-markets businesses so far. With the value of subprime securities still falling, that number could rise dramatically when fourth-quarter results are unveiled. Hopes that banks would be able to put the worst behind them in a single bad quarter have been dashed. Several bosses, including Citigroup's Chuck Prince, are under enormous pressure to steady the ship.

Big differences in the quality of risk management have become apparent. Merrill's controls were left in the dust as it ramped up its trading bets. Mr O'Neal sacked a senior fixed-income executive who had rung alarm bells last year. The board ignored a warning in April. By contrast, Goldman Sachs and (to a lesser extent) Lehman Brothers appear to have minimised damage through tight oversight and shrewd hedging.

But analysts think Goldman must also have taken some huge gambles to raise third-quarter profits in a difficult market (and despite a $1.5 billion write-down). That happy result may have had as much to do with luck as skill, thinks Roy Smith, a finance professor and former Goldman partner. Remarkably, given the pummelling most banks have taken, Goldman's share price is up by 24% this year. But it still trades at only around ten times earnings, little more than half the average for the S&P 500. “Investors will only pay so much for risk they can't see,” says Mr Smith.

In Europe too, they are struggling to penetrate the murk. UBS, the biggest Swiss bank and long regarded as a leader in risk management, gave no better answers than any other institution for calculating the future impact of the subprime crisis when it reported its third-quarter results on October 30th. UBS's investment-banking division lost SFr4.2 billion ($3.6 billion) in the third quarter. The bank's value-at-risk, the amount it stands to lose on a really bad day, has shot up (see chart). On 16 days during the quarter its trading losses exceeded the worst forecast by its value-at-risk model on the preceding day. It had not experienced a single such day since the market turbulence of 1998.

In a conference call to discuss the results, Marcel Rohner, UBS's chief executive, and Marco Suter, chief financial officer, struggled to explain the methodology behind their valuation of what seems to be a deteriorating portfolio of subprime securities. Reluctant to give a worst-case assessment of UBS's exposures in future, the best they could do was predict that the investment-banking division would not make a profit in the fourth quarter. They also promised to de-emphasise proprietary trading and to make traders think harder about their bets by raising the proportion of pay they receive in UBS shares.

Down the Bahnhofstrasse, Credit Suisse managed rather better, recording a small profit in investment banking despite big write-downs of its own. Germany's Deutsche Bank has navigated its way through the credit storm more deftly too. Its third-quarter write-offs, which were announced on October 31st, were nothing like those reported by Merrill and UBS, and were in line with predictions. At €179m ($259m), the bank's net loss in corporate banking and securities was modest. Deutsche's exposure to the American mortgage market is more or less hedged; in fact the bank has a net short position.

Nevertheless, investment bankers at Deutsche and Credit Suisse have relied on the banks' “stable” businesses, such as wealth management and private banking, to keep them afloat. The challenge facing them and their brethren is where next to find the juicy returns that they enjoyed before the credit bubble burst. There is already a lot of talk about commodities and currencies. Investments in distressed assets may also provide ironic comfort. Lehman has just launched a $3 billion fund that will buy discounted leveraged loans.

The more troubling question is how much more pain still lies ahead. Banks say they are following guidelines put out by the big accounting firms when valuing lumpier assets, but there is still plenty of room for subjectivity. It is possible that some banks will mark their assets down too far, and will be able to mark them back up at a later date. Or it may be that Merrill is using a more cautious methodology than other banks, and that they will have to take big hits of their own. (Merrill itself is expected to write down another $3 billion-5 billion in its fourth quarter.)

Auditors are urging the banks to mark assets to a “market price” that reflects recent transactions, even if there have only been a couple of these. With some AAA-rated CDOs trading at a mere 20 cents on the dollar, that can be painful (Deutsche Bank says it sold or otherwise unloaded €9 billion-worth of CDOs in the third quarter but is coy about saying how or at what price). Investors worry that banks will obscure the true value of their assets, hoping that prices rise.

But all the signs are that prices have further to fall before buyers are tempted to step in. Dilatory rating agencies are only now getting round to downgrading the most senior CDO tranches. In America, credit-card defaults are ticking up, which will further hurt asset-backed securities. Many subprime-linked instruments have become prohibitively expensive to hedge. Mr O'Neal fell in a falling market, but perhaps nearer the top than the bottom.

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© Graham Bishop