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November 13, 2007

Credit Markets, Minsky Moments, and FASB Rule 157

Good and relatively sober-minded reading from the Levy Institute here on the current troubles in credit markets. Is it a Minsky Moment? Read the piece. From it, here is a quote from a recent BiS report:

Who now holds [the risks associated with the present era’s new investment instruments]? The honest answer is that we do not know.Much of the risk is embodied in various forms of asset-backed securities of growing complexity and opacity. They have been purchased by a wide range of smaller banks, pension funds, insurance companies, hedge funds, other funds and even individuals, who have been encouraged to invest by the generally high ratings given to these instruments. Unfortunately, the ratings reflect only expected credit losses, and not the unusually high probability of tail events that could have large effects on market values (Bank for International Settlements 2007, p. 145).

The last sentence is the one that should snap you to attention. It's one thing to properly assess mortgage default likelihoods in a vacuum, it is something else altogether to assess market values of such things in a feedback-fueled pricing crisis.

Relatedly, and not to get all obscure and accounting geek-ish, but it's hard not to wonder if FASB Rule 157, which comes into force this Thursday, will turn out to be the fire that lights the final fuse here. While it's laudable and all to force transparency and push market pricing, when everyone is forced to find a market price for illiquid instruments simultaneously during a credit crisis the result is a regulation-imposed death-spiral, with devastating implications all around.

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More reading here, if you can stomach it, on how the pricing spiral is playing out by proxy in the ABX index of mortgage-backed securities.

As a result, some analysts are now using another technique to work out their mortgage-linked losses, namely, extrapolating from prices based on derivatives indices such as the so-called ABX. For although mortgage bonds have not traded much in recent weeks, derivatives have been bought and sold – meaning that the ABX can offer a trading price.

In recent weeks, this trading price has fallen sharply (see chart), which has increased the pressure on banks to mark their books down. However, the banks have not yet made write-offs as large as the ABX might imply. Merrill Lynch analysts, for example, calculate that mid-quality ABX debt is on average now trading at 40 cents in the dollar. But these analysts say that Merrill Lynch itself has only written this type of debt down to 63 cents in the dollar – and UBS is still assuming this debt is worth 90 cents. “Simple math would imply that UBS needs an additional $8bn write-down [on its $15.4bn holdings] if the ABX pricing is correct,” Merrill says.

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