PrefBlog

The IMF has announced:

The widening and deepening fallout from the U.S. subprime mortgage crisis could have profound financial system and macroeconomic implications, according to the IMF’s latest Global Financial Stability Report (GFSR).
At present, the issuance of most structured credit products—instruments that pool and tranche credit risk exposures in various ways—is at a standstill and many banks are coping with losses and involuntary balance expansions, the April 2008 report said. The report examines this and other forces that could push the current credit crisis into a full credit crunch, as well as offering policy recommendations to mitigate the impact.

The full report is available online (all 211 pages!).

There is bound to be massive excitement regarding their estimate of $945-billion in total losses due to the credit crunch – this has already been picked up by the Globe and Mail and, in turn, by Financial Webring Forum.

This figure comes from Table 1.1 of the report, and is most interesting since it is in two parts: the first half of the table estimates losses from Unsecuritized US Loans as being $225-billion on $12,370-billion outstanding (= 1.8%), while the “Estimate of Mark-to-Market Losses on Related Securities” is $720-billion on $10,840-billion outstanding (=6.6%). This is not entirely due to the somewhat different mix of these sectors – unsecuritized commercial real estate has an estimated loss rate of 1.25%, while CMBS has a loss rate of 22.3%. There will undoubtedly be some screaming that the bad paper was securitized, but let’s have a look at the methodology for the estimates, found in Annex 1.2 on page 46 of the report (page 63 of the PDF):

Losses on different types of loans were estimated from regression analysis using various relevant factors, such as changes in unemployment, lending standards, and housing and commercial real estate pricing, as relevant. In each case, the outstanding stock of the type of loan was multiplied with the change in the forecasted loss (charge-off) rate. The underlying historical data on loan loss rates and changes in lending standards were obtained from the Federal Reserve.
…
Losses on residential and commercial mortgages were also estimated by a second procedure. This one involved a three-step process. We first estimated the percentage of loans that would become delinquent, then the percentage of delinquent loans that would default, and fi nally losses on defaulted loans after completion of the foreclosure or recovery process. Each of these steps is detailed below.

Reasonable enough. How about for the securitized loans?:

Losses for securities were next estimated by multiplying the outstanding stock of each type of security by the change in the market price of the relevant index over the course of a year. The average price change was obtained by weighting price changes for constituent indices comprised of different vintages and ratings by the issuance in each of these categories.

In other words, this is simply the first method described in the leveraged losses paper by Greenlaw et al. that I have discussed previously.

As the authors note, however:

The fall in market prices may be overshooting potential declines in cash flows over the lifetime of underlying loans.

I suspect that this overshoot is quite considerable. If we apply the 1.25% loss rate for unsecuritized commercial real-estate to CMBS, we reduce the projected loss to $12-billion from $210-billion. If we apply the unsecuritized sub-prime loss rate of 15% to the ABS & ABS CDOs, we reduce these projected losses to $225-billion from $450-billion.

Clearly, my calculations above (which reduce total projected losses from $945-billion to $522-billion) are completely pie-in-the-sky, back of an envelope approximations. That being said, I would like to see more discussion on why securitized loans are projected to have such huge incremental losses over non-securitized loans … preferably, a discussion including actual facts.

There’s a very interesting point made on page 19 of the report, with its accompanying figure 1.17:

Some banks have rapidly expanded their balance sheets in recent years, largely by increasing their holdings of highly rated securities that carry low risk weightings for regulatory capital purposes (see Box 1.3 on page 31). Part of the increase in assets reflects banks’ trading and investment activities. Investments grew as a share of total assets, and wholesale markets, including securitizations used to finance such assets, grew as a share of total funding (Figure 1.16). Banks that adopted this strategy aggressively became more vulnerable to illiquidity in the wholesale money markets, earnings volatility from marked-to-market assets, and illiquidity in structured finance markets. Equity markets appear to be penalizing those banks that adopted this strategy most aggressively (Figure 1.17).

We may well see a bigger charge – and more differentiated by issuer – for non-government AAA assets in the next Basel agreement! Table 1.2 shows that the market is already making adjustments to the relative level of its haircuts … but in proportions that bely the headlines!

I’m mainly interested in policy implications, however: one, which echoes the new FASB rules on QSPEs, is introduced on page 38:

Stricter rules are needed on the use of off-balance-sheet entities by banks, and disclosure should be improved so that investors can assess the sponsor’s risk to the entity. Supervisors may need to strengthen guidelines regarding the circumstances under which risk transfers to off-balance-sheet entities warrant capital relief (see Chapter 2).

The executive summary of the report includes (on pp. xii – xvi) a number of short- and medium-term recommendations for future regulation and conduct. I’ll be returning to this topic … eventually!

Update: This report – and the loss estimate – has also been noted on Econbrowser by Prof. Menzie Chinn.

This entry was posted on Tuesday, April 8th, 2008 at 1:17 pm and is filed under Interesting External Papers. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.