July 9 (Bloomberg) -- Credit Suisse Group said losses for investors in bonds backed by U.S. subprime mortgages may total $52 billion, the low end of estimates as analysts try to determine the fallout from rising delinquency rates and foreclosures. Subprime defaults are ``clearly a huge problem'' for investors in collateralized debt obligations, Credit Suisse analysts led by Ivan Vatchkov in London wrote in a report. ``But we do not think that they are a systemic one.'' No one knows how much money is at risk from subprime defaults because CDOs made up of the loans aren't required to publicly disclose holdings. Deutsche Bank AG says losses from mortgages made last year to borrowers with poor or limited credit records or high debt burdens may reach $90 billion. Pacific Investment Management Co. in Newport Beach, California, in April estimated the fallout at as much as $75 billion. ``Investment banks operate in this market day and night and they know it better than most,'' Vatchkov said in an interview today. ``The market's been turning for the past 12 months, so I think they saw it coming.'' The maximum potential losses for investors in CDOS is equivalent to about a tenth of the $513 billion of equity capital for the world's biggest 10 investment banks, according to Zurich- based Credit Suisse. It's less than a quarter of the $227 billion that flowed in to hedge funds and mutual funds in the first three months of this year, Switzerland's second-largest bank said. CDOs package bonds and loans into varying pieces of risk, using their income to pay investors. Losses on subprime CDOs may be as little as $26 billion, according to the report. Subprime Losses Bear Stearns Cos. in New York, the world's fifth-biggest securities firm, is providing $1.6 billion to rescue one of its hedge funds invested in subprime debt. Queen's Walk Investment Ltd., a mortgage debt fund run by London-based Cheyne Capital Management Ltd., last month said it lost 67.7 million euros ($91 million) for the year to March 31. Cambridge Place Investment Management LLP in London last month closed the $908 million Caliber Global Investment Ltd. fund after losses on U.S. subprime debt. Not Transparent Banks are likely to suffer smaller losses on their own investments in CDOs than from lending to hedge funds that may be unable to repay the debt, according to Credit Suisse. The bank has ``outperform'' ratings on UBS AG in Zurich and Frankfurt- based Deutsche Bank because European banks are among the ``most conservative buyers'' of CDOs, said the report from the London- based equity-research team. ``Banks' direct exposure to CDOs is not as high as people think,'' said Vatchkov. ``They stand to lose $5 billion to $15 billion from direct exposures over time on the basis of what we know now. Banks have lent money to the people who bought the risky equity tranches of CDOs, but that market isn't transparent enough to estimate exposure and risks there could be bigger.'' Banks tend to hold the senior parts of CDOs rather than the riskier equity pieces, the report said. Delinquencies and defaults on U.S. subprime mortgages will keep rising as borrowers who received loans with less rigorous checks fail to keep up with repayments, Robert Parker, vice chairman of Credit Suisse Asset Management, said on July 5. Loans that require little or no documentation of income made up 46 percent of all U.S. subprime mortgages last year. U.S. homebuyers with undocumented income defaulted at a rate of 13 percent in February. Goldman's CDOs The share of subprime mortgages entering default in the first quarter was the highest in almost five years, the U.S. Mortgage Bankers Association said. Goldman Sachs Group Inc., the biggest U.S. securities firm, last week said the value of its CDOs fell by $1.56 billion, or 29 percent, in the second quarter. Its fixed-income revenue fell 24 percent in the same period as rising defaults cut the value of debt secured on mortgages. Losses in the U.S. market may be the ``tip of the iceberg,'' Bank of America Corp. analysts said last month. The impact of losses for banks should investors stop buying CDOs and asset-backed debt wouldn't be ``that material'' because the entire business of securitization only accounts for between 4 and 6 percent of bank revenue, Credit Suisse said. Banks and asset managers sold 59 billion euros of CDOs in Europe so far this year, 104 percent more than the same period a year ago, according to Deutsche Bank data. To contact the reporters on this story: Sebastian Boyd in London at sboyd9@bloomberg.net Neil Unmack in London at nunmack@bloomberg.net Last Updated: July 9, 2007 10:38 EDT
Excerpt from this weeks John Mauldin letter- can get the whole newsletter here http://www.frontlinethoughts.com/pdf/mwo070607.pdf Five Cents on the Dollar I think it will be instructive to look at the two Bear Stearns funds which have blown up, in the way that looking at a movie on lung cancer is instructive about the problems with cigarettes. (Thanks to Gary Shilling for the details. www.agaryshilling.com) There were two funds, with the names High Grade Structured Credit Strategies Fund and High Grade Structured Credit Enhanced Leverage Fund. The first was three years old and had 40 straight months without a loss, and the second was started last August. The first used its $925 million in capital to bet $9.7 billion on the bull side and $4 billion on the bear side of the subprime mortgage market for about a six times leverage. The "Enhanced Leverage" (what a seductive term) "had $638 million in investor capital on March 31 and borrowed at least $6 billion to make $11.5 billion in bullish bets and $4.5 billion in bearish wagers." That is ten times leverage if your shorts and longs were truly opposite each other, and a lot more if they were not. Let's look at the implications of ten-to-one leverage. Say you are borrowing at LIBOR (which today is 5.36%) plus 25 basis points, for a total of 5.61%. If you can average 8% on supposedly investment-grade paper after costs, with ten times leverage you make about 23%, before fees. And as long as the collateral is solid, you print money. But what happens if the total collateral drops just 2%? You are now down 20% because of the leverage. Ouch. And if the asset drops 40%, as the BBB paper has done, you can get wiped out if there was only 25% of your fund in BBB paper. From January through April, the Enhanced Leverage Fund (which could also be called the Enhanced Loss Fund) was down 23%. The gentle margin clerks at Merrill Lynch decided they wanted some of their collateral back to sell on the market when Bear Stearns refused to pay off the loans. Where was Bear going to go to raise capital? Sell what? And to whom? Better to stall and bluff. So Merrill tried to sell $850 million in collateral. Except there was a problem. The best stuff was getting bids of only 85 cents or so on the dollar, and others were getting bids as low as 30%. Let's review the math above. At a 15% discount of the assets, the fund would be more than bankrupt, and the lending institutions would be losing money they had lent at very low rates and very high margin on what they thought was investment-grade debt. As I understand it, Bear has not actually made, as of yet, a loan to the Enhanced Leverage fund. That is probably because there is no actual collateral for them to make a loan on. Better to save your money to deal with the lawsuits. And here's a side point in the banks' favor, from a culpability standpoint. All these banks were creating the CDOs and knew what was in them. Either someone forgot to tell the loan department, or they all drank the Kool-Aid and believed in the ratings. (Historical note: we use the term "drank the Kool-Aid" because the followers of Jim Jones were all true believers and drank a flavored drink containing poison in a mass suicide. However, it was not Kool-Aid they drank, but some other similar drink. But poor Kool-Aid, a very noble potion much enjoyed in my youth, gets the bad press.) Some investors in the Enhanced Fund have offered to sell their positions for 11 cents on the dollar. The offer is 5 cents. They should take it. And I will make you a leveraged bet that the offer comes from very litigious fund managers that are betting they can get Bear Stearns to pony up a lot more than 5 cents in settlement. Bear does have other problems. They were planning on doing an IPO of the fund management group, which was going to be owned 25% by the manager of the two busted funds. The offering memorandum said very nice things about the talents of the manager and the risks of the funds. Enter lawyers, stage right.
I wonder if they announced the loan just to try and help buoy the CDO market in the hopes they could slowly sell off some of the positions? Seems like an interesting possibility.