LIBOR / FASB 157 / 2008 Resets

A: Folks, keep an eye on LIBOR rates again as they are marching higher with the deadline of FASB 157 today. Although many brokerages and banks already adopted the new accounting change, the very fact that far more assets will be classified as Level 3, or hard-to-value given iliquid nature of the markets they trade in, is raising expectations of more devaluations and write downs to come. In addition, expect a whole new round of risk re-pricing in 2008 as ARM resets kick in causing havoc to many homeowners who already are struggling to pay monthly housing costs.

According to Bloomberg's article, "Overnight Dollar LIBOR Soars on Writedown Concerns":

The cost of borrowing dollars overnight rose by the most since September on concern investment banks will disclose more writedowns on securities tied to U.S. subprime mortgages. The London interbank offered rate, the amount banks charge each other for dollar loans, increased 19 basis points to 4.96 percent, its fourth straight day of gains, the British Bankers' Association said today. The three-month dollar rate rose 3 basis points to 4.91 percent.

"Everyone is very nervous about the possibility of further losses, and the market remains very fragile," said Nathalie Fillet, senior interest-rate strategist at BNP Paribas SA in London. "There are a lot rumors that banks are continuing to have problems accessing financing, and that is driving up borrowing costs."

On to accounting of hard to value assets, Professor Nouriel Roubini has a new discussion on FASB 157:

While FASB decided yesterday to to pospone the implementation of some parts of FASB 157, only non-financial assets (business combinations, etc.) have been excluded from this implementation; thus financial assets including asset backed securities and other illiquid financial assets will now have to be valued - whenever possible - using market prices or proxies of them rather than using voodoo-finance models and credit ratings (or better misratings) that don't make sense.

So far banks and other financial institutions have recognized losses only in the $40-50 range. But market estimates by myself and other analysts (RBS, DB) suggest that total losses for investors from subprime and other mortgages (and their related securitized assets) could be in the $300 billion to $500 billion range. While many of these losses will be borne by banks and investment banks many will be borne by other financial institutions (hedge funds, insurance companies, asset managers, both in the US and abroad). Losses will be even larger once we including the looming disaster in commercial real estate (expected losses of $100 billion), credit cards, auto loans and other consumer credit (securitized or not).

Happy day Nouriel is very hard to argue. While I respect his views and expertise, I think the only flaw to his logic is what actions will be taken to help ease the pain of the carnage that may come.

I'll be on a BULL vs BEAR panel at the Inman Real Estate Connect Conference in NYC in January with Professor Roubini & Barry Ritholtz; register here if you want to get in as I hope this becomes a Kudlow style heated debate!

Moving on. As I discussed previously, 2008 is going to be a very tough year for the housing market, write downs, and wall street. With so many ARM resets expected to higher rates, its only logical to expect defaults & foreclosures to rise; which is what got us into this credit crunch to begin with. The ABX indices certainly are pricing this in as investors bet on more carnage in the mortgage markets (buy credit protection), which leads to more seizing up of the secondary mortgage markets, which leads to no place to sell distressed mortgage backed securities, which leads to continued distressed pricing for Level 3 assets that no longer can use in-house model valuations. Get all that?

According to Seeking Alpha article, "Financial Sector Trap: the Worst is Far From Over":

Finally, has everyone just forgotten the billions worth of ARMs that are scheduled to reset over the coming months? The problem with the ARM situation is that rate cuts won’t help nor will refinancing, because in many cases the ARMs teaser rate payment is about as much as the borrower can afford. Once the teaser rate period is over the borrower has a loan they can’t afford even if they refinance to an uber-prime fixed rate mortgage, and rate cuts won’t prevent the loan from resetting to a rate that’s higher than the teaser rate. Over the next 2-4 months there is going to be a spike in ARM resets, followed by an accompanying spike in foreclosures 3-6 months later.

Here is a chart courtesy of SeekingAplha.com showing you the coming ARM resets on a month to month schedule.



The ABX Indices, while bouncing now for a 2nd straight day, have been pricing in this expected mess for some time, and we are about to hit the eye of the storm. Expect a volatile 2008 in terms of defaults, foreclosures, and many complaints about what can be done to help homeowners ease the pain of the coming payment resets!