In Subprime Crisis, the Worst Is Yet to Come

In Subprime Crisis, the Worst Is Yet to Come
By Beat Balzli and Frank Hornig
The consequences of the US real estate crisis are far greater than previously suspected. Wall Street could face losses of over $200 billion, and German banks are unlikely to escape unscathed. The full extent of the disaster will not be known for months.


AP
The full extent of the fall-out from the subprime crisis is still not known.Only a few weeks ago, in October, the world still seemed a fairly orderly place to Charles Prince, the chairman and CEO of Citigroup. Although the bank's earnings were already heading south as a result of the subprime crisis (more...), Citigroup's largest individual shareholder, Saudi Arabian Prince Alwaleed bin Talal, wasn't losing his cool. What was happening on the financial markets was a "mere hiccup," the Arab multibillionaire explained.
A short time later, at the beginning of last week, it was time for another Citigroup executive to take the company jet to the Saudi Arabian capital Riyadh for some urgently needed damage control. Until 2003, Sandy Weill (more...) was chairman of Citigroup, the world's biggest bank at the time. Weill, who is now 74, is credited with having expanded the company in the 1990s into the broadly diversified financial services conglomerate it is today. Now his life's work was in jeopardy.
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Find out how you can reprint this DER SPIEGEL article in your publication. Weill knew that the "hiccup" had quickly turned into a serious threat. "We discussed the situation, what was wrong and why things are happening like that," Prince Alwaleed told the magazine Fortune, describing his crisis meeting with Weill.
News of the meeting in Saudi Arabia sent faraway Wall Street into turmoil. Only a few days after Merrill Lynch CEO Stan O'Neal was let go, Citigroup chief executive Prince was also asked to clear his desk.
Both executives were guilty of a fundamental miscalculation. As a result, the two companies will each be forced to write off between $8 billion and $11 billion in bad debt. But, as dramatic as the events at Merrill Lynch and Citigroup were, they do not mark the end of the banking nightmare that began in mid-summer.
That was when the first financial institutions and hedge funds began issuing warnings that the US real estate bubble was on the verge of bursting. Many homeowners who had borrowed heavily against the equity in their homes, confident that real estate prices would continue to rise, were suddenly faced with the realization that they could no longer afford to keep up their mortgage payments.
PHOTO GALLERY: CASUALTIES OF THE SUBPRIME CRISIS



Click on a picture to launch the image gallery (6 Photos)The repercussions of the crisis have mushroomed since then, with billions at stake now instead of millions. And despite ongoing efforts by politicians and central banks to bring calm to the market, a crisis that began among smaller banks has since spread to the industry's giants.
The effects of the disaster on almost every major Wall Street institution and many European banks have been far more severe than previously supposed. The 10 biggest losers have already reported losses of more than $40 billion, and even this is only the beginning.
"I believe that we are still not aware of all the risks," said Alexander Dibelius, the head of investment bank Goldman Sachs's German office, only two weeks ago -- shortly before the CEOs at Citigroup and Merrill were let go.
Economists and central bankers are already predicting total losses in excess of $200 billion. "The bloodbath in credit and financial markets will continue and sharply worsen," Nouriel Roubini, a highly regarded American economist, recently wrote on his blog.
His fears stem from the fact that so far banks have only published their results for the third quarter of 2007, which, for most institutions, ended in August or September. The real estate crisis has worsened since then, with even greater losses expected for the fourth quarter.
The true scope of the debacle will likely become apparent only after annual financial statements are published next spring. Quarterly statements are an imperfect indicator, because they enable banks to defer their losses relatively unnoticed.


DER SPIEGEL
It's been a nasty few weeks for the global banking giants.One of the results of the dismal news is that, after weeks of rising prices, the US's leading stock market index, the Dow Jones, took a sharp downward turn in recent days. The central banks' efforts to improve the situation by increasing liquidity and lowering interest rates have evaporated like drops of water on a hot stone. Fear and suspicion are the prevailing sentiments on the world's stock markets. A banker in Frankfurt predicts: "We are just at the beginning of the second tsunami wave."
Its effects will likely extend beyond the banking sector. AIG, America's largest insurance group, is already reporting a 27-percent loss for the third quarter. In addition to the now notorious high-risk subprime mortgages, financial worries in the United States are now also being stoked by concern over subprime credit cards and subprime auto loans. For consumers unable to pay their mortgages, the monthly credit card bill or the car loan are also likely to present a problem.
With the price of oil close to the $100 mark and the dollar in a nosedive, the outlook for the US economy -- and the world economy -- is becoming increasingly bleak.
In a hearing before the US Congress last Thursday, Federal Reserve Chairman Ben Bernanke warned lawmakers of the consequences of the crisis: higher inflation, declining consumer spending and lower growth rates. On the same day, Bernanke's counterpart in the European Union, European Central Bank President Jean-Claude Trichet, expressed concern over what he called the "brutal moves" in the euro-dollar exchange rate.
To make matters worse, the banks' mortgage problem is developing into a crisis of confidence reminiscent of the collapse of the scandal-plagued US corporations Enron and WorldCom. The first investor lawsuit has already been filed, and the US market watchdog, the Securities and Exchange Commission (SEC), is taking a closer look at questionable accounting practices. New York Attorney General Andrew Cuomo has also launched his own investigations.




Part 2: Foolhardiness and Greed

But as complex as today's banking transactions are, the motives behind key players' actions are as simple as ever: foolhardiness and greed.
Take Stan O'Neal, for example. As chairman of Merrill Lynch, he pushed the company into increasingly risky real estate deals. Highly profitable in the short term, these deals earned O'Neal handsome bonuses. The fact that the entire model stood on shaky ground was water off a duck's back to O'Neal, who left the company with $162 million in severance pay.
PHOTO GALLERY: CASUALTIES OF THE SUBPRIME CRISIS



Click on a picture to launch the image gallery (6 Photos)To meet their profit goals, banking executives and their brokers had repeatedly delayed performing risk assessments of their financial instruments. "What would happen if Boeing Co. or Johnson & Johnson rolled out products with similar defect rates?" the Wall Street Journal asked rhetorically. The subprime crisis, the paper writes, acts as "a vital portal onto Wall Street, helping us understand just how upside-down the place has become."
In addition, the banks' boards of directors, blinded by the celebrity status of their senior executives, neglected to draft recruitment scenarios for top-level positions. The consequences of their neglect are now coming home to roost, as they face a limited selection of qualified candidates. The few remaining prospects, like Deutsche Bank Chairman Josef Ackermann, are suddenly in high demand.
Other US banks are also feeling the pinch. Morgan Stanley and Wachovia reported write-offs of $3.7 billion and $1.1 billion, respectively -- and those were only the numbers being reported late last week.
While Wall Street brokers are worried about their usually lavish Christmas bonuses, analysts at market research company CreditSights are busy calculating expected losses for the fourth quarter. Their predictions include a loss of $5.1 billion at Goldman Sachs, $3.9 billion at Lehman Brothers and $3.2 billion at Bear Stearns, whose CEO, James Cayne, has also faced heavy criticism. Trouble is also brewing at British bank Barclays.
Meanwhile Germany has by no means remained untouched by the fiasco. Despite posting substantial write-offs, Deutsche Bank, Commerzbank and Hypo Real Estate managed to report earnings growth in the last quarter. Nevertheless, this has by no means eliminated the uncertainty.
Only after their annual reports have been audited will "they all be able to breathe easier," says a risk management expert. "In other words, all kinds of things can reappear in the last quarter." According to the risk management expert, so far the Germans have taken a less hard line in their assessments than the Americans or Swiss banks like UBS. Does this mean that it's all just a question of valuation?
The valuation of complex credit products, for which there are currently almost no market prices, is a hotly debated issue among bankers, auditors and industry groups. Neither the German Federal Financial Supervisory Authority (BaFin) nor the Institute of Public Auditors in Germany (IDW) has offered clear guidelines. The resulting vacuum creates the temptation to doctor the numbers.
Fraudulent labeling is a hotly discussed issue at the moment, especially among Germany's state-backed banks, which are currently revising their accounting rules. Under the proposed new rules, the types of assets banks used to acquire purely for trading purposes, to earn a quick euro, so to speak, could now be declared as a long-term capital investment. The advantage of this approach is it would allow painful market losses in trading positions to be posted directly to the profit and loss statement. Securities held to maturity, however, would not have to be valued at current market prices, but instead at their acquisition prices. It's the perfect recipe for concocting an accounting fairy tale.



Part 3: 'Buy, Buy, Buy'
But the fear of time bombs on balance sheets raises worries on precisely the financial markets on which banks lend money to each other. Despite all efforts by central banks to intervene, everyone in these markets distrusts everyone else.
PHOTO GALLERY: CASUALTIES OF THE SUBPRIME CRISIS



Click on a picture to launch the image gallery (6 Photos)The year-end rally over funds that won't have to be repaid until January is already underway. No bank wants to risk no longer being able to guarantee its daily monetary transactions. "That's because most of them close their books starting in mid-December," says a London banker. "There's hardly any money available after that."
This scarcity makes borrowing money more costly. Financial managers use freshly borrowed cash primarily to plug the holes in their bank's sizeable investment funds. But the different possible solutions present the funds with a painful choice. Fund managers can either inject new cash, which could easily be consumed in no time, or they could face the prospect of devastating forced sales, which would lead to yet another broad decline in prices for credit products.
This is precisely the acute danger facing Sachsen Funding I, a €2 billion fund. In the next four weeks, Landesbank Baden-Württemberg and other investors will have to decide whether to inject additional cash or close the fund.
A rescue operation is already underway at an investment firm called Ormond Quay, which was responsible for the emergency sale of SachsenLB to Landesbank Baden-Württemberg.
To prevent a collapse, a consortium of German savings banks provided Sachsen Funding I with a €17.3 billion emergency funding package several weeks ago. Of German bank DekaBank's €6 billion share of the package, only about €500 million has been used to date.
WestLB, another German state bank, is also involved in an extensive bailout effort. According to a spokesman, WestLB had to provide its €3.3 billion Kestrel fund with "a credit line to support liquidity."
The credit line, says the WestLB spokesman, "guarantees the full repayment of all debt securities." It has also saved the fund from being downgraded by ratings agency Moody's.
WestLB believes that the prices in the Kestrel portfolio will recover. This reflects the current focus on faith in a world normally dominated by hard numbers. The situation is also tense at Harrier Finance, another WestLB company with assets of $11 billion.
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Is Harrier about to face a complete fire sale? This would be all too convenient for some financial jugglers. The first vultures hoping to turn a profit from the debacle are already circling.
One of them is market guru Bill Gross. For the past few days, Gross, who founded German insurance conglomerate Allianz's PIMCO pension fund, has been buying up the supposedly junk securities at bargain-basement prices.
Giants like Goldman Sachs and the Royal Bank of Scotland have been doing the same thing, investing their wealthy customers' money. If the market bounces back, these high stakes players could end up raking in huge profits in the global financial casino.
"If I had the money," says an envious chairman of a German state bank, "all I would do now is buy, buy, buy."
Translated from the German by Christopher Sultan


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