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Guesstimates Won't Cut It Anymore--Gretchen Morgenson in the NYT 10-28-07

Updated on October 28, 2007

The Derivatives Genie is Out of the Bottle!

Excerpts from Morgenson article;

The $30 billion in losses and write-downs taken by big brokerage firms in the third quarter are not likely to be the last.

After last week it was no longer plausible to deny that mortgage loans, and the complex securities derived from them, had crashed--and caused a lot of damage in the process.

First to face the music was Merril Lynch with an $8.4 billion write-down, $7.9 billion of which was for mortgage-related assets. The write-down was $3.4 billion more than it had warned investors about just three weeks before.

Almost $8 billion of the firm's capital had vaporized in the third quarter because it had underestimated the degree to which its holdings of collateralized debt obligations, or C.D.O.'s had tanked. C.D.O.'s are pools made up, for the most part, of mortgage securities divvied up into tranches of differing risk levels.

The executives on Merrill's dismal conference call conceded that even after they decided to value their C.D.O. holdings more conservatively--resulting in losses--much of their methology was based on "quantitative evaluation." For the rest of us that means that Merrill was in the unfortunate position of having to guesstimate its exposure to losses.

Analysts quickly responded by forecasting an additional $4 billion in write-downs on Merrill's portfolio.

The C.D.O.'s (Merrill's and other banks') that may be subject to a downgrade hold subprime mortgage loans worth $33 billion.

With the C.D.O. market stopped dead in its tracks, it is not clear who will be willing to buy and at what price. But it's a good bet that these forced sales aren't going to add buoyancy to the market. A better bet may be to expect Wall Street to recognize further losses.

Intense auditor scrutiny comes once a year, and that is the period we are in now--fiscal years at many big brokerages, Morgan Stanley, Lehman Bros., and Bear Stearns, for example, in November.

"When it comes time for the auditors to attest, they are going to be very conservative," Mr. Rosner (Graham Securities expert on asset backed securities) said. That means write-downs will have to reflect the reality in the market, not some rosy scenario.

Way back in 2003, Warren Buffett defined derivatives--like those exploding on a balance sheet near you--as "FINANCIAL WEAPONS OF MASS DESTRUCTION."

"THE DERIVATIVES GENIE IS NOW WELL OUT OF THE BOTTLE," he wrote, "AND THESE INSTRUMENTS WILL ALMOST CERTAINLY MULTIPLY IN VARIETY AND NUMBER UNTIL SOME EVENT MAKES THEIR TOXICITY CLEAR."

Last week Merrill shareholders got a taste of that toxicity. Others will soon have their turn.

Here's a link to Morgenson's article.

This Time, Housing Is Taking Department Stores Down With It by Floyd Norris and Michael Barbaro

....Since April, when investors voiced optimism that the housing slide had been contained, shares of the country's biggest department store chains have fallen by about 30 percent. Here's a link to Norris's and Barbaro's article.

Paul Krugman on Mortgage Meltdown

Moyers and Morgenson on Mortgage Meltdown

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