Last week, Citadel Investment Group, a Chicago hedge fund, bought E*Trade Financial (NASDAQ: ETFC)'s collateralized debt obligation (CDO) portfolio for 27 cents on the dollar according to The Wall Street Journal [subscription required]. If this price was applied to the Level 3 assets of nine of the largest banks, it would wipe out the capital of three of them.
It's important to point out, before presenting this analysis, that the 27 cents on the dollar price that Citadel paid applied only to E-Trade's CDOs. It may represent a worst case scenario price for these banks. Furthermore, the Level 3 assets of these nine banks include other illiquid securities besides their CDOs. Finally, the calculations I'll show are based on the most recent Level 3 assets and equity of these banks as of last month.
Having said that, here are the three banks whose capital would be wiped out if that 27 cents on the dollar valuation was applied to their Level 3 assets and written off from their most recent capital levels:
- Morgan Stanley (NYSE: MS): -$29 B (subtract 73% of Morgan Stanley's Level 3 assets of $88 billion -- or $64 billion -- from its capital of $35 billion).
- Goldman Sachs (NYSE: GS): -$14 B (subtract 73% of Goldman's Level 3 assets of $72 billion -- or $53 billion -- from its capital of $39 billion).
- Bear Stearns (NYSE: BSC): -$2 B (subtract 73% of Bear's Level 3 assets of $20 billion -- or $15 billion from its capital of $13 billion).
I'd like to think things are not that bad. (The portion of the ABX index tracking double-A-rated subprime bonds that is used by many investors as a proxy for determining the value of similar mortgage securities recently traded at 45 cents.)
Nevertheless, it would not shock me if these banks were scrambling behind the scenes to raise capital. But Level 3 assets are illiquid so when a market price like Citadel's comes along, bank audit committees have a hard time just ignoring it unless they can somehow justify why their computer models would set a far higher value.
I am not sure how long banks can delay the day of reckoning. But I think they should just get it over soon so the market can resume functioning.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in the securities mentioned.
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Reader Comments (Page 1 of 1)
12-04-2007 @ 10:48AM
nathan said...
Without knowing what CDO tranches E*Trade actually owned, putting a number on the total aggregate is a rather silly way to evaluate what the actual clearing levels were. The superficiality of the WSJ analysis seems to have caught your attention though. To apply that 27 cent number to everyone else's portfolio is pure guesswork and, frankly, sloppy. If Lennar sells its real estate to MS for, say, 40 cents on the dollar, does that mean all modest homes in America must be valued at that level regardless of location or quality? CDOs are complex and can really only be individually valued using computer models. That's why the average person is shying away from them right now, and pros like Citadel are stepping in and buying. If they were really worth so little, why is Citadel buying them? E*Trade had to sell and created a wonderful opportunity for Citadel. If the Street is forced to sell, like Long Term Capital did (no staying power), then perhaps the point of a low valuation is pertinent. I doubt with the capital being made available, that that will be the case. But simply to say that Level 3 assets are being given a benchmark at 27 cents is not very meaningful.
12-04-2007 @ 11:46AM
Linda said...
Things may be looking up for E*Trade Financial Corp as Citadel Investment Group agreed to make a $2.55 billion investment into the discount brokerage. The NewsVisual article http://www.newsvisual.com/newsvisual/2007/11/donald-layton.html#more suggests that Donald Layton will bring to the table the experience necessary to help reverse the company's downturn.
12-04-2007 @ 2:17PM
Brian said...
Actually, the assets in the portfolio that Citadel bought were not all CDO. About half of the portfolio was prime RMBS rated AA or better. Most likely, the CDO and 2nd Lien collateral was marked close to zero and the prime RMBS took a big haircut which is even scarier than selling CDO's for 27 cents on the dollar. More detail here:
http://calculatedrisk.blogspot.com/2007/11/etrade-abs-haircuts.html
12-04-2007 @ 3:31PM
nathan said...
My point was merely that without knowing the collateral of Citi, E*Trade, Lehman, Merrill or anyone else, a generalization of 27% across the board is rather specious. The fact that E*Trade has a mixed bag of commercials, res and other stuff is consistent with my thoughts that you simply can't use one number to evaluate the true losses in anyone else's portfolio. They aren't all identical in collateral, maturity, quality, etc.
12-04-2007 @ 5:29PM
Jim Hoffman said...
I am in the camp that ETFC is a strong candidate for a buyout; hence a great buying opportunity at any price under $6.00
12-05-2007 @ 12:29AM
Deborah said...
Very, very ugly...
When you look at this story about a family and the structure of their debt, http://www.signonsandiego.com/news/business/20071202-9999-lz1b2mortgage.html, well, it seems to me that even the prime portion of their debt looks scary.
Their second mortgage is already about 50% underwater, meaning the prime part of their mortgage only has about 12-13% equity, and considering the price of the condo and the dire straights many home owners are in, that kind of further hair cut on the equity would not be a surprise. I don't what building costs are, but $285/sq ft seems like a price with room to decline.
12-05-2007 @ 11:20AM
James I. Hymas said...
The analysis in this post assumes that the Level 3 Assets on the books of the given firms are currently valued at par. Do you have a link to support this assertion?
12-05-2007 @ 11:55PM
reed said...
""" CDOs are complex and can really only be individually valued using computer models. """"
Classic statement ! Tell me, since the computers were infallible how come they didn't see this mess coming? Answer is,,,,,, the 100 year flood doesn't happen every 100 years like clockwork. What was that Dudes name at LTCM, looks like the 100 year flood happened sooner then his machines were telling him. Time to move on to the 'next new thing' and watch that fail too. Rock on!