Monday, September 10, 2007

Market players try to estimate losses

One reason nervousness is rife in the international markets is that market participants do not have a clear idea of what their assets are worth- and how much losses they have incurred because of the turbulence in the market. This uncertainty, more than anything else, underlies the panic in the markets and the aversion to risk.

Incredible as it may seem, nearly a month after the problems began, banks and investment banks are yet to get a reasonable fix on their losses. Partly, this could be because they believe that disclosure could undermine market confidence. Partly is because the players themselves do not know what their assets are worth.

The latter is especially true of complex derivative portfolios. But banks and investment banks are also in a fix about valuing debt finance they had committed for takeovers and other purposes. Banks are stuck with large amounts of these debt- and interest rates have shot up. On a mark to market basis, these would entail huge losses. But banks are also trying to renegotiate rates with clients, so would like to delay the valuation.

Another issue is whether market players should be subject to uniform valuation norms. Central banks are inclined to believe this should so for banks. But the SEC, FT reports, would leave it to investment banks to use their discretion.

The SEC, which stepped up checks of how five of the largest US investment banks are valuing mortgage-related securities, is comfortable with valuations being different between firms – as long as their valuations are consistently applied and checked. “We don’t substitute our opinion for our firms’,” said one senior SEC official.

John Dugan, Comptroller of the Currency, regulator for some of the top US banks, gave a warning last week that banks should use market prices, rather than “models”, to value securities even if trading volumes were far below normal

As John Gapper notes in the FT, the market will soon provide solutions to these overhanging problems. There are funds being created to buy distressed debt at huge discounts. Historical experience suggests that returns on such purchases can be attractive.

There is probably a huge weight of money building up to clear the debt overhang that banks are now suffering. The reason the market is not already clearing is that banks are wary of selling off mortgage-backed debt at a huge discount now, only to watch the prices trade upwards again after a few months.

This game of chicken between wary sellers and astute buyers is bound to end at some point and, when it does, I suspect that liquidity will return to the debt markets as abruptly as it vanished this summer.

We should see plenty of action on this front once the first flush of panic subsides. I remain optimistic about the resolution of the present market crisis and the outlook for the global economy.

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