nab, the largest of Australia’s banks saw its share price fall by almost 14% today after they announced an A$830 million (US$795 million) provision on mortgage-backed CDOs (“collateralised debt obligations”).
It has been estimated that the US sub-prime mortgage crisis has resulted in over US$450 billion in write-downs to date and, earlier this year, the IMF suggested that the figure could rise to almost US$1 trillion. Up until now, Australian bank balance sheets had appeared fairly clean compared to their global peers, and they had avoided the large write-downs that have become common-place elsewhere over the last year. So what happened at nab?
There are 10 offending CDOs, which total A$1.2 billion in face value and started life in nab’s off-balance sheet “conduits”. At the time of purchase they were all rated AAA, not that credit ratings count for much these days of course. In May this year nab released their half-year results (to end March 2008) and announced a A$181 million write-down in the value of these securities. They explained that their modelling of the US housing market suggested that losses on the securities could reach around A$50 million. nab therefore characterised the A$181 million provision as an extremely conservative step to take.
Yet, less than three months later, they have decided to increase this figure by a factor of more than 5 as the A$830 million write-down brings the total provisions to over A$1 billion! So what has changed? Certainly Fannie Mae and Freddie Mac reached the verge of collapse and had to be propped up by the Federal Reserve, but mortgage-backed CDOs have been on the nose for a year now and could hardly have fallen any further in the last two months. So this seems like a drastic deviation from nab’s supposedly conservative model valuation. Many investors are now scratching their heads as to how nab could have got things so wrong, although as JP Morgan analyst Brian Johnson noted on the investor call, this is the same bank that lost over A$2 billion in 2002 from its distastrous investment in Homeside and around $400 million in 2004 in a currency trading fraud.
I suspect that the explanation may lie in the small print of the CDOs. CDOs consist of a pool of assets (usually loans or bonds) jointly owned by investors in securities of varying “seniority”. What this means is that if the underlying assets suffer losses, the more “junior” securities lose money first and the most “senior” securities lose money last. The more junior the security, the higher the interest rate it pays and the more senior the lower the risk and higher the credit rating. The highest possible credit rating is AAA, but securities ranking higher than other AAA securities are known as “super senior”. They are, in some sense “better than AAA”.
Although no two CDOs are exactly alike, many feature “trigger events”, such as rating downgrades, that allow certain investors, often the super senior security-holders, to initiate a “liquidation”. In this event there is a firesale, all the underlying assets are sold and the proceeds go to the most senior investors first. Needless to say, in the current market environment these liquidations do not do too well, particularly when the assets are mortgage-backed securities, and the super senior investors are likely to be the only ones to get any money back. nab is the super-senior investor for two of their investments, but not for the other 8. They indicated that one of these is currently the subject liquidation. My guess is that they have been told that they are unlikely to see any money from this liquidation and so have suddenly realised that their modelling is not very relevant if there is a forced liquidation in a terrible market. Perhaps, if they were able to hold onto the securities until maturity, they would only lose around A$50 million as their models suggested, but they may not have that option.
Whatever the explanation for the sudden change in their assessment of the value of these securities, nab is certainly now taking an extremely conservative position. The 8 AAA securities are now being valued at zero and the two super-senior securities at around 50% of their face value. This could send shockwaves around the globe as I suspect that many US banks could not afford to mark down their own positions so drastically: if they did, they would become insolvent.