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]. 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.
Reader Comments (Page 1 of 1)
12-05-2007 @ 3:07AM
Cindy said...
If Paulson is resetting the clock, and COLA picks up the rest of the tab. I can't see why they need to dump their portfolio. Besides, maybe FDIC was too pessimistic.