Subprime Writedowns: Is the Worst Over?

Standard & Poor's Ratings Services believes that the bulk of the writedowns of subprime securities may be behind the banks and brokers that have already announced their results for full-year 2007. There may be some additional marks to market as market indicators have shown deterioration in the first quarter. However, when we dissect the percentage of write-downs taken against various types of exposures, in our opinion the magnitude of some write-downs is greater than any reasonable estimate of ultimate losses. To this amount we add approximately $40 billion in writedowns of insurers (financial guarantors and other insurers) and banks in the Gulf States and Asia to arrive at a rough estimate of $150 billion in global disclosed writedowns to-date. Most of the writedowns have been on the so-called supersenior tranches of CDOs of subprime ABS. To date, banks have written down their unhedged supersenior CDOs of ABS by more than $65 billion. On an original exposure of about $160 billion, this represents about a 40% discount. However, that discount percentage varies tremendously from institution to institution. In our view, some of the variation may be based on differences in the specific securities the institution owns, as the securities vary widely in their ultimate loss characteristics. Some of the variables that affect the valuation are whether the exposure was to so-called CDO-squared securities (CDOs that purchased tranches of CDOs) or to the supersenior tranches of high-grade CDOs or mezzanine CDOs; the proportion of the underlying loans that were of 2005 or earlier vintages; how many of the CDOs' investments were in other CDOs and in subprime residential mortgage-backed securities (RMBS); and the levels of subordination in each structure. Based on available information, we believe that the largest players can be seen as having undertaken a rigorous valuation methodology to come up with conservative valuations. Citigroup Inc. and Merrill Lynch & Co. Inc., for example, value their high-grade supersenior tranches at 52% and 68% discounts to original exposure, respectively. The broader range of banks values them at only a 30% discount. Similarly, Citi and Merrill value the supersenior tranches of the mezzanine CDOs at 63% and 73% discounts, respectively, whereas the broader range of banks values them at a 48% discount.