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Saying that soaring US mortgage defaults require preparing for a "worst case scenario," the Melbourne-based National Australia Bank (NAB) Ltd., set aside A$830 million (US$795 million) for credit market losses. This followed a decision to write down its CDO portfolio, nominally valued at A$1.2 billion (US$1.15 billion), by 90%, to 10% of its nominal value.
(For those interested in the math behind the creation of CDOs from CDSs, see "A primer on financial engineering and structured finance." For a discussion of credit default swap (CDS) counterparty risk, see "Brilliant Nobel Prize winners in Economics blame credit bubble on 'the news.'")
An analysis by Credit Suisse indicates that other Australian banks may now be required to make similar writedowns of their US mortgage-based assets.
This NAB action has the potential to be extremely significant.
This appears to be the next step in the scenario predicted by Oppenheimer analyst Meredith Whitney.
Speaking on CNBC, Whitney said that banks are trying to avoid having to write down their assets for as long as they can avoid it. But the longer they wait, the worse it is, because the mortgage-backed assets keep falling as time goes on.
Whitney went much farther -- she predicted a full-scale panic when banks finally are forced to mark these assets down. Because the market will be loaded down with these securities from all sorts of financial institutions, they really will be almost worthless.
The NAB writedown of 90% establishes a market value for the CDOs in its portfolio. Other Australian banks may be forced to make similar writedowns, through either public or regulatory pressure. That same public or regulatory pressure may move to other countries, including America, and force American banks to start making more aggressive writedowns of their near-worthless mortgage-based assets. This could create a domino effect which, over a period of weeks, might trigger the panic that Whitney predicted.
I've estimated that the probability of a major financial crisis (generational stock market panic and
crash) in any given week from now on is about 3%. The probability of
a crisis some time in the next 52 weeks is 75%, according to this
estimate.
(28-Jul-2008)
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