26 July 2008

NAB sends a bleak message to the world

Other banks will now examine their exposure, conduit exposure especially.

Now, NAB has decided that the US housing crisis is so severe that up to 90% of the $1.2 billion value of the CDOs will be lost. There are 10 CDO lines in the portfolio, two of which were valued at $320 million, and accorded so-called "super-senior" status, ranking them at even better than AAA, the usual gold standard in debt ratings.

The balance of about $880 million was classed as senior AAA. Yesterday's $830 million write-down came on top of a $181 million write-down of the same exposure that was announced at the half-year results on May 9.

Stewart said yesterday that in pushing the provision to just over $1 billion, NAB was assuming that it would recover no value at all from the AAA tranches, and only about half from the two super-senior tranches. Stewart is in a spot of bother about how NAB has handled this revelation.

The bank priced $850 million worth of senior bonds last Tuesday, and will settle on them next Tuesday, for one thing. NAB actually flagged that it was reviewing the value of its US CDO mortgage exposure two weeks ago, and the dimensions of the write-down did not coalesce until after the bond issue closed - it was signed off by the board yesterday morning.

However, NAB is sensitive enough about the fact that the bonds were priced ahead of the write-down, to have yesterday given to those who bought them until Monday to withdraw.

Stewart's second perception issue is that in May he said that management had mined the $US1.2 billion mortgage exposure forensically, and only found the need to write it down by $181 million.

NAB is a repeat offender when it comes to nasty surprises, and that affects confidence about its predictions. Before this, there was the 2004 foreign exchange loss debacle, and before that, the 1998 acquisition of US mortgage company Homeside, which cost $US1.23 billion, and $4.1 billion to bury.
Other banks will now examine their exposure, conduit exposure especially.

NAB's decision to book an $830 million charge against $1.2 billion of US home loan exposure to carry write-downs to 90% of the original value sends an extremely gloomy message to the global banking system and the world's sharemarkets.

NAB chief executive John Stewart says it is a worst-case view. Investors everywhere will have to hang on and hope it is not confirmed.

NAB's write-down relates to indirect "conduit" exposure to US mortgages, and reflects NAB's view about how the US housing market slump will unfold over two or three years, as defaults continue to rise, the queue of unsold houses continues to lengthen, and forced sales generate nowhere near enough to cover the mortgage. In some cases, sales were recouping as little as 50% of the outstanding mortgage, Stewart said yesterday.

The write-down reflects two ultra-conservative calls. First, the bank is valuing its US mortgage exposure on a worst-case view of how that process of defaults and forced house sales occurs. Second, it has decided, after some internal discussion, to front-load the expected losses, instead of trickling them out.

There is no way NAB's 90% write-down will be mirrored by every bank with US mortgage exposure. Measured by the mortgage debt, the US housing market is worth about $US5000 billion ($A5212 billion). It simply is not going to fall to 10%, or $US50 billion.

But after NAB's move other banks will examine their exposure, conduit exposure especially.

Banks around the world have so far written off $US410 billion in the credit crisis, and the new consensus is that losses will reach between $US1000 billion and $US1300 billion before it is over (the first, shocking estimate nine months ago was $US200 billion).

NAB's 90% write-down begs the question: is even $US1300 billion enough? NAB has so-called conduit exposure to US home loans. This a guarantee, in effect, on securities called collateralised debt obligations (CDOs) that it issued, which in turn were (and are) backed by the US mortgages.

As the credit crisis unfolded in the second half of last year, banks everywhere began acknowledging that their balance sheets ultimately supported the CDOs. But John Stewart and his team remained confident that the call on the balance sheet would not be made.

The mortgages concerned are not subprime junk. In fact, they had received an AAA credit rating originally, which as Stewart said yesterday, implied a one in 10,000 chance of defaul

Stewart correctly argued yesterday that the mortgage write-down sterilises that specific exposure, in light of NAB's views about the likely duration and intensity of the credit squeeze, and its new view that the bottom has not been reached (he said in May that he thought it had, after the mid-March rescue of Bear Stearns, but has changed his mind). But NAB has another $13.2 billion of conduit exposure, and $4.5 billion of it is in areas with proximity to the debt market meltdown: northern hemisphere corporate debt and commercial real estate.

There is more corporate debt exposure than real estate exposure, which is better than the other way around.

Stewart, chief financial officer Mark Joiner and NAB Capital boss John Hopper also said the portfolio had been stress tested, and while loan provisions were generally trending higher as the crisis morphed into a global economic downturn, no extraordinary write-downs were needed.

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