Sub-Prime Losses Overstated?

WSJ: A key measure of estimating the value of subprime mortgage-backed securities may be overstating potential losses of triple-A securities by more than 60%, according to the Bank for International Settlements, which puts its own estimate of such losses at US$73 billion.

The BIS, often called the central bankers' central bank, has few formal banking duties but is a hub for economic and monetary research as well as for global policy makers. Its most recent quarterly report adds to growing criticism of a key measure of the subprime-mortgage market called the ABX.

Launched more than two years ago by Markit Group Ltd., the ABX is an index that tracks the value of securities backed by subprime loans. ABX is based on credit-default swaps: actively traded instruments that insure against default on the securities.

The index often is used by banks and other organizations as a proxy for the value of mortgage-backed securities. Echoing other concerns, the BIS says the ABX prices may be unreliable because the indexes only cover a small percentage of the market. Some observers also contend that ABX prices have been driven lower largely by bearish traders.

The BIS also says the ABX indexes may misrepresent the structure of the securities they claim to reflect. The specific triple-A securities referenced by the index, in the case of a default, would be paid only after all other triple-A obligations had been met. Recalculating with new data for triple-A securities that would get paid faster, the BIS says the ABX overestimates triple-A losses by 62%.

The BIS says the value of subprime mortgage-backed securities outstanding issued from 2004-07 is about US$600 billion. At the end of May, the report says, ABX prices suggested a value of about 59 cents on the dollar for such securities, indicating losses of about $250 billion, almost half of which -- US$119 billion -- would come from triple-A securities.

Under the BIS's new calculations, losses on triple-A securities total only US$73 billion. That would bring the total subprime-mortgage-related losses down some 18%, to US$205 billion.

Comment: This is highly significant for the investing landscape going forward. BIS is highly respected and their findings are usually highly accurate and fair as well. That being the case, this lends a lot more weight to a potential super bull run in 2H2008. As I expect the oil price bubble to be deflated by then, a drop back to US$100-110 would act as a good deflator of inflationary pressures. This in turn should ignite a bull run for equities. Soon as funds start to swish around, there will be greater re-evaluation of the sub-prime write offs as being too severe. Analysts will then be trying to estimate the amount available for banks to write back some of the losses, thus adding to the equity upswing. Very important news to digest and keep in mind.

p/s photos: Ying Chatcha Rujirano