Global banks have written down nearly $110 billion in losses related to mortgage backed securities. Are there more to come and what the write-downs mean for the future of banking? By Vivek Sharma

Here is a poser to all young Indian managers who aspire to head global corporations some day - Do you have it in you to announce a quarterly loss of nearly $10 billion, without losing your marbles? Can you tell your shareholders that you are writing down 'their' assets by more than $22 billion in a single quarter, and still keep gushing about the wonderful business opportunities your company is well positioned to exploit and extol the great team you have under you?

$22 billion is what India's defence forces, the fourth largest in the world, will spend this financial year, including purchasing equipment. With $22 billion, you can buy out TCS or Infosys. You really need very special skills to take a $22 billion knock in a single quarter and appear calm and sane.

Well, that is what Vikram Pandit, newly minted CEO of Citigroup, did last week. To be fair to him, those huge losses were not his fault. Those losses were a result of his predecessor's eagerness to 'keep dancing while the music lasted'. Citi, and many others, continued to dance and turned in amazing numbers - quarter after quarter. Unfortunately, their risk management teams were sleeping while the music was on. When the music finally stopped, all the muck surfaced and heads rolled.

Citi's quarterly loss is nothing when compared to the erosion in its market value over the last one year - more than $130 billion! You can acquire the whole of Reliance Industries with that money and still be left with enough to buy out a couple of PSU oil companies.

Citi is not an exception. Global banks have so far written down their mortgage-related assets by an astronomical $108 billion over the last couple of quarters, and it is still not over. Of this, the top five losers - Merrill Lynch, Citigroup, UBS, Morgan Stanley and HSBC - account for more than 70 per cent.

How could they let this happen?
One question that begs an answer is how did all these banks together land in such a prime mess? How did the supposedly sophisticated risk management systems fail so completely? How come no one in the senior management teams, who claim to be the best in the business, anticipated the downturn in the US housing market and take corrective steps?

While there are no clear answers as yet, the most plausible explanation is that not many really understood the complex derivative instruments linked to mortgage assets - not even their creators. Most believed that risks were widely spread, as chunks of the same assets were held by a diverse group of investors. And very few expected the housing market downturn to become this ugly.

While the US housing market was booming, it was a veritable gold mine for these banks. A traditional banker would have sold a loan product to a homebuyer and held on to that asset. But, increasing securitisation of such loans meant that banks could sell their assets to financial investors, raise cash, and then lend even more. Parts of the assets were parked in 'structured investment vehicles' (SIV), which do not need to be consolidated in bank balance sheets. This allowed the banks to expand their business volumes without a corresponding increase in capital.

Financial investors were attracted by the high yields and low perceived risks of mortgage-related securities. Banks earn a fixed fee when they package loan assets into derivatives and sell them. Demand for these derivatives was huge from investors flush with funds.

At some point, securitisation became more profitable than loan origination for banks. So, it was in their interest to originate as many mortgages as possible - to be packaged and sold to investors. Credit standards were lowered, teaser interest rates were introduced and the sub-prime boom started.

As the boom continued, bankers conjured up increasingly more complex derivatives. These derivatives were structured to make them appear sophisticated and safe to investors and credit rating agencies. The latter conveniently bought the story and assigned AAA ratings - for a fee, of course. Investors continued to lap them up, as they came with the assurance of investment-grade ratings.

Even though the aggregate size of the mortgage-related securities market hit trillions of dollars, there was no active secondary market for these assets. As a result, these assets were valued using internal methods and calculations. There was no concept of marking them to market, like in the case of other securities, because there were no market quotes for these securities.

This was fine as long as the underlying assets - mortgages - remained sound. As the US housing market started cooling and the first wave of mortgage defaults hit, the hedge funds with heavy exposure to these securities went belly up. When they started a distress sale of their holdings, prices of these assets plunged. Those prices became the reference prices, and the banks were forced to mark down the value of their holdings. The meltdown began.

Banking will never be the same
Once the dust settles down, whenever that is, the entire banking industry would have been thoroughly shaken. There will be substantially higher regulatory pressure to tighten up controls and end risky business practices. Financial investors will think many times before putting their money in derivative securities. Commercial banks will go back to the basics and focus more on traditional banking. 

It is unlikely that banks will stop all kinds of securitisation, which will be an undesirable outcome of this unpleasant episode. Securitisation has enabled banks to stretch their resources and ensured credit availability to millions of homebuyers in the US. In fast growing economies like India, where housing demand is very high, securitisation is essential for housing finance companies.

Even derivative securities are desirable as long as they can be properly valued and investors understand the true nature of risks involved. Hopefully, banks will not end up throwing the baby out with the bathwater!

More trouble in store?
Even after all these write downs, large banks still hold billions of dollars worth mortgage-related securities. If the US housing market takes longer to bottom out and defaults rise as the economy slips into a recession, there could be more write downs. That will make life even more difficult for bankers, who are struggling to raise capital to support their profitable revenue streams.

Citigroup results also point to another big risk lurking around the corner. During the December quarter, Citi made a loan provision of over $4 billion - for credit cards, auto and other unsecured loans. That is a clear indication that borrowers are finding it difficult to repay their credit card and other loan outstanding.

Aggregate credit card outstanding in the US, at over $900 billion, is rather miniscule when compared to total home mortgages. But, during periods of economic weakness, credit card defaults can rise much faster than home mortgages - as those who are financially weak and rely more on credit cards are often the worst hit. That could lead to further pressure on consumer spending.

There could be a potential upside to the massive write-downs as well. The write downs announced so far are based on estimated values of mortgage-related assets, based on current market conditions. If and when housing market conditions improve, values of these assets will also recover and banks will be able to write back part of these markdowns.

Some analysts have already started arguing that the current write downs are excessive, as it is in the interest of the newly appointed CEOs like Vikram Pandit to exaggerate past troubles and then take credit in future when things may turn out to be not as bad as feared.

Are big banks too unwieldy?
As the big banks struggle, it is being argued that it may not be a good idea to have such large banks. The main reason for building large banks was that risks will be spread over diverse businesses and geographies and hence will be more manageable. Now that the theory has been thoroughly discredited, it is natural that there are calls to break up the big banks to more manageable units

As the global economy is getting more integrated, there is undoubtedly a strong business case for large banks with wide geographical presence which can cater to the needs of global businesses. This need is less evident in consumer banking.

In the case of Citi, which is a traditional commercial bank and an investment bank rolled into one, the question is whether these two businesses can be better run as two separate companies. That is a question that Vikram Pandit may find himself asking more often in the coming months. If he finally decides to break up Citi, he would be the right person to do it. After all, not many can match his track record of selling himself to Citi for $800 million! That was when Citigroup acquired Pandit's hedge fund Old Lane, which critics said held not much value other than Pandit's impressive Wall Street experience.