Subprime fallout: Who's stuck with $400 billion in losses?

How asset-backed securities tied to risky mortgages and US consumer debt are affecting investors around the world.

Wall Street sometimes calls the subprime mortgage packages and other risky investments troubling the world's financial system "toxic waste." Analysts estimate foreigners own a quarter to a third of this dangerous stuff.

Losses on subprime-related investments alone could reach $400 billion, the finance ministers of the Group of Seven leading industrial nations were told earlier this month at a meeting in Tokyo. If so, banks and other investors in Europe and elsewhere participating in the global financial market could suffer losses of perhaps $100 billion to $133 billion.

Often these investments had been characterized as AAA, or quite safe, by the leading American agencies that rate bonds and more complicated investments known as derivatives and asset-backed securities.

Is that fair?

"They were sold a bill of goods," says John Williamson, an economist at the Peterson Institute for International Economics. "We [American financial institutions] were, too."

But as Mr. Williamson and others see it, the issue is not simply black and white, bad guys versus good guys.

For one thing, today's financial mess seriously affects most people around the world today and possibly for years to come. Credit markets have frozen to considerable degree not only in the US but also in Europe. Banks and other financial firms can no longer sell to investors what Washington consulting economist Harald Malmgren calls "trust-me securities." These fancy security packages, assembled by Wall Street investment banks, included mortgages on residential and commercial properties, auto loans, and even credit-card debts.

"The entire market for asset-backed securities is dead in the water," says Mr. Malmgren. They are only sold on money markets at huge discounts, ranging from 15 cents off the dollar of face value to 75 cents off. "This problem will not go away quickly. It affects every human being."

For individuals, getting a mortgage or car loan has become difficult. Those struggling to make credit-card payments or reaching their credit limit face stiffer penalties and less flexibility from credit-card companies. Retirees may also be affected as thousands of pension funds around the world, private or government, have found their assets shrinking from toxic holdings of asset-based securities.

Major investors in the multitrillion-dollar world capital market are supposed to be sophisticated. But they often didn't fully know what they were buying because the information they received from investment bank sellers was obscure and inadequate. That's why Malmgren speaks of "trust-me securities." And that's why these investors no longer trust the sellers, or, for that matter, the "contaminated" investments that were sold all over the world. "Nobody wants the stuff," says Malmgren.

By now, the list of financial institutions hit by the freeze is long. Companies in the United States writing off massive losses include Citibank, Merrill Lynch, and Morgan Stanley. Joining them abroad are regional banks in Germany, Chinese banks and companies, and Taiwanese banks, among others.

Usually these foreign investors were seeking a higher yield for their money than offered by supersafe US Treasury bonds. With US consumers and companies buying massive amounts of foreign goods each year, many foreign institutions had billions of dollars to invest in some way or another. Packages of mortgages on American houses put together by Wall Street seemed like a good opportunity since home prices were rising steadily and the packages were blessed by rating agencies.

These agencies earned extra fees to examine them, but Williamson doubts they were influenced by these fees to "deliberately misrepresent" the safety of these investments. But, he adds, "they didn't ask difficult enough questions" of the Wall Street investment banks selling the packages.

In any case, Standard & Poor's president Deven Shama announced Feb. 7 that the company was strengthening its ratings process. The two other key agencies, Moody's and Fitch, also have unveiled new methodologies and standards for rating financial products.

So far, various financial institutions in the US and abroad have announced some $120 billion in losses from these investments.

But the big question in the financial community is: Who holds the remaining $280 billion of toxic waste? (The $400 billion estimate minus the $120 billion in announced losses.)

Those holding it are reluctant to admit it, says David Wyss, chief economist at Standard & Poor's in New York

"The only people who tell us are the people who have to tell us," he says. "We don't know where the rest of it is."

Disclosure laws require US banks to reveal losses. But the disclosure requirements abroad are often less strict than US rules. "There is a lack of transparency," Mr. Wyss says.

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A bad-investment breakdown

To get a better idea of who owns the bad investments tied to the battered US real estate market, follow the CMO. That's shorthand for "collateralized mortgage obligation." Basically, CMOs are packages of mortgages on American houses put together by Wall Street investment banks.

In the US, hedge fund managers generally talk about their holdings of financial "toxic waste," such as CMOs, only if they suffer severe losses and go out of business. Pension-fund CMO losses may only show up in periodic public reports.

Deborah Lucas, an economist at Northwestern University in Evanston, Ill., and another economist, Joseph Haubrich, did a study last summer of CMO holdings worldwide for the Federal Reserve Bank of Cleveland. Using somewhat shaky data for year-end 2003, they calculated a total of $709 billion in CMO issues. Of that total, $182 billion were owned by foreign investors. US commercial banks held $263 billion, life-insurance companies $155 billion, and smaller amounts were held by other financial institutions. Since 2003, billions more in CMOs have been sold. And that is just one bunch among the various classes of asset-backed securities that have shaken world markets.

Of course, financial troubles are not new to the world. In the 1970s and '80s, US banks were stung by defaults after investing billions in "petrodollar" deposits from the oil-rich Middle East into Latin America. The Asian financial crisis of 1997-98 also cost foreign investors a lot of money.

In the meantime, more and more owners of CMOs and other "toxic waste" are suing the issuers of those debt instruments, charging basically that they were misled.

To Professor Lucas, it's all part of the way the game is played. Investors who want international diversification and higher yields, she says, should anticipate "unexpected losses."