by Dan Butterfield
December 4, 2008
“I never thought I’d see the day when someone defaults on their condo in Ft. Lauderdale, and Iceland melts.” So said Princeton’s Nobel prize-winning economist Paul Krugman in November 2008. Professor Krugman was offering a bit of gallows humor, yet his quote is a fitting way to highlight the global nature of the current financial crisis. What began as a housing bubble in the United States soon grew into an international credit crisis that roiled financial markets and destabilized world economies. The 24/7 news media love a good crisis and it’s no surprise that economic doomsayers have been featured guests on financial shows. Fear can be its own self-fulfilling prophecy and all of the dramatic headlines have had an effect on consumer and corporate behavior. Businesses have curbed spending, instituted hiring freezes and begun layoffs. Consumers are tightening their belts, and most are making due with last year’s model. It’s not all bad news for business. More-for-less foods such as Spam, pasta and oatmeal are flying off the grocery shelves. Discount retailers such as Wal-Mart, and value menu restaurants such as McDonalds, are doing surprisingly strong business. Yet this may be more a sign of the times than reason for solace.
There are a few sliver-linings to this crisis. Are you in the market to buy anything? New homes are 25% to 45% lower than 2005 levels. Need a new car? Take William Shatner’s negotiating advice and name your own price … then go lower. And you can afford to drive again. Prices at the pump are no longer stupid high. It may also be time pull that hidden cash out of the mattress and go back in the market. Stocks are on sale; literally “half-off” the October 2007 highs! On October 16, 2008, for only the second time in his storied career, legendary investor Warren Buffet publically stated (New York Times – Buy American. I am) that now is the time to buy stocks. The last time Buffet made such a proclamation was October 1974, at the bottom of a major bear market. Buffet may have been early with his 2008 call, but as he noted – “if you wait for the robins, Spring will be over.”
What are governments and financial authorities doing to stem this crisis? If you count throwing money at the problem as progress, then much has already been done. On July, 13, 2008, during Congressional hearings on Fannie Mae and Freddie Mac, U.S. Treasury Secretary Hank Paulson requested authority to carry “not a squirt gun, but a bazooka.” The press picked up on this quote and Paulson earned the nickname – Bazooka Hank. The Secretary was referring to authorization for substantial funding to combat the current financial crisis. Paulson received his money, but he would soon be back before Congress to ask for more. In September the Treasury orchestrated an $85 billion (later increased to $125 billion) financial rescue for the giant insurer American International Group (AIG). This was accompanied by numerous Federal Reserve injections of cash into the banking system in an effort to unfreeze lending. Next came Congressional legislation authorizing a $700 billion Troubled Asset Relief Program (TARP)Þ. Some have derisively renamed the TARP the “GULP!” as Treasury abruptly changed the TARP’s mission. Instead of buying up toxic assets, TARP morphed into an equity injection plan. To date, 30 banks have received almost $350 billion in TARP infusions. As we now know, Paulson’s bazooka is no longer a concealed weapon and many world governments have followed our lead. Tens of billions of Dollars (Euros, Pounds, etc.) in liquidity are being pumped into the international banking system and government officials across the globe are throwing everything including the proverbial “kitchen sink” at the financial crisis.
History teaches us that if we don’t learn from the past, we are doomed to repeat it. Excessive leverage, lax market regulation and wild speculation were all causes of the 1929 market crash and the ensuing Great Depression. Given the aggressive, proactive and truly worldwide response to the current crisis, a second major “depression” seems an unlikely outcome. But the story continues to unfold and it may be many months before we know the full depth and severity of our problems. What is clear is that the personal and corporate deleveraging process will continue in 2008, 2009 and perhaps well into 2010.
The Perfect Financial Storm – What Happened?
How did we get ourselves into this perfect financial storm? It may be a bit early to play Monday morning quarterback, but we’re going to give it a try. We will begin with a summary of key underlying causes of the financial crisis and then move to the subsequent fallout in the markets and finish with a summary of newly proposed regulations and reforms. President-elect Obama and the incoming Administration will no doubt have a very busy economic agenda.
♦ Step-by-Step Review of the 2008 Financial Crisis
Note: The causes outlined below are not all laid out in a straight timeline as many events occurred simultaneously and others continue to unfold.
CREATION OF THE HOUSING BUBBLE
♦ “Easy Money” Policies 2000 through 2004 – Let’s do the Limbo – How low can you go?
Following the “tech bubble” and “9/11” terrorist attacks, Federal Reserve Chairman Alan Greenspan worried that the U.S. faced a severe recession. Greenspan began cutting interest rates (Fed Funds and Discount Rate) down to 1% and kept them at that level until 2004, thereafter raising them slowly, only 0.25% at a time.
Many fellow Monday morning quarterbacks have pointed to the Fed’s push to lower rates from 2001 through 2004 as a key catalyst for an artificial run-up in housing prices. “Easy money” helped to pump up the balloon.
♦ Homeownership for All – No credit, no problem
Under the Clinton and George W. Bush Administrations, Community Reinvestment Act (CRA) legislation was expanded and concerted efforts were made to promote home ownership through special loan programs for those not in a position to obtain financing or make down-payments. These initiatives received bi-partisan support from Congress. In a speech on October 15, 2002, President Bush laid out specifics of this plan. In hindsight, these noble initiatives clearly contributed to the higher default rates that began to manifest in 2007 and 2008.
Fed Chairman Greenspan was also an important advocate for initiatives to expand homeownership and new loan programs. In February, 2004, in response Congressional questioning, Greenspan stated: “American consumers might benefit from different non-traditional mortgages.”
♦ Sub-prime and Specialty Loans – How to pump up a balloon
From 2001 through 2005, Fed policies kept interest rates low and the real estate industry entered a booming “sellers market” (when buyers often pay top dollar). There were many instances of multiple offers on homes and “above asking price” deals. The mortgage lending industry entered its own boom phase. Banks and brokers were eager to lend and home values continued to increase. This newfound wealth affect gave rise to a surge in demand for home equity lines of credit (a.k.a. “HELOCs”). Many homeowners took advantage of their equity; some responsibility and others simply used their homes as a giant ATM (“automated teller machine”).
Adding rocket fuel to home price surges was the added focus on CRA lending and rapid growth in sub-prime loan programs. Although there is no standardized definition of “sub-prime,” these loans are usually classified as those where the borrower has a credit score below a certain level (e.g. a FICO score below 660).
The standard 30-year fixed rate mortgage was soon yesterday’s news. Beginning in 2001, specialty loan programs came into vogue. These loans offered a means for many to get into a home they might not otherwise be able to afford. Popular specialty loans included:
o Adjustable rate mortgages (ARMs) – low teaser rate in initial years
o “Interest only” (no principal payment required) loans
o Negative amortization (“neg am”) loans – allowed for variable payments
Another mortgage lending practice that helped many to qualify for loans was the rapid expansion of “stated income” mortgages. These “no doc” loans, cynically referred to as “liar’s loans,” (< must see video) allowed qualified borrowers to obtain financing without showing proof (no documentation) of income or expenses.
♦ Loan Securitization – “Weapons of financial mass destruction”
Warren Buffet once called “derivative securities,” including securitized mortgages, “weapons of financial mass destruction.” Sadly, Buffet’s words may prove to be prophetic. While there are many types of “derivative securities” (a security who’s value is “derived” based on the value of another investment), the 2008 write-down of structured pools of mortgages decimated the balance sheets of thousands of firms, funds and investors.
“Loan securitization” is a process that can be described as bundling loans into a tradable investment or “security.” How big is this market? Over $4 trillion of the $11 trillion in total mortgage debt outstanding is now packaged into a collateralized security. Packaged mortgages frequently included sub-packages, a.k.a. “tranches,” holding high-risk, medium-risk and low-risk loans. These securities were then sold as Collateralized Mortgage Obligations (CMOs) or Collateralized Debt Obligations (CDOs). Keeping some higher quality loans in the package was a way to make them more stable and more likely to receive a higher rating by various rating agencies.
Government sponsored enterprises (GSEs) – Fannie Mae and Freddie Mac have been among the most active participants in the CMO secondary market. The securitization of loans exploded in volume from 2004 through 2007. Packaging and selling these “derivative” securities was highly profitable business for the GSEs and Wall Street firms.
High rate and high ratings made for strong demand. In the stretch for yield, investors could buy AA-rated corporate bonds and earn 50 basis points (1/2 of 1 percent) over long-term Treasuries; however, if you bought AA-rated mortgage-backed securities you’d get 150 basis points (1-1/2 percent) more. As a result, from 2004 through 2007, CDOs and CMOs sold like hotcakes! Sadly many of these hot cakes will go down in history as “toxic waste” on corporate balance-sheets and a prime cause of the current financial crisis.
♦ Transfer of Risk to Secondary Market – It says “as is” and you drove it off the lot
If you can transfer risk to another party, why not? Pre-packaged mortgage securities offered a means to move trillions of dollars in loans from banks’ balance sheets over to the secondary market. This massive migration also transferred the credit risks (late pay or default) over to the buyers of the mortgage securities. The loan originators, primarily banks, thrifts and mortgage brokers, were now emboldened to make loans that under normal underwriting circumstances, they would never make. The credit risk was now born by far away investors. “Far away investors” was often a very apt description, as CMO/CDO buyers included many international investors, domestic and foreign hedge funds and sovereign wealth funds controlled by foreign nations. In that sense you can begin to understand how this became a global problem.
Not all risk was transferred away from the loan originators. Many banks kept a large share of mortgage loans in their own portfolios and hence they were not immune to real estate woes.
♦ Inflated Ratings – Making sows ears into silk purses
Wall Street firms who were involved in “repackaging” mortgage loans into bundled securities products, often touted the pooled loans’ diversification as an important offset to the underlying credit risks. Diversification was achieved by mixing together mortgages with different risks and from different regions of the country. Simply put, if you packaged sub-prime loans together with higher quality loans with geographic diversity (e.g. not all in California or Florida), then you have less risk. On the surface this made sense, as theoretically not all areas of the country were likely to drop in value at once, and the high quality loans would offset any loss experience in the more risky pools of loans. To make them saleable to investors, one or more of the major credit rating agencies reviewed these mortgage securities and more often than not stamped them with “investment grade” ratings (“A”-rated or better). In fact, “AA” and “AAA” were the most common ratings applied to CMOs.
Hindsight is 20/20, and it is now clear that the vast majority of structured mortgage securities were simply rated too high. Rating agencies endeavor to be objective providers of ratings advice, but this process involves both art and science. While school is long since out, many have excoriated the rating agencies for their “grade inflation,” conflicts of interest and sub-par work on rating mortgage backed securities.
♦ Burst of Housing Bubble – What’s that giant hissing sound?
When exactly did the housing bubble burst? Home prices across the nation were near their peaks somewhere in the Fall of 2005. The market declined a bit in 2006 and then a bit more in 2007. The “hiss noise” became quite audible in late 2007. If there was a “balloon burst,” it occurred in 2008 when thousands of underwater homeowners simply stopped paying their mortgages and mailed their keys to the bank.
The chart at right shows the “double whammy” of mortgage delinquencies and housing price declines from October 2005 to October 2008. Several municipalities in California and Florida were hit hard – 30 to 50% declines from their peak in 2005. Mortgage delinquencies in these areas are now approaching double digits. Other regions have fared much better, yet virtually all have felt the impact of the deflating housing bubble.
How big is this problem? According to the Office of the Comptroller of the Currency (OCC) the amount of mortgage credit outstanding in the U.S. (combining commercial and residential) is $14 trillion. How much of that debt is seriously delinquent – defined as more than 60 days past due? As of November 20th 2008, 4% of the total market or about $560 billion is categorized as seriously delinquent. The OCC does not provide forward-looking forecasts, but there are no shortage of analysts and pundits offering up “crystal ball” guesses. Optimists see a leveling off of delinquencies at the 4% level, with improvements sometime in mid to late 2009. More gloomy prognosticators suggest that up to 6% ($840 billion) of the market will become delinquent in 2009 and market recovery may have to wait until 2010.
Is there any help on the horizon for homeowners? The Treasury and FDIC have proposed new mortgage loan “adjustment” programs for financially distressed homeowners that go beyond the program set up in October by the Federal Housing Authority (HOPE for homeowners – H4H). There has been much speculation about revision and expansion of these programs when the Obama Administration comes to power in January 2009. “Nothing is certain but change.”
LEVERAGE – TWO-EDGED SWORD
♦ Congress Relaxes Regulations – From Casablanca – Capt. Renault: “I’m shocked, shocked to find that gambling on going in here!” … Rick’s casino croupier: “Your winnings sir”… Capt. Renault: “Oh, thank you very much … everybody out at once!”
Who was asleep at the switch when the economy began to veer dangerously off-track in 2007 and skid into the ditch in 2008? You need not look further than Congress. The U.S. House of Representatives has a Financial Services Committee and the U.S. Senate has a Committee on Banking. The Chairman and members of these respective committees have responsibility to oversee the financial services industry and intervene when necessary. Have any elected officials stepped forward to acknowledge responsibility for failure to oversee mortgage-lending miss-deeds and financial firms’ gambling through leverage excesses, derivatives and swaps? Nope. Not a one. Brings to mind the classic truism – “victory has a thousand fathers, but defeat is an orphan.” Yet our elected officials have demonstrated no shortness of breath when chastising “the orphans” during recent Congressional testimony. “I’m shocked, shocked!”
It was not just failed oversight that caused harm. In 1999 Congress gutted the Glass-Steagall Act (1933), which had separated traditional banking and investment banking. The 1999 repeal enabled banks and brokers to again cross the lines of their traditional business. Large commercial lenders soon acquired investment-banking entities and then underwrote and traded in mortgage-backed securities, collateralized debt obligations, bought and sold CDS and more.
A bit later, in 2001, Congress passed the Commodity Futures Modernization Act of 2000 (CFMA). CFMA removed derivative securities (e.g. collateralized mortgage obligations, collateralized debt obligations) and credit default swaps from the purview of federal oversight. CFMA streamlined or eliminated “unnecessary regulation” of CMOs/CDOs and credit default swaps (CDS). It was these very same complex and illiquid securities that contributed mightily to the credit market freeze-up beginning in September 2008.
♦ The 2004 – 2008 Leverage Parade – I’m feeling lucky, quintuple or nothing!
Under increasing competitive pressure from European investment banking firms, in early 2004, several major Wall Street firms lobbied the SEC for exemptions from net capital rules that prevented them from holding larger amounts of riskier assets. The firms pointed to their own sophisticated computer models and risk management teams as an offset to the investment risks. On April 28, 2004, the SEC approved a recommendation from their own Division of Market Regulation to relax the rules for large investment bank holding companies. The end result was that these firms were able to expand their debt-to-capital (“leverage”) ratios. Simply put, an increased ratio would allow firms to expand their level of borrowing for investments and other business activities.
As the chart at right illustrates, from 2004 through 2008, the largest investment banking firms in the U.S., expanded their gross leverage (debt-to-capital) ratios significantly; in several instances jumping up to whopping 30 to 1. That means for every one ($1) dollar of capital, the firm borrowed thirty ($30) dollars. This increased leverage is a two-edged sword. When investments are going up, the leverage greatly enhances the profit potential. However, when investments go down, leverage can significantly compound losses. In the wake of the 2007/08 real estate market’s plummet, it’s now painfully clear that structured mortgage-backed securities were bad bets. Yet many large financial firms were loaded up with these “toxic” derivative securities (e.g. CDOs, CMOs and variants).
To be fair, it was not only the investment banks which boosted their leverage during this timeframe. This was truly an international phenomenon. Across the globe, many hedge funds, banks, insurance companies and financial firms of every type, joined the “leverage parade.”
Beginning in 2007, many firms saw the dangers inherent with high levels of debt, and began de-leveraging their balance-sheets and raising new capital; a process that picked up momentum in 2008. This “de-levering” process may continue for several years to come. Yet, for many financial institutions, this move to boost capital and reduce debt, was simply too little, too late.
♦ Economy in Recession – She won’t go any faster if we’re outta gas
According to the National Bureau of Economic Research (NBER), the economy slipped into a recession beginning in late 2007. This economic decline may have been one of the catalysts to accelerate the 2008 credit crisis. At the very least the recession helped to put the wheels in motion.
The prospect for a potentially severe recession has caused many corporations and individuals to review their budgets and consider ways to reduce expenses. This retrenchment creates momentum for further economic downturn. While this sounds gloomy, it is important to note that recessions have been around forever. Down-cycles will eventually be followed by up-cycles.
♦ Impact of Mark-to-Market Accounting – “Look Mac, I don’t care what it’s ‘really worth’. You need cash and this is a pawn shop … Take it or leave it!”
The debate over mark-to-market accounting (a.k.a. FAS 157) is a heated one. This rule requires firms to show on their balance-sheet, each quarter, the current market value of their assets. In October a well-known television commentator, Rick Santelli, got into a heated on-air exchange with an economist who was arguing for changes to FAS 157. The economist felt that mark-to-market accounting was severely worsening the financial crisis by requiring firms to drastically write-down assets that had no discernable market value in the midst of the current crisis. Santelli quipped in response; “So if you don’t like the temperature, you’ll just break the thermometer, huh!?”
How did “mark-to-market” rules factor in the current crisis? When the real estate bubble burst in 2008, the true risks in structured mortgage securities became all too clear. Homeowners’ late mortgage payments and defaults soon filtered their way into many CDO/CMOs. The cash flows from these securities became erratic and due to their complicated structure (e.g. bundled loans with different “tranches”), corporate accountants struggled to come up with a “fair value” for these securities. There were few if any buyers for these securities, yet the rules say the firm must price the security at current market value. Consequently many firms “wrote down” their CDO/CMOs to just pennies on the dollar. Huge losses can result in capital deficiencies. Firms with high levels of “toxic assets” faced an urgent need to raise more capital. To make matters worse, if a firm’s solvency was in question, short sellers would soon be on the scene.
There are compelling arguments to be made on both sides of the mark-to-market debate (draconian and unnecessary vs. no more hiding problems). Yet it is clear that the FAS 157 rule did accelerate the financial woes for many thousands of firms with exposure to illiquid assets.
♦ Speculators, Hedge Funds and Shorts – Hide the keys to the Ferrari!
Except from an investor’s June 2008 open letter to SEC Chairman Chris Cox:
“Giving your rambunctious teenager the keys to the Ferrari, the pool house and the liquor cabinet, and then leaving on holiday and expecting there to be no trouble is just foolish. That’s exactly what the SEC is doing by allowing hedge funds to go unregulated, giving them freedom from the uptick rule, and virtually no action on naked shorts’ fails to deliver.”
Whatever happened to “buy and hold?” In 2008 year to date, there has been an astounding 340% turnover in the Standard & Poors 500±. And there has been no lull in activity this Fall. Volume and volatility have picked up dramatically. On November 20, 2008 over 11 billion shares of stock changed hands on the NYSE and NASDAQ markets together. This is a staggering volume of trading and reflects an extreme level of speculation.
What’s behind this volatility? The influence of hedge funds together with the rise in program trading and “quants” (funds using mathematical/automated trading strategies) has dramatically increased the level and rapidity of stock price movements. Although hedge funds account for less that 12% of total assets under management, year-to-date they have accounted for 43% of the total trading volume in equities on both the NYSE and NASDAQ.
Hedge fund strategies proved fallible in 2008 and tens of thousands of investors sent in redemption requests. Since hedge funds commonly use leverage to boost returns, redemptions can accelerate sell offs (e.g. a fund levered 5 to 1 may need to sell $500K in securities for every $100K in redemptions). This has helped to push stocks down.
As of November 20, 2008, the DJIA sits at 7,552. With the exception of 1929, the current (2008) bear market rivals or surpasses all those in the 20th century.
The increased volume of short selling has also had an impact during this crisis. Short selling has been most directly focused on under-capitalized banks and financial institutions. In September and October, the SEC and Financial Services Authority (FSA) in the UK, along with many global counterparts, imposed several temporary bans on the shorting of financial stocks. These bans have now been lifted and future bear raids are likely, albeit “short squeezes” (rush to cover, forcing prices up) can happen too. Many hedge funds and professional short sellers will not soon forget the name of Porsche’s CIO. Google “the greatest short squeeze in history + VW” and you’ll understand.
♦ The Paulson, Bernanke and Geithner Show – Let the shotgun mergers begin
Beginning in March 2008 and accelerating through the Fall, there were literally dozens of mergers and acquisitions in the financial services industry. Many of these marriages were arranged with the direct involvement of the U.S. Treasury, the Federal Reserve Bank and the FDIC. This merger activity began in the U.S. and would soon span the globe. Some deals were done privately (without assistance) and others were encouraged by government agencies. There were also a few “shotgun weddings.” Merge, restructure, or else!
The fall of Bear Stearns – In early March 2008, the first of many arranged mergers pared JP Morgan, the “rescuer,” with the ailing investment bank Bear Stearns. Treasury Secretary Paulson and New York Fed President Tim Geithner (rumored to be President-elect Obama’s Treasury Secretary nominee), were actively involved in the Bear Stearns deal. Dozens of credit teams from Wall Street firms were pouring over Bear’s books. At the eleventh hour, when JP Morgan, the last viable suitor, threatened to walk away, Hank Paulson signed a document to indemnify JP Morgan against unknown Bear losses. Bear was then sold to JP Morgan at $2 per share, a price that was later adjusted upward to $10 per share. This was a true shock to Bear Stearns’ shareholders who had seen their stock trade as high as $170 over the previous 12 months.
Lehman Brothers’ Bankruptcy – Just a few months after the hastily arranged JP Morgan/Bear marriage came the “game changer”— the bankruptcy of Lehman Brothers. In an eerily similar pattern to the Bear Stearns’ death march, in September 2008, Lehman Brothers’ share price began to fall. Lehman’s credit default swaps (CDS)’ spreads also began to rise. The short selling came in relentless waves and few buyers were there to defend the share price. Fearing a solvency problem might be forthcoming, Lehman’s creditors began to call-in short-term loans, thereby helping to create a self-fulfilling liquidity problem. In the end, Lehman could not raise enough capital to secure their debt positions. Lehman had to be acquired or face bankruptcy. Another emergency conclave was hastily arranged. The barons of Wall Street came together again to examine the books of an imperiled member firm. The mood was somber and no firm was anxious be the first bidder for Lehman. Many knew of trouble brewing at AIG and the rush to shore up their own balance sheet far out weighed the desire to buy up troubled Lehman, even for pennies on the dollar. There would be no special government intervention this time around. Lehman had to declare bankruptcy.
The “too big to fail” AIG – The next key domino to fall was the giant insurer American International Group (AIG). AIG held tens of billions in CMOs/CDOs and other derivative securities. AIG was also a major player in the credit default swap (CDS) market. The first significant signs of trouble at AIG came in August of 2008. Like Bearn Stearns and Lehman Brothers before it, AIG soon became the focus of solvency rumors. Short-sellers hit AIG stock hard. Yet AIG was truly “too big” and interconnected to fail. AIG held $1.1 trillion in assets with 74 million clients in 130 countries. If AIG were to go into bankruptcy, there would likely be panic in the streets, or other irreparable harm caused to the markets and global economies. Moral hazard or no, something had to be done. An $85 billion federal loan package was put together for AIG. The money was allocated to give AIG time to sell off their many solvent subsidiary companies. The loan repayment came into doubt when the full scope of AIG’s credit default swap exposure became apparent. Soon AIG executives were back “hat in hand” asking the Federal Reserve for loan extensions and another $40 billion. They got their wish.
Rescue for Citigroup – The month of November 2008 was a rough one for Citigroup. In what looked to be a repeat performance, the short sellers began to hit Citigroup hard. Citigroup was heavily exposed to real estate and consumer loans and the shorts were betting on insolvency. Just two weeks earlier Citigroup shares had been trading in the mid teens but during the week of November 17th Citi dropped from $11 down to $3 and Citi’s CDS’ spreads were widening alarmingly. Like AIG, Citigroup was in the “too big to fail” club and the government stepped in. The Citigroup rescue plan will guarantee losses on more than $300 billion in troubled assets and make a fresh $20 billion injection in the company.
As an interesting side-note, two of the world’s richest men have bet big on Citigroup. Just before the announced rescue, Saudi Prince Alwaleed raised his stake in Citigroup to 5%. Immediately following the rescue, the world richest man – Carlos Slim, bought 26 million shares of Citigroup. A television commentator and well-known analyst predicted that these two billionaires would be “carried out on their shields” for their imprudent investments in Citigroup common. Thus far (as of November 26, 2008) score one for the billionaires, who’ve roughly doubled their money in just a few short days.
♦ Credit Markets Freeze – “Is it safe?”
“If I told you that someone on the trading floor has an incurable disease and if you do a trade with him, you’ll get the disease … you wouldn’t trade with anyone!”
This is the way one veteran floor trader explained the banking system freeze up in the wake of the Lehman bankruptcy and AIG rescue. Banks and financial institutions were in total fear/survival mode. Many financial institutions held Lehman “pay on default” CDS obligations or were counterparties to Lehman Brothers’ trades. When Lehman went into bankruptcy, they had to take millions in losses. Banks and financial firms were in no mood to gamble. “Who’s next?” And “how do I raise more capital so that my company is not the next one in the crosshairs of short-sellers?” This was the mindset of many financial institutions during September and October of 2008. As a result, global credit markets were virtually locked up. No one was lending to anyone! They all feared getting the incurable disease.
Without consumer and corporate credit, the world’s economies come to a grinding halt. Recognizing the clear and present danger, the Federal Reserve and European counterparts rushed into action. They injected tens of billions of liquidity to the banking system, lowered interest rates and effected financial rescues for key firms. The FDIC followed by raising insurance coverage on bank deposits and the Treasury moved to offer insurance to participating money market funds to prevent “breaking the buck” (maintenance of the one [$1] dollar net-asset-value). The Treasury also pushed Congress to pass the TARP rescue. These actions had a positive effect. The gargantuan spreads on interbank lending (e.g. T-Bill/Euro-dollar or “TED” spreads and London Interbank Offer Rate – LIBOR) slowly began to narrow, signaling a willingness of banks to lend to each other. The “credit freeze” thawing must continue, but the signs for more fluid credit markets look better today than during the dead freeze months of September and October.
♦ Credit Default Swaps – “Didn’t anyone notice King Kong in the room?!”
In the wake of the Lehman bankruptcy and AIG rescue, the credit markets were virtually locked up. There was also a sudden focus on the immense liabilities associated with “quasi-insurance” contracts that go by the name credit default swaps (CDS). The CDS market is an unregulated “over the counter” (no public exchange) market wherein firms can buy “insurance” against the risk that a firm’s debt security might go into default. Although CDS walk like a duck and squawk like a duck, it should be noted that the International Swaps and Derivatives Association (ISDA) insists that CDS are not “insurance contracts.” If CDS were insurance, they would have to:
o Be regulated by state insurance departments
o Insurers would need to hold reserves to back up their obligation to pay on default
o Buyers of CDS would have to have some “insurable interest” in the transaction
o Large speculators and hedge funds could not be using CDS as a synthetic short
CDS were written against all types of debt securities and this market has exploded in size since 2004. At last estimate the CDS market size was $62 trillion covering some $18 trillion in debt securities. That’s right. There is 3.4 times more “insurance” written than the total debt covered by CDS contracts! By way of comparison, the entire market in equity securities (stocks) represents about $5.2 trillion. To say the CDS market is “out of control,” would not be an understatement. The opaque nature of the CDS market has been very troubling during the current crisis. – Who owns what and who might soon owe what? Can firm “A” payoff if firm “B” goes into default? The uncertainty creates a climate of fear for trading partners and for the parties on both sides of CDS contracts. The huge yet largely unknown liabilities associated with CDS continues to be a major reason for jitters and price volatility in financial stocks.
♦ Decoupling Myth Exploded – Someone defaults on a Florida condo and Iceland melts!
For many decades the old adage went – “When the U.S. catches cold, Europe gets a fever.” By 2004, many economists scoffed at this idea. This was an “old economy” notion. Beginning in 2000, China, India and many emerging market nations began to enter a major economic up-cycle. Second and third world nations were riding the “outsourcing” and globalization wave. New plants and manufacturing jobs were popping up everywhere. European banks were the primary financiers of emerging nations’ growth. With the strength of the Euro and bustling international trade, many governments and economists began to talk about the “decoupling” of the European economies from the United States.
The word “de-coupling” is no longer used, except by pundits and economists who talk about the “exploded myth.” The present day crisis has shown that the world economies are far more interconnected than was believed. It turns out that many European financial institutions mimicked the same poor investment choices (e.g. structure mortgage securities) and extreme usage of leverage made by so many U.S. financial institutions. How about those emerging nations who took loans from European banks? These “up and coming” countries (Russia, Romania, Hungry, the Baltics, and many more) were counting on robust demand from American and European consumers to buy their goods. With a sizable global recession now looming, many European banks are justifiably nervous over their exposure to emerging nations.
What started in U.S. has now spread. The U.S., Europe and the entire globe are fighting a very bad cold and working furiously to prevent a fever.
RECAPITALIZATION, REMEDIES and REGULATION
♦ World-wide Restructuring and Recapitalization – “We’re all in this together”
The volume of restructuring and recapitalization (deals, mergers, loans, equity infusions, etc.) picked up momentum in the Fall of 2008 and continues to date. Hundreds of banks and financial firms across the globe have made dramatic changes. In addition to the aforementioned Bear Stearns, Lehman Brothers and AIG cases, here are a few prominent restructuring actions
At home –
Strategic Actions (all initiated between March and November 2008)
TARP – Trouble Asset Relief Program. As part of the Emergency Economic Stabilization Act of 2008, in October Congress authorized $700 billion to buy troubled assets held by financial institutions – primarily illiquid mortgage backed securities. TARP has now morphed into an equity injection plan with “toxic asset” buy-up as a secondary objective.
TALF – Term Asset-Backed Lending Facility. Under the TALF, the Federal Reserve extends up to $200 billion in non-recourse loans to holders (primarily financial institutions) of asset-backed securities backed by consumer (e.g. credit cards, student loans, auto loans) and small business loans. The Treasury Department will extend $20 billion in funds under the TARP Troubled Asset Relief Program (TARP) to support the TAL initiative.
TLGP – Temporary Liquidity Guarantee Program. The FDIC set up the TLGP in late November creating a temporary window of opportunity for banks to issue debt securities backed by the full faith and credit of the FDIC. This temporary program eases strains that kept many banks from refinancing maturing debts.
AMLF – Asset-Backed Money Fund Lending Facility. AMLF is targeted directly at helping money market mutual funds stay liquid. The Fed set up this plan to allow banks to buy weakened commercial paper (short-term company debt) and other products from money funds to make sure money-market funds don’t “break the buck” which could cause a run on trillions held in money funds.
TSLF – Term Securities Lending Facility. The TSLF actually allows the Fed to swap bad mortgage and other debt on banks’ books rather than merely lend using those assets as collateral. TSLF is a trade, not a loan.
SLFs – Special Lending Facilities. The Fed set up SLFs to loan money to JPMorgan to help buy Bear Stearns. SLFs were also used to back AIG’s balance sheet to avoid total collapse.
PDCF – Primary Dealer Credit Facility. PDCF extends the Fed discount window borrowing facility to non-bank primary dealers.
Tactical Actions (all initiated between March and November 2008)
o Insolvent GSEs taken under conservatorship – Fannie Mac and Freddie Mae are taken under conservatorship and recapitalized by the U.S. Treasury.
o $25 billion in Federal funds authorized for re-tooling GM, Ford and Chrysler, and second $25 billion bridge loan is under Congressional review
o Indy Bank taken under FDIC receivership
o Wells Fargo acquires Wachovia
o JP Morgan acquires Washington Mutual
o Bank of America’s $44 billion merger/acquisition of Merrill Lynch
o Warren Buffet’s preferred shares equity stake in Goldman Sachs
o Citigroup Rescue – Under the plan, the government will guarantee losses on more than $300 billion in troubled assets and via TARP make a fresh $20 billion injection in the company.
Abroad – (Abbreviated list of tactical actions only – March through November)
o Mitsubishi Bank takes and equity stake in Morgan Stanley
o The Swiss government provides a loan to improve UBS’ capital position
o The Dutch government provides 10 billion Euros to shore up ING
o BNP Paribas buys insurance giant Fortis after an 11.2 billion Euro cash injection by Belgium, the Netherlands and Luxembourg
o British mortgage lender Bradford & Bingley is nationalized
o Lloyds TSB takeover of HBOS
o Northern Rock is recapitalized by Bank of England
o Iceland takes control of its third largest bank (Glitnir) and announces a $6 billion IMF led rescue to stabilize its banking system
The entire list of recapitalizations, restructurings and quasi nationalizations is too long and detailed to review here. We have also left out many strategic initiatives undertaken by the EU and international financial authorities. Suffice to say that the dramatic surge in deleveraging and recapitalization that had began in the U.S. remains underway across the globe.
♦ New SEC Short-selling Rules – Locking the barn door after the horse has been stolen
One hallmark of the current financial crisis has been the waves of short selling on financial stocks. This has caused great concern in the industry and led to several temporary bans on the shorting of select financial stocks. While many feel that the SEC has been slow to act, there have been several important new SEC regulations imposed to curb abusive “naked” (failure to complete a borrow) short selling, including:
o New SEC rules requiring a hard T+3 close out to prevent naked-short selling
o New SEC warnings to those engaged in false rumor-mongering that might be used to foment fear and drive down targeted stocks.
o New SEC rules requiring institutions with sizeable short positions ($10 million or more) to disclose directly to the SEC, via a weekly filing, their short positions.
♦ Proposal to reinstate an uptick rule – Back to the future
On October 21, 2008, NYSE Euronext CEO Duncan Niederauer published a survey (below) he sent to securities industry executives. The overwhelming majority (85%) of respondents support a reinstatement or re-work of the “uptick” rule. Many feel that the SEC’s 2007 controversial repeal of the uptick rule (which previously required a flat or “up-tick” in price before a short sell can be executed), gave an unfair advantage to those who specialize in short selling. The SEC’s studies done in 2006 discount this view. Nonetheless, this remains a hotly contested topic and momentum is strong for reinstatement of some form of uptick rule.
NYSE Euronext Survey Results (summary):
o 85% seek re-instatement of “tick-test” (uptick) rule to bolster confidence;
o 92% say investment managers should publicly disclose short selling activity;
o 60% believe short selling is harmful to company’s stock and shareholders;
o 75% want prohibitions to short selling in volatile markets.
♦ New Reform Proposals – “On the drawing board”
There are many additional reform ideas that are on the drawing boards. On October 9, 2008, Morgan Stanley Chief Executive Officer John Mack told CNBC Television that he thinks the securities business and financial services industry need to be overseen or regulated by a global authority. This idea has picked up momentum and at a minimum there will be much greater coordination between national regulators and their international counterparts.
There are no silver bullets and the economic crisis will not go away overnight. President-elect Obama has assembled a team of advisors who will focus on remedies and new regulations. They will need to hit the ground running. A sizable economic stimulus package (up to 5% of GDP) has been discussed and new mortgage relief programs may be in the works. Here is a brief bullet point list of reform proposals that have been floated:
o FAS 157 – Repeal or revise the “mark-to-market” rule
o Hedge fund regulation – Greater transparency into trading and short selling
o Short sale “uptick” rule – Reinstate or revise the uptick requirement
o Credit Default Swaps – Regulation and moving CDS to an exchange
o Restrictions on over use of leverage by financial institutions
o More disclosures on sales of derivative securities
o Mortgage industry reforms
o Rating agency reforms
o The FHA, Treasury and FDIC are all developing various mortgage relief programs (e.g. extended repayment terms, rate reductions and/or principle forbearance) to assist distressed homeowners.
♦ Looking Ahead – Fortune favors the bold
Finishing on a note of optimism… Economic cycles have been around forever. The pendulum has now swung vigorously to the side of fear and retrenchment. It will swing back again! Fortune favors the bold and waiting for irrefutable evidence of recovery may mean lost investment opportunity. While due caution and proper investment allocation is always important, prices are down now (DOW @ 7,552 on Nov 20, 2008) and values are there for those able to hold (long term) and/or able to “dollar cost average” back into the markets.
For those in the industry, take heart that the markets will recover and the robins will sing again. But don’t wait for Spring to map out a plan for your clients.
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* Treasury Secretary Henry Paulson was telling lawmakers that he may need to rescue Fannie Mae and Freddie Mac however the funding amount was not yet known and would need to be open-ended. When asked why he needed a “blank check” and not a specific amount, Mr. Paulson said – “If you’ve got a squirt gun in your pocket, you probably will have to take it out. If you have a bazooka in your pocket and people know it, you probably won’t have to take it out. By having something that is unspecified, it will increase confidence, and by increasing confidence it will greatly reduce the likelihood it will ever be used.”
Þ On October 3, 2008, Congress passed the Emergency Economic Stabilization Act of 2008 (“EESA”). A key element of this bill is the Treasury’s oversight of the $700 billion Trouble Asset Relief Program (TARP).
± YTD, as of November 20, 2008, the total float – “outstanding shares” – in the Standard & Poors 500 Index has been bought and sold or “turned over” 3.4Xs or 340%.