End of An Era

One minute I held the key
Next the walls were closed on me
And I discovered my castles stand
Upon pillars of salt and pillars of sand
Coldplay

Everyone ought to bear patiently the results of his own conduct.
Shakespeare

It has been over two months of financial turmoil. For over 25 years I have been studying banks, monetary policy, credit markets and financial crises. So following these events for me has been fascinating and appalling. I have been saying in my newsletters and presentations for well over a year that we were facing serious problems. I have ranted and raved that risk wasn’t priced into the market, how the misuse of derivatives was going to lead to trouble and that unless the U.S. housing market was resuscitated that things were going to keep getting worse. I just didn’t think that it would mutate to such an extreme outcome. Things are moving so fast that I will not be able to talk about everything that has happened. I will try to hit the main highlights of the last seven weeks. It is like watching dominoes fall knocking each other haphazardly. It has been unclear what impact each falling domino would have on other dominoes. I will try to walk you through the chain of falling dominoes and what the impacts have been.

As we have previously discussed, financial institutions had taken huge bets using derivatives which were not properly reflected on their balance sheets or understood by management. These derivatives amplified the impact of the collapsing housing market. It was as though an atomic bomb was detonated in the credit markets flattening many institutions in its wake.

This current episode started when the Treasury nationalized Fannie Mae and Freddie Mac on September 8th in response to the failing housing markets and shriveling of the credit markets. The combined assets of Fannie and Freddie are over $5 trillion. These entities had been set up to support the housing market. Their job was to help guarantee most of the mortgages in the United States (provided they met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn tacitly backed by the government. The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company. In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but the Fed and others have argued that this rarely occurred. Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the “conforming” mortgage market. Regardless, many firms and foreign governments considered the debt of Fannie and Freddie as a substitute for U.S. Treasury securities, and snapped it up eagerly.

Fannie and Freddie were weakly supervised, and strayed from their core mission. They began using their subsidized financing to buy mortgage-backed securities, which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.

But once the debt was guaranteed to be secure (and the government wiped out shareholders both preferred and common shares), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over. The Treasury only got authority from Congress to take this action in July, and in seeking the authority had insisted that no intervention would be needed. The opposite has happened. The Treasury has replaced the management of both companies and will presumably oversee their operation. This decision marked an acknowledgment by the government that the mortgage market and the institutions to make it operate in the U.S. are broken.

It is now clear that the government should not have wiped out the preferred shareholders. These shares were extensively held by financial institutions, foundations, school districts, and municipalities and were seen as ultra safe. The impact was percussive and reverberated through the market. It has taken weeks to see the full impact, but it is clear now that this was one of the reasons the credit markets completely seized up.

The following Monday the largest bankruptcy filing in U.S. history was made by Lehman Brothers. Lehman had over $600 billion in assets and 25,000 employees. (The largest previous filing was WorldCom, whose assets just prior to bankruptcy were just over $100 billion.) Lehman’s demise came when it could not even keep borrowing. Lehman was rolling over at least $100 billion a month to finance its investments in real estate, bonds, stocks, and financial assets. This may sound like a crazy way to run a business, but this is how all the investment banks were operating financing long term needs with short term debt.

Basically, when it is hard for lenders to monitor their investments and borrowers can rapidly change the risk on their balance sheets, lenders opt for short-term lending. Compared to legal or other channels, their threat to refuse to roll over funding is the most effective option to keep the borrower in line. This was especially relevant for Lehman, because as an investment bank, it could transform its risk characteristics very easily by using derivatives and/or by churning its trading portfolio. So for Lehman (and all investment banks), the short-term financing is not an accident; it is inevitable.

Why did the financing dry up? For months, short-sellers were convinced that Lehman’s real-estate losses were bigger than it had acknowledged. As more bad news about the real estate market emerged, including the losses at Freddie Mac and Fannie Mae, this view spread.
Lehman’s costs of borrowing rose and its share price fell. With an impending downgrade to its credit rating looming, legal restrictions were going to prevent certain firms from continuing to lend to Lehman. Other counterparties that might have been able to lend, even if Lehman’s credit rating was impaired, simply decided that the chance of default in the near future was too high, partly because they feared that future credit conditions would get even tighter and force Lehman and others to default at that time.

The failure of Lehman rippled through the market causing havoc. Its assets were sold in a chaotic fashion, causing stable assets to plummet in value. Lehman’s business units that made markets for many bonds and derivatives were not operating. The results were disastrous. First, the short term commercial paper market froze, which then caused some money market funds to fail (or they broke the buck). Banks stopped lending to other banks and started to hoard cash. The blood (cash) was no longer circulating and the patient (economy) went into cardiac arrest. In retrospect, allowing Lehman to fail was the worst mistake the U.S. government made. A plan to liquidate Lehman in a controlled way would have avoided much of the turmoil that followed. From this point on, fear escalated and the herd began to stampede for the exits.

The next day (Sept 16th), the Federal Reserve made a bridge loan to A.I.G., the largest insurance company in the world with over $1 trillion of assets and over 100,000 employees worldwide. The loan is for two years at 850 basis points (8.5%) over Libor (the rate that banks in Europe lend to each other). The Fed has the option to purchase up to 80 percent of the shares of A.I.G., is replacing A.I.G.’s management, and is nearly wiping out A.I.G.’s existing shareholders. A.I.G. is to be wound down by selling its assets over the next two years. The Fed has never asserted its authority to intervene on this scale, in this form, or in a firm so far removed from its own supervisory authority.

A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real estate related investments. While its core insurance businesses and other subsidiaries (such as its large aircraft-leasing operation) were doing fine, these contracts, called credit default swaps (C.D.S.’s), were hemorrhaging.
Furthermore, the possibility of further losses loomed if the housing market continued to deteriorate. The credit-rating agencies looking at the potential losses downgraded A.I.G.’s debt on Monday, Sept. 15th. With its lower credit ratings, A.I.G.’s insurance contracts required A.I.G. to demonstrate that it had collateral to service the contracts; estimates suggested that it needed roughly $15 billion in immediate collateral.

A second problem A.I.G. faced is that if it failed to post the collateral, it would be considered to have defaulted on the C.D.S.’s. Were A.I.G. to default on C.D.S.’s, some other A.I.G. contracts (tied to losses on other financial securities) contain clauses saying that its other contractual partners could insist on prepayment of their claims. These cross-default clauses are present so that resources from one part of the business do not get diverted to plug a hole in another part. A.I.G. had another $380 billion of these other insurance contracts outstanding. No private investors were willing to step into this situation and loan A.I.G. the money it needed to post the collateral.

In the scramble to make good on the C.D.S.’s, A.I.G.’s ability to service its own debt would come into question. A.I.G. had $160 billion in bonds that were held all over the world - nowhere near as widely as the Fannie and Freddie bonds, but still dispersed widely. In addition, other large healthy financial firms had guaranteed A.I.G.’s bonds by writing C.D.S. contracts. A failure by A.I.G. would have taken some of these institutions down. Given the huge size of the contracts and the number of parties intertwined, the Federal Reserve decided that a default by A.I.G. would wreak havoc on the financial system and cause contagious failures. There was an immediate need to get A.I.G. the collateral to honor its contracts, so the Fed loaned A.I.G. $85 billion. Since then A.I.G. has had to borrow even more from the government to stay afloat. Its board of directors is analyzing which divisions to sell off first to start repaying the loans.

Then Merrill sold itself to Bank of America. This is the type acquisition that would normally take months to negotiate. Instead, it was thrown together over one weekend. Merrill Lynch knew it could not weather the storm created by Lehman’s failure. B of A has always wanted to own Merrill Lynch’s retail brokerage business. Merrill knew that if it did not find safe harbor (a willing buyer) before Monday morning, that it would be dead before the end of the week. So it was a shot-gun wedding. Now the dominoes fall even faster.

By Wednesday the credit markets (this is where bonds are bought and sold and funds are lent from one firm to another) has ceased to function. Investors fled the credit markets and ran to Treasuries. The price was bid up so high on Treasuries that they had no yield and investors were paying the government to hold their money for free (see chart). On the flip side, the cost of borrowing for companies soared. This stunning flight to safety started to cause serious damage to an already compromised economy. The last remaining large Wall Street firms, Goldman Sachs and Morgan Stanley, which just weeks before were considered relatively strong, came under assault. Their stock prices plummeted and no one would loan them money. Remember how devastating this was for Lehman.

Now it’s Thursday, and the Treasury and Federal Reserve begin discussions on what would become the largest financial bailout in U.S. history. The plan was to authorize the government to buy distressed mortgages at deep discounts from banks and other institutions. The program would be run by the Treasury and use $700 billion of taxpayer’s money to fund the program. The goal was to inject liquidity into the banking system and jump start the market in the mortgage-backed-bond market back to life. The markets rallied on the news. Discussions between Congress, the Treasury and the Federal Reserve continued through the weekend on TARP (Troubled Asset Relief Program). Everyone assumed Congress would pass the bill on Monday. Congress did vote on Monday but failed to approve the bill. Fear gripped the markets resulting in the worst one day decline in the U.S. stock markets in two decades. Congress did not pass the bill because many representatives do not understand the financial markets. They saw this as a bailout of greedy investment bankers. Over a week later, the Senate passed the bill followed by Congress but the administration had to compromise on several fronts, such as pay caps for executives. The delay caused more market turmoil and the markets fell further.

In the meantime, the last two independent investment banks on Wall St., Goldman Sachs and Merrill Lynch, transformed themselves into bank holding companies. Now they will be subject to greater regulation. Instead of reporting to the relatively “hands-off” SEC, Goldman and Morgan Stanley will have much closer supervision by bank examiners from several government agencies. The firms will look more like commercial banks, with more disclosure, higher capital reserves and less risk-taking. In exchange, the firms get access to the Federal Reserve’s lending facilities, which should help them avoid the fate of Lehman Bros.

As officials in Washington were still negotiating TARP, Washington Mutual was seized by the FDIC and sold to JPMorgan Chase. The FDIC then pressured the weakened Wachovia into a deal with Citigroup. Four days later Wells Fargo made a richer offer for Wachovia and the legal wrangling started. In the end they decided to split the baby in half so Citicorp and Wells Fargo split Wachovia. Throughout the turmoil the FDIC has done a tremendous job of handling failing banks so there is as little turmoil in the financial system for consumers and businesses as possible.

During the week, the crisis became increasingly global. Many financial institutions and banks overseas had purchased some of our more toxic securities and derivatives. In addition, these firms had adopted the Wall Street model of high leverage and imprudent use of derivatives. They had also extended risky real estate loans in their own countries. In Europe, the week was punctuated with one state intervention after another to rescue faltering banks in Germany, Belgium, the Netherlands and Britain.

Over the weekend of Oct. 4th many of the leaders of the European Union met to try to come up with a coordinated effort, but failed. Separately, the German government said on Sunday that it would guarantee all private savings accounts in the country in an effort to reinforce increasingly shaky confidence in the financial system. The rest of the European nations followed suit on Monday. If they had not guaranteed deposits each country faced a run on their banks. European leaders still could not agree on any coordinated response to the crisis, leaving the markets in disarray. Further away in Iceland, the country’s financial system completely collapsed. The government intervened and now owns all five of Iceland’s banks. The cost of intervention in Iceland was greater than the country’s annual GDP (value of all goods and services produced in a year). The European stock markets fell precipitously.

On the same day, emerging markets took one of their biggest collective tumbles in a decade as stock markets from Mexico to Indonesia to Russia were gripped by fears of a collapse of Europe’s banking system, and concern that a global recession could drag down the price of commodities, forcing a steep slowdown in emerging-market growth. Many of the world’s fastest-growing economies thought they had insulated themselves from problems in the developed world. But economists said that simultaneous turmoil in Europe and the United States was too much for these markets to bear.

On Tuesday, Britain and Spain moved to shore up their failing banks. The violent fallout in the housing market in both countries was causing their banks to fail. Both countries stepped up to inject liquidity into the system.

At this point the markets fell further. The technical term for it is “negative feedback loop.” I just call it a panic. The Federal Reserve and European Union announced a coordinated interest rate cut. In response stocks ignored the good news and declined again. Credit markets remained frozen, with banks still hoarding cash. These declines were free falls caused by very low trading volume. The price of stocks was declining on very few trades. So there are only a few panicky sellers that are willing to sell at any price to a few brave buyers while the majority of investors sat on the sidelines watching the carnage. Once the madness starts it is difficult to stop. The market falls out of fear like a freight train and no one wants to get in front of it.

What finally calmed the markets was a direct injection of capital by the Treasury into nine of the nation’s top banks. In other words, the government is guaranteeing the basic plumbing of the financial markets. Treasury Secretary Paulson asked the nation’s top bank executives to a meeting in Washington on Monday October 13th. At 3PM Treasury Secretary Henry Paulson, flanked by Federal Reserve Chairman Ben Bernanke and Federal Deposit Insurance Corp. Chairman Sheila Bair welcomed the executives to one of the most important bank gatherings in history.

For an hour, the nine executives listened to the Paulson and Bernanke paint a dire portrait of the U.S. economy and the unfolding financial crisis and how the government intended to buy a stake in each of their firms. Each banker was handed a term sheet detailing how the government would take stakes valued at a combined $125 billion in their banks in the form of preferred stock, and impose new restrictions on executive pay and dividend policies. The participants, among the nation's best deal makers, were in a peculiar position: they weren't allowed to negotiate. Mr. Paulson requested that each of them sign the deal and described it starkly. He told them that they could accept the government's money or risk going without the infusion. If their companies found they needed capital later and couldn't raise money privately, Mr. Paulson promised the government wouldn't be so generous the second time around. Paulson argued the plan represented a good deal for the banks: The government would be buying preferred shares, and thus wouldn't dilute their common shareholders. And the banks would pay a relatively modest 5% in annual dividend payments. Each bank was asked to participate so that no bank would look weak by accepting the capital infusion. The meeting ended at about 4 p.m. By 6:30 p.m., all of the sheets had been turned in and signed by the CEOs.

The magnitude of the infusion into the banking system calmed the stock markets and allowed the credit markets to thaw. Banks have begun lending to other banks and businesses again. The panic and fear that had gripped the markets has abated, but the de-leveraging process is now reverberating through the Main Street economy.