Thursday, October 23, 2008

A real domino story- aren’t there any adults in charge?

The Banking Crisis!
By Raymond May © 2008
Matthews NC

Depression, crash, unemployment, worst in a lifetime, bailout - what are they talking about and how did we get here?

It's not many times since 1997 when I left my trading desk at JP Morgan in New York where I was head trader for U.S. dollar derivatives to start a new life in Charlotte North Carolina that I have given much thought to the goings on of Wall Street.

I missed the sub-prime crisis completely, it passed me by, no one offered me more money than my house was worth maybe I just never asked. It was not until my wife came home from having her nails painted at the "nail girl" that I knew something was wrong. She always came back with thrilling stories of the goings on of the nail girl’s children in a dysfunctional way. Her daughter 19 and recently married having lost her job as a cleaner was now pregnant and her new husband having lost his job as a cement truck driver where now months in arrears on the mortgage. Pardon me! Who would give them a mortgage I thought! I guess we all know the answer now.

What is sub-prime? As part of the “New Deal” in the 1930’s the US Government set up Fannie Mae to operate in the U.S. secondary mortgage market. Rather than making home loans directly with consumers, to work with mortgage bankers, brokers, and other primary mortgage market players to help ensure funds where available to lend to home buyers at affordable rates. Fannie Mae has been a key player in the mortgage market ever since and their so-called conforming mortgages are referred to as A-paper or prime. In the 1990’s a new market developed outside the GSE structure with disastrous consequences – the Alt-A or alternative-A paper. These mortgages were offered for an additional fee to individuals who for whatever reason could not qualify for a conforming GSE mortgage. It could be a small businessman with insufficient documentation, a new resident with no credit history etc but was clearly considered a good risk. It was only a small step to the “liars mortgage” – or no docs and sub-prime – mortgages made to people who did not qualify at any level. It was the additional fee or higher rate of these mortgages that attracted the Investment Banks and the CDO bonanza that was to follow.

Subprime mortgages from across the country were being sold by mortgage originators to Wall Street houses who in turn packaged these mortgages into what are now referred to as CDO's [collateralized debt obligations]. These CDO's in turn were sold on to investors with respective credit ratings provided by the rating agents. These CDO's provided wall street with profits and bonuses from a vast sausage machine backed by ever-increasing prices in the housing market and vast demand from investors looking for higher yields. Wall Street demand pushed originators to push the envelope in creating more new mortgages.

CDOs where pools of mortgages packaged so that each buyer was ordered according to who would take a default loss first, second, third etc. The slice that took the last loss, the most safe was called the “super senior”. This was sold first, but when AIG and other buyers were full up the issuing Investment Bank was obliged to buy the super senior themselves in order to sell the rest. As a result Citibank, UBS and Merrill Lynch ended up with huge portfolios of super senior CDOs. To show how bad this has got, Merrill Lynch stated when announcing third quarter results on October 16, 2008 “Net write-downs of $5.7 billion resulting from the previously announced sale of U.S. super senior ABS CDOs “ Merrill Lynch also announced that it had sold in all 30bn of super senior CDOs, it is safe to assume they did not receive much in return for this Triple A paper.

As is now known the sub-prime and CDOs experience turned into a disaster for all involved, but why were so many people taken in? Wasn’t the outcome obvious? Lets pass the obvious villains, company management and boards and look at two other groups who should have been the canaries in the mine; the rating agencies (S&P, Moody & Fitch) and the Internal Risk Management Departments at the big Wall Street houses, how did these groups miss the obvious?
Why do we have rating agencies, and their sisters - monoline insurance (Ambac Financial Group Inc and MBIA) and the GSEs (government sponsored enterprise - Fannie Mae and Freddie Mac)? In the age of the Internet it seems that we can do our own research but that's not always been the case and these three groups came into existence to be responsible to do the necessary groundwork on corporate bonds, municipal bonds and mortgages respectively so that investors could have confidence in what they were investing in. They were there so we could trust in the system! And capital would reach those places where it would otherwise never reach. Each of the players got greedy and expanded their participation in their respective markets, creating conflicts and eventually failing the system.
Back to the rating agencies, these institutions extended their business from rating corporate bonds to providing ratings on CDOs. The conflict of interest between Wall Street houses sponsoring the CDO issues and the issuer (the same wall street firm) resulted in the rating agencies clearly doing insufficient work. They had to rate these bonds as required by the Investment Bank if they wanted to continue to get the rating business.
As for Internal Risk Management Departments at the Wall Street Firms, they clearly must have been persuaded by business managers that the penalty for failing to pay and fulfill ones mortgage obligations was such that foreclosure would not be an issue. Basically the effect on an individuals' credit score and future restrictions on availability to credit for seven years would be sufficient deterrent to ensure compliance and negative equity would not result in foreclosure. However on further reflection it is completely rational for a borrower to return the keys on a house where the borrower has negative equity. It is hard to believe that Wall Street firms believed house prices would always go up. A second possibility is these groups were making so much money, had their own complexity that the risk management responsibilities were given to the CDO management. It was rumored the CEO of Merrill Lynch would spend significant time with the securization group, demanding more market share.

(as an aside - The monoline insurers whose role is central in a well functioning municipal bond market should never have been allowed to expand their business into insuring CDO's. When the CDO's began to fail these organizations had insufficient capital to protect municipal investors.)

As for the GSE's, how the mighty have fallen. Starting in the early nineties Freddie Mac (the smaller of the two GSE’s, founded in early 70’s to provide competition to a newly privatized Fannie Mae) and Fannie Mae began to expand rapidly take advantage of their pseudo government status to raise capital cheaply in the bond markets. On September 7 2008 when these institutions were placed in Conservatorship by the US Treasury they together had outstanding debt in excess of $1.7 trillion and had capital of only 60 billion (half of which was represented by tax credits! don’t think they will be paying tax for a while) representing a capital ratio of less than 3% much lower than the 8% held by banks. This debt was invested in mortgages (although not subprime mortgages). Their collapse was a result of the knock on effect of the subprime affecting uncertainty in Mortgage Securities generally and foreclosure spilling over into the prime mortgage market. With the need to continually replace their borrowing with new borrowings, the small capital base, increasing skepticism of lenders ensured that these institutions would fail. Ironic that an institution created in the 1930s to help lead the country out of the depression should itself help threaten us with a second great depression. These two huge corporations highlighted so much of what was bad leading up this crisis including excessive lobbing by corporations, excessive CEO compensation and lack of oversight. As Jim Cramer of Mad Money screams on his TV show “government by and for the corporation”. Freddie and Fannie spent $160mm on lobbying in the last ten years. It is no surprise that no new oversight made it into law.
As the crisis grew falling prices in the house market led to more foreclosures, a crashing CDO marketplace lead to uncertainty in the valuation bank balance sheets and the confiscation of the failing GSEs left investor's in a position of real uncertainty. What institutions could be trusted?

Worst was to come.

So what is a credit default swap (CDS for short)? Here is a simple example: the U.S. government issues a five year bond (a transferable loan) to yield 4% [commonly referred to as the five year treasury] whereas Ford Motor Company would need to issue the same five year bond to yield 9%, the differential of 5% is referred to as the credit spread. The introduction of the credit default swap in the late nineties allowed for the credit spread to trade independently of the bond as a credit default swap. In a CDS one party would pay 5% each year for five years in return for receiving 100% if Ford Motor Company defaulted on the bond.

Back to the current crisis, house prices continue to fall, the monoline insurance companies tottered on bankruptcy, banks continued to take right offs against their mortgage portfolios and foreclosure rates climbed. It is still very much a housing relating crisis at this point. For banks and especially Investment Banks the liquidity (the ability to sell at the current market price quickly) is assumed in order to support a leverage of greater than 12-1. The stability in asset prices over the last 15 years had led many Investment Banks to ran leverage positions of 30 or 40 to one. Even at this stage in the crisis it may have been possible for the system to survive providing there was no run on any bank.

For investment bank with no depositors, assets are funded through market instruments like commercial paper, repurchase agreements and traditional bonds.

The CDS price (normally quoted in basis points (.01 of a %)) on any company is the market statement of the likelihood of that company defaulting. The lower the spread the less likelihood of default. It is also the premium over the equivalent government rate that the company must pay in order to borrow funds. Hedge funds saw an opportunity here by buying a CDS (pay the spread to the seller in return for getting 100% if the target defaulted ) and adding pressure on the cost of funds. The seller of the CDS to the hedge fund would need to in turn sell the targets stock or bonds short in order to hedge their position, creating uncertainty and widening of CDS spreads, increasing the borrowing cost of the target and increase likelihood of default. Nasty game, but this is why the weakest investment bank was in big trouble. Pack always picks on the weakest!

The next chapter in the falling dominos occurred in March 2008, it was a Friday and the CDS spread for Bear Sterns widened to 14%, unprecedented wide levels, Bear was suddenly cut off from the credit markets, unable to replace short term funding. It would need to sell assets, but liquidity was not there. Over the weekend the Federal Reserve sponsored the acquisition of Bear Sterns by JP Morgan. One event in 2007 signaled the coming crisis. Two Bear Stern hedge funds required large capital injections by Bear after Merrill Lynch sold $825mn of the hedge funds CDOs assets held as collateral and raised only 100mm a measly 12 cents for each dollar.

In saving the system from a Bear Stern failure, shareholders were paid $10 per share, something at least greater than zero, bondholders saw their securities jump to 100% as their borrower was replaced by the mighty J P Morgan. JP Morgan received a guarantee on Bear Stern Assets from the Federal Reserve, putting the US taxpayer at risk with little likelihood of a return. The only loser here seemed to be the taxpayer! JP Morgan completed the acquisition on 30th of May 2008.

The next domino in the crisis was principal itself. The moral hazard implied by saving Bear Sterns. Largely occurring within the republican administration and its supporters. Capitalism was best served by allowing the natural process to take it course and government should not get involved in selecting winners or losers. This argument directly led to the central incident of the crisis that was yet to occur and that ensured the crisis would be global, deep, scary and put the world Financial System at risk. Over the last 20 years the capital markets have grown more complex and the inter-dependence of all the large players has grown to a level not fully understood. Trillions of dollars of OTC (over-the-counter) derivatives have been written between all players. One large player disappearing overnight would leave a huge level of uncertainty in the market. Would it bring the whole system down? No one knew.

I was woken on Sunday, the 15th of September by a friend who thought I should know that Lehman Brothers was filing chapter 11 and Bank of America was buying Merrill Lynch at $29.00 a share. I was incredulous this was impossible they could not possibly let Lehman file! surely they knew what they were doing, how many trillions of derivative contracts did Lehman hold? This would be an almighty mess. If they wanted to make an example Washington Mutual would have been better simpler choice, but of course they are politicians and Washington Mutual would affect the man on the street at least superficially whereas Lehman was those bad guys from Wall Street. Clearly the CEO of Merrill Lynch was the only one who knew what he was doing, if Lehman disappeared he was next, by arranging a buyout all this would be avoided.

This one action to let Lehman fail which in hindsight after the moral hazard debate that had preceded was inevitable, on top of everything that had come before, completely sent the financial markets into a tailspin. Only weeks before Lehman had announced a quarterly profit and net assets of $26bn and now the bonds were trading 10¢. What had happened? Where had $150bn dollars gone? How was this possible? From this point on a credit markets froze! No institution could trust any other institution; nothing was what it seemed no balance sheet could be relied upon. Just the speed Lehman had vanished was enough to spook everyone.

The dominos continued to fall. The first impact of Lehman’s bankruptcy was seen went markets opened on Monday 16th September. On Friday the 13th two days before Lehman filed for bankruptcy the credit rating agencies downgraded AIGs debt. AIG being the 18th largest corporation in the world and its largest insurance company saw credit default swaps as a natural extension of the insurance business, it was simply the process of insuring a bond in case of default and how many default had there been? Not many. From the start of this crisis credit spreads had began to widen and AIG began to take paper losses on their large portfolio of Credit Default Swaps (CDS), unfortunately all spread were widen! That was not meant to happen, all companies were not to be in trouble at the same time. But the rating downgrade from triple A triggered an event that was also not meant to happen. AIG would need to post Collateral to the owners of these CDS contracts based on their current market value in case AIG was no longer triple A. on Friday AIG disclosed to the market that it would need $40bn cash to post as collateral. This was a liquidity crisis and not a statement that AIG was in financial trouble. When the market opened on Monday following Lehman’s demise AIGs collateral requirement had grown to $85 billion. Basically credit spreads had more than doubled as a result the Lehman bankruptcy. At this point AIG had no alternative but to declare bankruptcy if Federal government would not provide a loan. Who else was going to come up with $85bn! The terms extracted by the Treasury once again looked like confiscation and put a shocked market into more shock.

[Lehman Brothers, a classic investment bank, had 700 billion of assets funded by 21 billion of capital (or 33:11), 125 billion in bonds and 550 billion of traditional market finance. Washington Mutual the largest credit union in the United States had 310 billion in assets. AIG had assets of over one trillion dollars and shareholders equity of $104bn2.]

The world didn't have long to wait for the next chapter. This was a straight run on the bank, after months of speculation a collapsing share price and rumors, depositors began to withdraw funds has increased pace from Washington Mutual. On the 25th of September 2008 after losing $16 billion in deposits in the week following the Lehman bankruptcy, the FDIC seized WaMu and assets, depositors and branches handed over to JP Morgan for less than $2bn. Leaving investors and bondholders of WaMu with nothing. But the politicians were gratified that no depositor was hurt and the FDIC paid out no funds in the process. This time the tax payer and JP Morgan won. But this just insured the dominos would continue to fall. Only in April 2008 WaMu had raised $7bn of new capital and was not a sub-prime lender.

Washington Mutual may have passed into history with no further incident had not JP Morgan not fully disclosed the valuation it attributed to the assets it had purchased from Washington Mutual. Washington Mutual held in large portfolio of option ARM mortgages, which J P Morgan discounted by 23%. Enter our next victim, Wachovia was known to hold a portfolio of over 120 billion of option ARM mortgages and would need to write off 28 billion to conform to the JP Morgan pricing. Wachovia CDS exploded to over 14%. I received a phone call from my stepfather asking me if he should withdrawal his funds from Wachovia, the stealth run had begun, $15bn being withdrawn in the first week. Wachovia needed help and fast and was eventually purchased by Wells Fargo.

Who was next? Basically the system was broken. Morgan Stanley, Goldman Sachs, Royal Bank of Scotland, Nat City, SunTrust you name it they were all in trouble. When General Electric was unable to raise short-term funds and their CDS widened to 4% everybody was in trouble, not just banks. The crisis now introduced the equity market as the next domino. Share prices of financial companies had fallen throughout the crisis but now everyone was affected and the whole stock market began to unravel.

International banks began to fail; international stock markets began to unravel.

Paulson, US Treasury secretary introduced his “troubled asset relief program” or TARP on the 19th September 2008. On Monday September 29th the House of Representatives votes to not pass the measure, starting a major crash in the stock market. Congress re-thinks and passes the bill on a second attempt on Friday 3rd October only to look out dated over the week-end when the UK government announces that they planned to invest $85bn directly into their banks.

The TARP gave the US Treasury authority to buy up to $700bn in distressed assets from financial institutions at some price fixed by auction between the distress levels and some value based on fair likely return on expected cash flows. Basically this was seen as a bailout of the bad actors at a cost to taxpayers but something had to be done. And this was the only proposal on the table until the UK acted. It is three weeks since the TARP was passed into law and still no auction has occurred. The TARP will end up being unworkable has the same author that allowed Lehman to fail.

The UK government less restricted by political dogma went to the heart of the issue of shoring up bank balance sheets without having to work out a valuation for the distressed assets. The UK extracted their pound of flesh without the look of confiscation. Some management had to step down, salaries would be restricted, dividends would be restricted, and returns on preferred would be a high 12% but shareholders would not be thrown out completely.

The US morphed the TARP into authority to invest directly into 9 banks, but instead of extracting a pound of flesh they offered a deal that was to good to refuse. So much for not selecting winners! The stock market begins crashing anew leading to a run on Hedge Funds as money was pulled out leading to more selling.

Now the scene switches to Congress to find blame and what we need to put in place for the future.

But this is not yet over. All assets have depreciated, equities from 14000 to 8000 a 42% fall, Oil from 145 to 65 a 55% fall, gold from 950 to 700 a 26% fall, the only safe harbor in this storm has been $ and Yen government bonds.

The Hedge Fund industry is in trouble, the industry that emerges from this crisis will be very different to the one that entered it. There has been almost no barrier to entry, no regulation and high profit margins. All of this will change for those that survive.

We are seeing “super” banks emerge, one stop shops with credit cards, deposits, mortgages, business loans, investment banks, equity brokers all under one roof. This looks very like pre Glass-Steagall, which created the FDIC and prohibited a bank holding company from owning other financial companies. This ban was repealed on November 12, 1999. Is this in the best interest of our nation? How will these giants be regulated? How do we insure the FDIC is not liable to investment banking losses?

The economy is the next domino, negative growth, just how negative? How many cars are going to me made and sold in the USA in the next 12 months? How many people are going to lose their jobs? I think we will be very lucky if unemployment stabilizes below 9%.

To summarize or conclude on what went wrong. In a low regulation world great faith is placed in management of banks own self interest being aligned with the public good. This failed.

The rating agencies, monoline insurance companies and mortgage GSEs must be regulated and not allowed to expand their businesses for profit.

Internal Risk management groups must be independent of management.

OTC derivatives need to be centrally cleared.

CDS should regulated. In the Lehman example $400bn of CDS where settled against 125bn of Lehman’s bonds outstanding. Basically Lehman should never been allowed to fail.

Back to my own experience. I left J P Morgan in 1997 with a business plan to create an electronic platform to allow banks to trade OTC derivatives and therefore replacing the existing secretive opaque system. As a small start up we experienced many challenges namely technology, funding, regulation and market acceptance. We solved the technology and funding and after 2 years of hard work in Washington and legal uncertainty and testifying six times in Congress the regulation issue was solved – the market would stay unregulated, the platform would not be regulated by the CFTC provided we did not clear trades and access was kept to professionals. Through out the regulation uncertainty the large Wall Street banks were very helpful to us, the banks had a huge self interest to ensure the market remained un-regulated.

Finally we had a working technology, funding and certainty on the US regulation situation, we were now ready to launch the platform. Boom! We hit a brick wall that same self interest which had prompted the major banks to help us through the regulation maze re-appear to thwart us. The market was so profitable they wanted it to stay opaque. 10 banks ganged up, threw $100mm into the hat and told the marketplace not to use our platform as they would create a cheaper better platform. We struggled to get anyone interested, we were locked out (can I say anti-trust or coercion?). It is ten years later and there still is no electronic platform operating in the derivatives world.

{Here are the milestones:
The subprime mortgage market grows to include no docs 100% mortgages. The hottest housing markets see price declines and the start of foreclosures. The CDO market for secondary mortgages begins to unravel. UBS, Citibank and Merrill Lynch announced vast loss provisions. SIV vehicles put Commercial Paper market at risk. The monoline insurance companies begin to collapse. Baer sterns collapses and is rescued by the fed and JP Morgan. Outcry on “moral hazard”. Treasury seizes Freddie Mac and Fannie Mae. Lehman collapses and is allowed to go into bankruptcy. Credit spreads explode wider. Treasury seizes AIG. FDIC seizes Washington Mutual and awards assets, branches and deposits to JP Morgan. After stealth run on deposits Wachovia is forced into the hands of Citibank (Later acquired by Wells Fargo). No institution can trust any other organization, Inter-bank activity ceases. Congress eventually passes the TARP bill (allowing Treasury to purchase mortgage assets from banks). The British government rescues three British Banks by injecting capital therefore becoming shareholders. The stock market crashes. The U.S. Treasury follows the UK lead by taking direct stakes in nine banks.}


1. Lehman 2007 annual report
2. AIG 2007 annual report