Accounting for Derivatives and
How bonuses are paid.
© Raymond May 2008
It was a Monday morning in 1995, at that time I was the head trader of US fixed income derivatives in New York for JP Morgan. I arrived at my trading desk at 60 Wall Street later than usual, just after eight having battled through my commute from New Jersey to find a post-it attached to my computer screen to "call Bill". I soon got the message that I was "done"- "oh not to worry the trade had been done at very good levels and a printout was on my desk". "Done" meant a trade had been executed and I owned the resulting position. I quickly scanned the one page and realized it was a very BIG trade, the biggest I had ever seen, at least $15 billion! This was the first time I had ever had a trade executed on my book without consulting me for pricing information. The bond market was open, futures opened in 10 minutes but were trading on the electronic platform. Shock! the futures were printing red, very red, indicating a very large downward market movement. A big market movement on an ordinary day was 10 basis points or one 10th of a percent. This Monday the screen was RED and down big, the futures were showing down more than 50 basis points, the market was not yet open, there was nothing I could do but wait. We were down $25,000,000 before we started, why was I the last person on the planet to know about this trade? As the futures opened the prices continued to fall, now down 75 basis points – I felt ill?
Come bonus time, the bank had lost 25 million but the great and good Investment Bankers that put the deal together claimed to have made 25 million. Now it was all politics and Bill was king and his word was all that counted. So the bank loses all the way round, 25 million on the deal and then pays out a bonus! I of course am blamed for losing 50 million as if it was separate and no one was interested in the truth or it ensuring it did not happen again.
This is a small example of the bonus situation in 2008. And this example occurred in 1995! it has got much worse since then. The best way to get a bonus is to arbitrage the accounting system! There are many ways to take advantage of the accounting system but the simplest is to record a profit based on some model today that will not be realized until sometime in the future.
If there was ever a case when the fixed / variable explanation for high investment banker bonuses 2008 was it, this is the true test. The argument put forward is that investment bankers receive low salaries and a majority of the remuneration is paid in the form of a bonus based on performance. In 2008 all these institutions have lost huge amounts of money and the variable piece should be "zero" but that is not what is happening. "I made money, not my fault someone else lost it" goes the cry. There is some truth to that and anyone truly adding value should be paid, but who is the judge of this value? they certainly don't have my confidence based on my experience. Very few people add much above the benefits offered by the organization (systems, network, processes, brand).
Many good analyses are available on this crisis including in January 09's Economist, which highlights how well the financial models in interest rates, foreign exchange and equities performed. And that it was the poor performance of the CDO (collateralized debt obligation) that lies at the root of this crisis. Although this is a good analysis one element of the investment bank that stands out from my own experience of 13 years in the City and Wall Street which is the true root cause is the accounting model, which revolves on the "bonus pool". Or as I like to say, "getting close to the pig trough".
I remember someone saying to me in the 80's "why invest in Merrill Lynch? if the company makes money the management takes it and if Merrill loses money you take it" it really made me think, and it has disturbed me every since. And now the whole world knows.
When an investment banker claims to have contributed a "$50mm" profit, this is very debatable, but until this year no one debated it. First the 50mm is usually "revenue" not profit and second the revenue is based on very unclear mark to market models and respective allocations.
The basic aim in the accounting model it to align the employees self interest with that of the organization. Make them make money and the rewards are shared. In a classic sales role a salesman is rewarded with commission on successful sales. This is a model well understood in all businesses, but in the financial markets when you are talking CDO or Swaps, what is the "profit"? It all depends on the accounting method. In many businesses "commission" depends on "cash-in" and not just profit. This has not been the case on Wall Street.
Lets go back to the beginning. At JPM we began executing "swaps" in the early 1980's based out of London. A swap (or interest rate derivative) is a relatively simple concept - combine a floating rate note with a fixed rate note allows only the net coupons payment over time between a fixed interest rate and the later market interest rate. This introduced the now popular LIBOR index. This allowed Treasurers to manage interest rate payments without having to call and re-issue bonds and debt. When I joined the accounting group at JP Morgan in London the few deals that had been executed were accounted for as two loans! One fixed and one variable. Each month the accounting department calculated the interest receivable and payable and the net total was the monthly earnings... nice and simple. Accept we did it all by hand, can you imagine that today! 1000 deals computed one at a time! It took all month, so we calculated the monthly earnings just in time to start again. The month earnings number did not vary much month to month, it was very stable.
There is a funny story here, each month we had to report earnings to New York on the 4th day of the month, we never had a chance – we knew the big number – e.g. 4 or 5 million, it was something close to last month, but in order to get the rest of the number we would need many more days, so we simply made them up by taking the last 6 figures from a random 10 pound note!
The average length of the deals at that time was approximately five years. Even with no computers this business generated stable positive income. This was a result of how the business was managed, simply and conservatively - by executing new deals in groups. First a transaction was executed and later one or more equal and opposite transactions where grouped together, leaving a closed group with a positive earning stream. There was no market to market at this time.
My first task was to develop a computer system to help manage this portfolio. It took six months and many long nights. It was at this time that I was approached by the banks external auditors to confirm that the portfolio did not hold a "future loss". Oh what a question? What was the present value of this portfolio? At this time we had no model, the zero curve was a thing of the future. It took 12 months to answer the question. The first model we developed we named 1 plus i, or principal plus interest.
The One plus i model:
From the observed yields on treasury bonds for all maturities and credit spreads we were able to define a current yield curve. All cashflows from all deals are calculated and complied into a single list of date and cashflow amount, the sum of all cashflows by day – as a result each day had either a positive or negative daily total. Moving to the most far out cashflow and dividing it my the appropriate current market rate (i) giving a P amount and an I amount (example - cashflow of 20mm and i =10% on12/31/2020, gives a P = 18.18mm and I = 1.82mm. The P is saved and the I amount is added/subtracted to each original amount listed on each 12/31 annual anniversary. This is performed for each date back to the present date stepping forward one day at a time. The sum of all the P's is the present value of the portfolio. I hope you followed that! Quite simple really and required no complex models. The difficulty was to generate an accurate list of all cashflows. At this stage all the deals where nothing more than paper deal confirmations.
The first run of our model took place on the 8th August 1988 (8.8.88) and we valued 66,666 cashflows! we did this on a mainframe and those two numbers were printed on the top of the green striped computer paper! very chilling. But the value was minus a few trillion and needed much further reconciliation. Between August 1988 and the final audit in January 1989 we were able to calculate the correct number with much certainty, including accounting for future hedging and operational costs. This opened the debate on mark to market accounting, which was easily won and implemented at JP Morgan in 92 based on that first 1988 model. The business head had told me before we started out that “there was over 250mm in NPV”, he was right on the mark!
Once we had developed a method for calculating the mark to market or current value we needed a model to do this daily not just annually. This was accomplished by reversing the 1+i model and creating the zero coupon curve which was first accomplished in that same year 1988, and now a market standard. We reached the zero curve in two places quite independently. In the late summer of 1988 I received a visit from Bob Barker a New York based researcher that had been given the take of developing a pricing model for a swap. He wanted to compare his model to mine. It was amazing we had reached exactly the same conclusions and our models matched exactly. I would have to assume that at the same time others around the street were reaching the same answers. I still have my first zero coupon curve workings – hand written proofs. (Bob’s spreadsheet model later became know as 3 + I and was used through the organization until the late 90’s)
The computation of the net present value of this complex portfolio allowed us to develop two further advances. The first was model position and risk management, the representation of this historically portfolio in terms of today’s market – and allow for the accurate hedging of the whole portfolio and no need to use "matched groups" and secondly the accurate reporting of daily profitability – the change in mark to market over time.
The current positions where calculated using two different methods - one was simply to add the P's that resulted from the 1 + i calculation into annual buckets and the second was to "tweak" the current market rates used as inputs one at a time, recalculating the NPV each time. By changing or tweaking just the 10 year treasury yield by one basis point and re-calculating the NPV the portfolio sensitivity to the ten year rate could be calculated and therefore the correct hedge amount. This allowed large portfolios to be accurately managed.
In the summer of 1989 I now had six month data on the mark to market and was able to monitor the performance on a monthly basis of the business - I was shocked they were making a LOSS! I decided to bring this up with management, who informed me I must be mistaken - they were making record profits! Now it was true that the portfolio was making money, but that was being generated by the historical portfolio, all new business was all being added at a loss. My information was not helpful and certainly could not be true. Sound familiar? My word against all those more knowledgeable managers. Eventually after what was years I was able to win the argument but not before many bonuses were paid along the way. But the power of mark to market accounting was demonstrated for all time.
The next question to resolve was how to allocate profitability (or rather new revenue). From 1989 the best model I developed was the "change report" this allocated the change in NPV from one day to the next to all the possible reasons. Classical interest accrual, movement in market rate, new business etc. This needed the market conditions at the time of all new deal to be captured. This was done in a spread sheet and required a "mid market rate" to be agreed, from which new revenue or bid.offer to be calculated. How should this be allocated between the "marketer" and the "trader" to ensure they were incentives to help each other. It was decided to generate a normal bid.offer margin this was subtracted first and allocate this 60% to the trader and 40% to the marketer, excess profit would be allocated 60% to the marketer.
As you can see the trader was incentivized to "shade" his mid market and the marketer to gain an attractive mid market.
Back to the 1995 trade example: The accounting revenue allocation model was set up for normal business and required a tacit agreement between the trader and the marketer. However the trade executed in 1995 was huge, so huge that the ability to hedge was very uncertain in normal times and certainly very tricky when it was public knowledge and the simple revenue allocation set out above would and could not apply, certainly not based on a prior Friday end of day closing prices when by Monday the market knew of the distress the trade was causing and any hedge could only be executed at very reduced pricing. This irresponsible was small compared to the events that occurred in 2006-2007 but indicated what was likely to happen!
The second issue is the use of revenue, uncertain revenue rather than fully costed profit and loss in setting investment bankers bonuses. It is amazing how little interest senior investment banks have on costs and processes allowing operations to run hog wild in these big organizations. Costs don’t affect how senior peoples bonuses are calculated, so why care? If you have even been in a meeting with senior investment bankers and operations managers and watch the bankers eyes glaze over. No they like everything to key of revenue only.
This is my perspective from inside JP Morgan, at that time nothing or very little was shared across the industry. Today these models are available to be purchased.
Showing posts with label Credit Panic of 2008. Show all posts
Showing posts with label Credit Panic of 2008. Show all posts
Monday, February 23, 2009
Tuesday, November 25, 2008
Democracy in the selection of Board of Directors
By R Raymond May
1526 Reverdy Oaks drive, Matthews NC 28105 (tel) 704.847.0008
I was asked at a neighborhood get together in November 2008 for my opinion on what was the root cause of this fine mess we find ourselves in at the end of 2008. Interesting, everyone knows it was all caused by the collapse in house prices and the sub-prime mortgages debacle! or was it?
No I said, those were only the first symptoms; the root cause was the wholesale institutional culture of corporate theft that has taken hold. The most clear cut sign is the incredible levels of CEO pay, golden parachutes and most of all pay levels on Wall Street. 17 billion dollars for the 2007 Goldman Sachs bonus pool! Almost equal to the company’s current market capitalization.
One group of the stakeholder club – “management” holds all the cards. The others - Capital, employees, community take what management gives them. There are lots of “good” managements but there are no checks and balances and it is hard to see the good from the “bad” until it is too late.
The only check and balance on management is the Board of Directors. But how is the board put into place and who checks the board? Certainly not the shareholders, but no, it is the same shameless management.
In response to the corporate scandals in 2001-2002, the major U.S. exchanges came up with new director and committee independence requirements, which are intended to enhance board oversight. We use this regulation event to shed light on the effect of board structure on CEO compensation. We find a significant decrease in CEO compensation upon compliance with these requirements. The significant decrease in compensation is due to a decrease in the option-based portion of the compensation. The results suggest that board structure is a significant determinant of the size and structure of CEO compensation.1
None of these changes has addressed the key issue – how do we select and remove a board of directors? Other than having a yes vote to management’s selections for us.
Corporations are so big, and the amount of cash available is just too temping. I remember thinking out loud as a young trader on Wall Street "why are we paid so much?" My boss the future CFO of JP Morgan replied "it is because we are so close to all the money".
During my time on Wall Street I observed two types of people. Type 1 had the corporation, group or businesses interests in mind foremost. Type 2 only had their own interests at heart. Types 2 were definitely the majority and you hoped you did not have to work for one of them. The business seemed cyclical in terms of which type was dominant.
Clearly this mess was caused by the gradual prominence of type 2s. What is the purpose of owning stock in a company where all returns go to management? Why own a company where the number of shares increases at the same speed as profits just to be given to management?
As the US government agrees to bailout Citibank all the talk on the TV shows is on the removal of the Board! but even if we wanted to how would that happen? And how would a new board be selected?
We need real democracy in the selection of Board of Directors!
1. Chhaochharia, Vidhi and Grinstein, Yaniv,CEO Compensation and Board Structure(October 2006). Available at SSRN: http://ssrn.com/abstract=901642
1526 Reverdy Oaks drive, Matthews NC 28105 (tel) 704.847.0008
I was asked at a neighborhood get together in November 2008 for my opinion on what was the root cause of this fine mess we find ourselves in at the end of 2008. Interesting, everyone knows it was all caused by the collapse in house prices and the sub-prime mortgages debacle! or was it?
No I said, those were only the first symptoms; the root cause was the wholesale institutional culture of corporate theft that has taken hold. The most clear cut sign is the incredible levels of CEO pay, golden parachutes and most of all pay levels on Wall Street. 17 billion dollars for the 2007 Goldman Sachs bonus pool! Almost equal to the company’s current market capitalization.
One group of the stakeholder club – “management” holds all the cards. The others - Capital, employees, community take what management gives them. There are lots of “good” managements but there are no checks and balances and it is hard to see the good from the “bad” until it is too late.
The only check and balance on management is the Board of Directors. But how is the board put into place and who checks the board? Certainly not the shareholders, but no, it is the same shameless management.
In response to the corporate scandals in 2001-2002, the major U.S. exchanges came up with new director and committee independence requirements, which are intended to enhance board oversight. We use this regulation event to shed light on the effect of board structure on CEO compensation. We find a significant decrease in CEO compensation upon compliance with these requirements. The significant decrease in compensation is due to a decrease in the option-based portion of the compensation. The results suggest that board structure is a significant determinant of the size and structure of CEO compensation.1
None of these changes has addressed the key issue – how do we select and remove a board of directors? Other than having a yes vote to management’s selections for us.
Corporations are so big, and the amount of cash available is just too temping. I remember thinking out loud as a young trader on Wall Street "why are we paid so much?" My boss the future CFO of JP Morgan replied "it is because we are so close to all the money".
During my time on Wall Street I observed two types of people. Type 1 had the corporation, group or businesses interests in mind foremost. Type 2 only had their own interests at heart. Types 2 were definitely the majority and you hoped you did not have to work for one of them. The business seemed cyclical in terms of which type was dominant.
Clearly this mess was caused by the gradual prominence of type 2s. What is the purpose of owning stock in a company where all returns go to management? Why own a company where the number of shares increases at the same speed as profits just to be given to management?
As the US government agrees to bailout Citibank all the talk on the TV shows is on the removal of the Board! but even if we wanted to how would that happen? And how would a new board be selected?
We need real democracy in the selection of Board of Directors!
1. Chhaochharia, Vidhi and Grinstein, Yaniv,CEO Compensation and Board Structure(October 2006). Available at SSRN: http://ssrn.com/abstract=901642
Friday, November 21, 2008
Black Friday - the collapse of Citibank
November 21 2008
Seems to be another black Friday, Citibank shares trade below $4.00, Bank of America is on the verge of becoming a single digits stock, the once mighty JP Morgan has seen its stock tumble 50% in the last month.
Why is this happening?
One clear reason can be laid firmly at the door of Treasury Secretary Paulson. Lack of Confidence.
I have this picture in my mind of Fort surrounded by bad guys and on the verge of having to give up its defense, all hope rests in the arrival of a relieving force. But a smoke signal is seen in the distance from the relief force saying that they are going home! the Fort will just have to wait for another force to arrive in a few months. This is effectively what Paulson said this week in front of Congress. The TARP [troubled asset relief program] would no longer be used by the current administration to buy bank assets. Whoosh! Shock!
From the moment Paulson said this, commercial mortgage assets, credit card loans assets, auto loans assets on bank balance sheets have seen spreads widen, and once more raising the specter of bank failures.
History will judge Paulson once we have a better view of these events with the advantage of perspective. However Paulson is already trying to write his own version of history, his press conference earlier this week attempted to set out a defense of events surrounding the demise of Lehman as being caused by "insufficient authority" vested in Treasury and the Federal Reserve. This is a tacit admission that the demise of Lehman was a turning point in the crisis and a mistake, one in which ensured this would be a major crisis and one that would be difficult to arrest. For my two cents – history will not judge him kindly.
I for one believe Lehman could have been saved in some form. Lehman's demise taken together with the effective confiscation from equity holders that resulted from the Conservatorship of Freddie, Fannie and AIG has resulted in the equity markets collapsing - there are no buyers of equities. Why would you buy equity when you are unclear what you are buying and risk confiscation by the government?
As the equity market collapsed, holders of equities are forced to liquidate generating even more downward pressure. The final collapse has caused hedge funds that held equities as glorified mutual funds to report large losses and start a stampede of withdrawals from all hedge funds.
So what started as a housing crisis is no longer a housing crisis and those that say in order to fix this crisis the housing market must be shored up are no longer correct. The issues now lie in commercial loans, commercial mortgages, credit cards, auto loans, hedge funds, manufacturers or just about everybody. It is very difficult to see how confidence in balance sheets, businesses and our economy can be restored.
Management of Citi were right in saying that the share price should have no affect on the ability of the bank to operate normally. Oh how we wish this was true! Unfortunately Citi needs to continue to roll over its short-term finances! Who will lend Citi the money? As the share price falls, the price of funding increases, at some point the bank is no longer viable. We have seen this play out many times. But we are at a place now that the only buyer of Citi is the government and we all know the price of that is! So selling Citi shares at $4 seems very rational. Back to Paulson - he's been very inconsistent, very unfair and is provided no leadership - expect a bad weekend!
One last point - the administration has allowed huge financial corporations to be created! We are back to where we were in 1928! before the Glass-Steagall Act that resticted bank holding companies own other financial firms. Is this really a good idea?
Seems to be another black Friday, Citibank shares trade below $4.00, Bank of America is on the verge of becoming a single digits stock, the once mighty JP Morgan has seen its stock tumble 50% in the last month.
Why is this happening?
One clear reason can be laid firmly at the door of Treasury Secretary Paulson. Lack of Confidence.
I have this picture in my mind of Fort surrounded by bad guys and on the verge of having to give up its defense, all hope rests in the arrival of a relieving force. But a smoke signal is seen in the distance from the relief force saying that they are going home! the Fort will just have to wait for another force to arrive in a few months. This is effectively what Paulson said this week in front of Congress. The TARP [troubled asset relief program] would no longer be used by the current administration to buy bank assets. Whoosh! Shock!
From the moment Paulson said this, commercial mortgage assets, credit card loans assets, auto loans assets on bank balance sheets have seen spreads widen, and once more raising the specter of bank failures.
History will judge Paulson once we have a better view of these events with the advantage of perspective. However Paulson is already trying to write his own version of history, his press conference earlier this week attempted to set out a defense of events surrounding the demise of Lehman as being caused by "insufficient authority" vested in Treasury and the Federal Reserve. This is a tacit admission that the demise of Lehman was a turning point in the crisis and a mistake, one in which ensured this would be a major crisis and one that would be difficult to arrest. For my two cents – history will not judge him kindly.
I for one believe Lehman could have been saved in some form. Lehman's demise taken together with the effective confiscation from equity holders that resulted from the Conservatorship of Freddie, Fannie and AIG has resulted in the equity markets collapsing - there are no buyers of equities. Why would you buy equity when you are unclear what you are buying and risk confiscation by the government?
As the equity market collapsed, holders of equities are forced to liquidate generating even more downward pressure. The final collapse has caused hedge funds that held equities as glorified mutual funds to report large losses and start a stampede of withdrawals from all hedge funds.
So what started as a housing crisis is no longer a housing crisis and those that say in order to fix this crisis the housing market must be shored up are no longer correct. The issues now lie in commercial loans, commercial mortgages, credit cards, auto loans, hedge funds, manufacturers or just about everybody. It is very difficult to see how confidence in balance sheets, businesses and our economy can be restored.
Management of Citi were right in saying that the share price should have no affect on the ability of the bank to operate normally. Oh how we wish this was true! Unfortunately Citi needs to continue to roll over its short-term finances! Who will lend Citi the money? As the share price falls, the price of funding increases, at some point the bank is no longer viable. We have seen this play out many times. But we are at a place now that the only buyer of Citi is the government and we all know the price of that is! So selling Citi shares at $4 seems very rational. Back to Paulson - he's been very inconsistent, very unfair and is provided no leadership - expect a bad weekend!
One last point - the administration has allowed huge financial corporations to be created! We are back to where we were in 1928! before the Glass-Steagall Act that resticted bank holding companies own other financial firms. Is this really a good idea?
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.}
Notes:
1. Lehman 2007 annual report
2. AIG 2007 annual report
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.}
Notes:
1. Lehman 2007 annual report
2. AIG 2007 annual report
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