On August 15th, I wrote an essay Fire Next Time. In that essay, I described some of the problems that I felt would impact negatively the stock market and the economy.
Subsequently, including today, there have been so many terrible revelations that we should realize that we indeed have a major financial problem on our hands. Moreover, Central Banks around the world really do not have the tools to overcome many of today’s financial problems.
Specifically, Merrill Lynch appears not only to have lost $8.4 billion, but speculation is rampant that future write offs could be an additional $10 billion dollars. In today’s Wall Street Journal, the paper indicated rumors that Merrill Lynch could be guilty of a felony called— “Parking.” Parking is when you take inventory off your balance sheet at inflated prices to hide losses. The methodology is selling for a short period your inventory at inflated prices to investors such as hedge funds with the obligation to repurchase this inventory. While repurchase agreements are perfectly legal, “parking is illegal.” The difference between repurchase agreements and parking are that repurchase agreements involve the selling of securities at or below the market with the obligation to repurchase. “Parking” on the other hand is when you sell these securities at inflated prices in order to hide losses. The rumor appears to be so well founded that Merrill Lynch’s stock is down another 8% today, and the insurance premium that bond investors are willing to pay to protect themselves against Merrill going bankrupt has skyrocketed in price. In essence, Stan O’Neal sensing the deepness of the Merrill Lynch problem possibly courted Wachovia because he understood Merrill’s precarious financial condition with the probable deterioration in their balance sheet.
Other Wall Street firms’ stocks have also declined significantly, because of fear that they also face significant write offs. The problem for the Wall Street firms is that they are leveraged over thirty to one, and hold Level 3 inventory (inventory where there is no valid third-party affirmation of value) far in excess of their net worth. Because Wall Street firms depend upon billions of dollars of short-term borrowing to finance their bloated inventories, they are very vulnerable particularly when their credibility has become impaired.
On top of this problem relating to the Wall Street firms, other problems have potentially surfaced. For example, Washington Mutual is being investigated for putting undue pressure on a subsidiary of American Title to inflate housing values in order to support very high mortgage loans. To the extent, that these loans exceeded the value of the homes and moreover home prices have declined, the problem becomes a serious one.
Another problem is the investigation into the credit rating agencies. Prosecutors and SEC officials are asking tough questions of the credit agencies on their overly optimistic granting of AAA ratings to the senior tranches of collateralized loan obligations. That is, in my almost forty years on Wall Street, I cannot recall ever the wholesale rating downgrades from AAA to junk bond status. On one occasion Texaco was downgraded from AAA to junk following their loss of a liability suit to Pennzoil, but this was a one-time event involving one company. We are now discussing downgrades involving hundreds of billions of dollars of bonds.
On top of this, insurance companies such as MBIA, AMBAC, and MGIC have suffered significant market losses because their insured these so called “AAA” securities against default. Thus, a default by these mortgage-backed security pools could flow over to these insurance companies.
The problems seem to have global repercussions because investors not only in the United States, but also all over the world invested billions of dollars in these collateralized securities. Thus, we are now dealing with a worldwide financial crisis.
The commercial banks that have exposure such as Citicorp to mortgages and junk bond loans are under enormous pressure. Citicorp has already written off $5.8 billion dollars, with the prospect of further significant write offs. Over the past few weeks, United Bank of Switzerland and Credit Suisse have taken major write offs on their mortgage and junk bond positions.
One of the problems is that the Federal Reserve and the Treasury cannot overcome of major fallacy in the system. That is a loan against an overvalued security, such as home or a company, cannot be helped just by lowering interest rates. To the extent, that people paid too much for homes or home prices have dropped or company valuations have deteriorated, puts the lender at tremendous jeopardy. To the extent that commercial and investment banks have hundreds of billions of dollars committed to take out financing for leveraged buyouts, the investment banks and commercial banks face the prospect of enormous write downs. Moreover, because credit spreads have widened, the lowering of the federal funds rate does not in itself help unload these commitments. That is, lending is based on a spread over the London Interbank Borrowing Rate. If market purchasers require a wider spread given the decline in the value of the security then the commercial and investment banks will need to take substantial discounts to offload their loan commitments.
In conclusion, in recent years, in the financial community, executives were handsomely rewarded for taking huge leveraged bets. They increased their trading inventory significantly, owned significantly lower quality and illiquid securities, and made heavy investments in hedge funds and companies with highly leveraged balance sheets. We are now seeing the flip side to the risk taking. Unfortunately, as the $160 million severance package to Stan O’Neal suggests, the shareholders, not the senior executives have borne the risk. That is, Merrill Lynch, Citicorp, AMBAC, MGIC, etc. are trading at prices lower than levels of several years ago. In essence, huge bonuses have been garnered and the shareholders have been left holding the bag.
Fire Next Time
I have borrowed the title of the book of the late Black author, James Baldwin, who threatened that the Black community would burn major urban areas if full civil rights were not implemented. Unfortunately, unless the Federal Reserve in the United States and the central banks of the major economic countries throughout the Globe do not take remedial action, the world could face a different type of meltdown than James Baldwin threatened.
In essence, there are a number of failures on the part of regulatory authorities around the world that have exacerbated the current crises.
That is, central banks have a responsibility to impose credit limits on loans whether to finance homes, or companies. Stated differently, individuals and private equity firms have been enabled to use significant leverage to make acquisitions by a laissez faire attitude on the part of regulators. In essence, this lax policy has resulted in acquisitions at prices that are unsupportable either in housing on in industry.
In housing, the worldwide increase in prices has outstripped real disposable income. In order to support these acquisitions, lenders have allowed 100% financing, lending without borrowers furnished audited income statements, or adjustable-rate mortgages. Thus, any glitch in a person’s earning power or any escalation in mortgage costs can make the home unaffordable.
In the corporate world, there have been many acquisitions in both real estate and in industry at prices not sustainable by the cash flow of the projects. That is, paying 12x cash flow to acquire a typical company or buying real estate at 20 times earnings cannot be sustained over a long time. At some point, a company’s earning momentum slows down or higher vacancy rates occur. These economic realities cause hardships to acquirers who have leveraged significantly to make acquisitions.
In essence, the lender whether a commercial bank to support private equity acquisitions or the mortgage banker to support leveraged housing acquisitions confronts a credit crisis when the borrower cannot repay the debt. That is, high foreclosure rates directly impact lenders such as commercial banks or mortgage bankers, because these institutions rely upon margin to make their loans. That is, commercial banks and mortgage bankers’ use credit themselves to make loans. The Federal Reserve can reduce significantly lending by imposing higher margin requirements on commercial banks, particularly if the Federal Reserve regulators feel that the loans are “risky.”
While housing in the United States has gotten the bulk of the bad publicity, the problem is a global one. That is, central banks in Europe and Asia have poured in significantly more credit than their American counterparts to stop the financial hemorrhaging. Stated differently, of the $500 billion that has been put into the system by central banks, at least two-thirds has been outside the United States. This is concrete evidence that central banks throughout the globe are concerned about risky loans.
Over the past few years, there have been several financial engineering gimmicks that have enabled widespread lending abuses. Specifically, collateralized mortgage obligations and collateralized loan obligations have been created and issued to facilitate lending. In essence, mortgages and corporate loans have been packaged and then syndicated to a broad and diverse group of lenders in order to spread out the lending process. Let me try to simplify my explanation. Let us say, Bank A lends $100 million dollars to Borrower A. In order for Bank A to finance this loan, Bank A can syndicate the loan. That is, Bank A can split the $100 million package into many parts with different maturities and different layers of credit protection. The “tail pieces” contain generally the longest maturities and the weakest credit protection. These “tail pieces” are generally bought by junk bond funds. Initially, the problem in the United States was sub prime lending. The problem has not spread to slightly better credits than sub prime and the problem has spread to money market funds that used leverage or invested in “riskier credits” to enhance their returns.
However, we are learning about other abuses in the lending practices. For example, mortgage bankers made loans at greater levels than the value of the houses or business properties. In order to hide the problem, a person could postpone paying his mortgage payment; thus, his mortgage increased in value rather than amortized which is the traditional manner of paying off a mortgage. The mortgage bank at some point would raise the mortgage rate on the mortgage compounding the problem. That is, a borrower who could not amortize a $100,000 loan at 6% was certainly unable to pay off $125,000 mortgage at 9%.
Another problem is that both commercial and investment banks have not fully syndicated their loans to finance company acquisitions. That is, the aggregate amount of not syndicated loans could approach $500 billion dollars if all the proposed acquisitions take place. Since both investment banks and commercial banks borrow extensively to finance their on-going businesses, the inability to syndicate loans has draconian implications. Again, the Federal Reserve or foreign Central Banks could have put a finite limit on the amount of non syndicated loans that a particular institution could underwrite.
Let me give you an example of a very well run, fine investment bank which has enormous leverage. I want to state clearly that I do not have first hand information about Bear Stearns or other investment banks. Instead, I am relying upon information provided in newspapers and magazines.
Bear Stearns has an outstanding reputation; however, because two of its hedge funds have experienced huge financial problems, Bear Stearns has gotten unfavorable press attention. Bear Stearns has about $13 Billion in equity to support approximately $400 Billion on its balance sheet. That, it is leveraged more than 30 to one. My guess is Lehman Brothers, Morgan Stanley, Goldman, Sachs are also highly leveraged. While these are all fine institutions, their traders and corporate finance people can easily make mistakes, or can face financial pressures because their security acquisitions either trade at a major discount or because the secondary market for the securities dries up. For example, let us say, that Bear Stearns has to sell $50 billion dollars of securities because of lack of financing. They could easily lose $3 Billion dollars to reduce their balance sheet to $350 Billion dollars. My guess is that the market would punish Bear Stearns if Bear Stearns took a $3 billion dollar loss to reduce their leverage. Moreover, other investment banks would be under similar pressures to Bear Stearns, causing a “falling domino” effect.
Another problem is the proliferation of derivatives. A derivative is a security that derives its value from the volatility and price of another security. Stated differently, an option is a derivative. The value of the option depends upon its remaining life, the price of the underlying stock, and the volatility of the stock. The value of the derivative can change dramatically depending upon the “perceived change” in volatility. That is, an option can decline or rise in value, even if the price of the stock stays the same, if market participants decide that in the future the volatility of the stock will change. Given that commercial and investment banks have billions of dollars of exposure in derivatives, and that many of these derivatives do not have a publicly traded price, one can quickly see how flaky the balance sheet of a commercial bank or investment bank can be.
In essence, over the last twenty years, many executives of financial institutions, including hedge funds, have made enormous incomes by their willingness to take tremendous risks. That is, they have used tremendous leverage to enhance their profitability. A majority of the profits of investment banks derives from proprietary trading, and not investment banking or commission-based revenues. Moreover, since bonuses are paid annually, traders are encouraged to take tremendous risks during the course of a given year, rather than look to remuneration over a 20-year career span. Stated succinctly, it is better to make a $20 million bonus this year, than get $40 million over a 20-year career. In the commercial banking field, loan officers are now called production manufacturers because they produce loans by making high risk loans to finance leveraged buyouts.
In conclusion, I really do not know whether the “fire will be next time” or the fire is now. I do believe that if foreign central banks and the Federal Reserve do not take remedial steps, the developed world will one day suffer a draconian financial credit crisis that will not be solved by lowering the federal funds rate by 25 to 50 basis points. Also, bigger is not necessarily better. For example, Japan suffered a recession for over a decade because its huge banks made irresponsible loans. Thus, let us not fall into the trap of “too big to fail.” If an investment bank or commercial bank makes enough bad investments or loans, it can fail irrespective of the intervention of a government regulatory authority.
Originally published in the Sarasota Herald-Tribune
