FYI | Mar 16 2008
By Greg Peel
The problem of a “run” on a bank is it is a self-fulfilling phenomenon, driven by a possibly irrational collapse in confidence and the unfortunate outcome of “Chinese whispers” (With apologies to the Chinese. This is an old parlour game in which a comment whispered to one guest is then passed on to the next in a whisper and so on. The last guest then restates the comment aloud, and it is always vastly different from the original).
I am again reminded of the incident in the late seventies when popular Sydney broadcaster John Laws informed listeners on his morning radio program of a rumour that the then St George Building Society was in some sort of financial trouble. By the time I arrived home from school, my mother was ready to drive me to the local branch to join the long queue to withdraw what money we had. In my case, I believe it was a princely sum of something like $300. The bank manager himself was on hand amongst the depositors to supervise the orderly processing of requests. One lady remarked “I don’t suppose we are helping”. He smiled as best he could and simply said “No.”
But St George survived the incident, and went on to become a fully-fledged commercial bank following deregulation of the banking industry in 1984. As such it has access to the Reserve Bank’s lender of the last resort facility. In 2008, however, the baby member of the Big Five is under pressure given its comparative lack of deposit base (doesn’t have my $300 anymore) and reliance in the now seized up securitisation markets for funding.
While St George may have survived back in the seventies, it was not the case for UK regional bank Northern Rock last year. Northern Rock was one of the first commercial banks to feel the pain of ever-tightening credit markets, and once the news spread a slippery slope was in train and there were near riots as small depositors swarmed on local branches. To that point Bank of England governor Mervyn King had maintained an attitude that any casualties of what was then a credit crunch that looked like it might be contained would just have to fall as necessary victims of de-risking and rationalisation. However, the wild scenes at local Northern Rock Branches prompted the Chancellor of the Exchequer to take the extraordinary step of overruling King and forcing him to guarantee not only the deposits at Northern Rock, but at every UK commercial bank. The move was unprecedented.
The government then set about the task of attempting to sell the Rock to any acceptable and willing party at no doubt what would have been a knock-down price. But bids, including one from Virgin’s Richard Branson, were rejected on the basis of having too many caveats that effectively shifted risk onto the British people. The only solution remaining was to nationalise the bank. While it may have been the only solution, it also evoked the “moral hazard” in that ultimately the humble British taxpayer had been forced to bail-out an organisation that got itself into trouble by taking bets in the spurious mortgage security market.
The same moral hazard is now confronting the US Federal Reserve.
US investment bank Bear Stearns is the latest institution to have suffered a “run”. In Bear’s case however, there were no angry little people banging on padlocked branch doors, pitchforks in hand. Bear is not a commercial bank, and as such has limited access to lender of the last resort facilities from the central bank.
As St George is the baby of the Big Five commercial banks in Australia, Bear Stearns is a baby of the group of large US investment banks which includes the likes of Goldman Sachs, Morgan Stanley and Merrill Lynch. Among the group, it is the bank whose business model relied most heavily on the securitisation of assets, including mortgages. It was Bear Stearns who set the whole global credit crunch in train back in July when it announced two of its hedge funds, which specialised in investment in subprime CDOs, were in trouble. Bear Stearns’ primary lenders then seized the collateral and tried to quietly farm it out to the market, but received a somewhat rude shock when there were simply no buyers. That situation remains to this day.
According to a Wall Street Journal report, it was nearly two weeks ago that word began to spread among fixed income traders that European banks had ceased trading with Bear. By last Monday US firms started doing the same. They wanted to pull their cash for fear it could be locked up if there were to be a bankruptcy risk. Thus the familiar slippery slope had begun. Rumours intensified that Bear was facing a liquidity crisis. Were the cautious cash withdrawals helping? No.
It was on Tuesday that the Fed made its announcement it would accept certain prime mortgage-backed securities as collateral directly from investment banks to the tune of US$200bn, with hints of more to come if needed. Previously the Fed had been feeding only the commercial banks with liquidity, as are its rules as the lender of the last resort. But to date commercial banks had not passed on massive amounts of injected liquidity onto the investment banks, despite aggressive cutting of the cash rate at the expense of the US dollar. As to whether it was the Bear Stearns rumours which prompted the Fed to act is arguable, but one crucial element of the initiative is that it was not due to begin for another 28 days (and as yet still isn’t).
Yet still the Bear Stearns rumours persisted. The Dow rallied 400 points on that Tuesday, but has since given it all back. It is virtually impossible to halt a slippery slope. Bear’s counterparties – who had previously accepted the investment bank’s collateral in daily transactions – were now insisting on cash instead. Hedge funds who used Bear as a funding source also withdrew what cash they had. On the Wednesday, Bear Stearns’ CEO made the fatal error of appearing on television to ensure that everything was fine. By the Thursday night the board of Bear was in crisis talks with its largest lender, commercial and investment bank JP Morgan. JP Morgan in turn appealed to the Fed.
At 5am on Friday, in a phone hook-up of a quorum of governors, the Fed decided to invoke an emergency rule that had been put in place in 1932 in the depth of the Great Depression. The Fed would provide secured funding to Bear Stearns for 28 days, via its banker JP Morgan. JP Morgan would simply be the conduit – the Fed would take the risk. On Friday shares in Bear Stearns fell 47%. The Fed had now reached a pinnacle in the “moral hazard”.
The Fed had little option. To not act would be to risk a domino collapse of US investment banks which would shatter the entire global financial system. If Bear Stearns was allowed to go under, the risk is that terrified counterparties would start pulling cash out of everywhere. All of Bear’s troubled assets would need to be offered onto the market – a market which is already extremely reluctant to buy. And we’re not just talking subprime. We’re talking every single debt security, prime or otherwise, that is not issued by the US Treasury.
All eyes are now upon JP Morgan. Bear Stearns, as it is, will not survive. It has 28 days to be rescued by someone willing to buy its assets. JPM is the obvious primary candidate, although other names, such as Britain’s HSBC, have been mentioned. But JPM has had long association with Bear, is its biggest lender, and is also known to have been in the market for acquisition bargains as the credit crunch has deepened.
There are too ironies to the events of Friday. The first is historical. In 1907, US banks were in crisis and were undergoing a run from depositors. The New York Stock Exchange was at risk of running out of cash. Legendary banker J. Pierpont Morgan, then semi-retired, picked up his Bell telephone and raised an extraordinary US$25 million – allegedly within 10 minutes – and saved the Exchange. The crisis was averted. The government’s response to Morgan’s successful actions was to later create the semi-public, semi-private US Federal Reserve as means of averting any subsequent crises. And so this “central bank” model was adopted by countries across the globe. Then, as now, the primary purpose of the central bank was to protect small depositors.
But it was not created to protect high-flying, risk-taking, entrepreneurial ventures, such as what can be called today’s capital markets – markets that exist to provide and profit from finance outside the simple commercial banking structure of deposits and loans. This is the market of Bear Stearns. Thus by taking the action it did on Friday, the Fed was forced to evoke the emergency precedent of the Depression. It was not trying to save Bear Stearns for Bears Stearns’ sake, or for JP Morgan’s. It was attempting to avert the ramifications of a bankruptcy that would spiral through the whole financial system, ending in more write-downs, more mortgage foreclosures, and more pain for the American people. And possibly resulting in the second Great Depression.
The second irony is that when Bear Stearns announced to its lenders in July that two of its hedge funds were struggling to meet margin calls, JP Morgan was among the first of the lenders to seize the assets and offer them into the market. Eight months later, JP Morgan is fighting to protect not just a few hundred million of loans to a subprime hedge fund, but possibly billions implicit in its relationship with Bear Stearns. Good call.
The question now is: Has the Fed’s action averted disaster?
The stock market’s movements on Friday provide some clues, but no answers. While the Dow fell 194 points, this is not the stuff of disasters, and in fact the close represented a bounce back for a perilous fall in excess of 300 points. Clearly there was sufficient relief in the market that the Fed’s intervention was a positive sign. But now the concern is that Bear Stearns may not be the final victim. Just how confident is the market going to be in their dealings with other investment banks? A similar slide in confidence of Merrill Lynch, for example, which is the next investment bank nervous traders have their eyes on, could prove to be the second in a possible string. How many banks can the Fed prop up?
The Fed’s comments were, as ever: “The Federal Reserve is monitoring market developments closely and will continue to provide liquidity as necessary to promote the orderly functioning of the financial system” – a line which has appeared in some form in every Fed statement since the credit crunch began. But with the US dollar having already fallen substantially, how far can it go? It is also the Fed’s primary responsibility to ensure the stability of the currency.
It is also expected by the market that if JP Morgan were to “acquire” Bear Stearns, it would only do so on a selective basis. For example, Bears’ prime brokerage is a key Wall Street business used by hedge funds to borrow money and to clear trades. It is also a business JP Morgan is not engaged in. While the acquisition of this part of the business could prove attractive, it is unlikely JPM would agree to take on all the distressed asset-backed securities Bear still has sitting on its balance sheet. Nor would anyone else likely be interested. Everyone is having to deal with their own problems at present. Bear’s securitisation business is thus likely doomed to fall, meaning all the remaining toxic waste of securities no one will buy would still end up on the market one way or another.
This comes back to the ongoing process of investment bank “write-downs”. Across the global community, such write-downs now total some US$188bn. Expectations are that the final figure will reach something like US$500bn. But “write-downs” are not “write-offs”. Losses have not yet been crystallised, other than those of smaller hedge funds and others who have already fallen victim. Those institutions are merely being forced to mark down valuations of instruments such as CDOs as required by updated accounting laws introduced in the US in November. Some of those instruments are being marked as low as 50 cents in the dollar. Yet until they reach maturity in up to five years time it is not yet guaranteed that they all will default. Many will successfully mature, one assumes, once the immediate credit crisis problem begins to ease. As yet, the losses are simply “on paper”.
But what the write-downs have meant is an erosion of investment banks’ capital bases. Banks must maintain a certain ratio of capital in liquid, high-rated securities under their licences to operate. Such capital includes AAA-rated paper, which previously had included CDO instruments given such a rating by agencies such as Standard & Poors. Not only have those ratings been brought into question in the first place, but as the mark-to-market value of the paper diminishes, and the number of defaults on mortgages forming the collateral for such instruments increases, the agencies are de-rating. And the swift diminishment of value has now extended to all sorts of asset-backed securities – prime mortgages, commercial mortgages, corporate loans and so forth. If these instruments no longer satisfy capital requirements of credit worthiness, then prop-up capital has to be found elsewhere in the meantime.
As the board of JP Morgan no doubt spends the weekend scouring the balance sheet of Bear Stearns, one is reminded of a similar, albeit much smaller scale, experience in Australia. Mortgage lender RAMS Home Loans was the first local listed victim of the global credit crunch, and was at threat of going under until white knight Westpac moved in. However, Westpac was not there to save the distressed company – it merely picked off that which was attractive. In this case, it was simply the RAMS label and branch network, allowing Westpac to suddenly expand its reach of outlets to promote the banks consumer products, including mortgages. What was left was a company called RHG, which in turn was left holding the entire existing loan book. RHG is still waiting to see whether it can attract the financing required to maintain that loan book as its existing facilities roll off this year. The only benefit original RAMS shareholders received from Westpac was time. RAMS did not go bankrupt, but there remains a chance that RHG will.
Similarly Bear Stearns will not go bankrupt, but there will likely be some part of the carcass left behind by JP Morgan or another, which will further rot and promote further disease among the investment banking sector. This, in turn, will mean simply more pressure on existing bank balance sheets. Forced sales of securities will affect even further write-downs across the whole sector.
Following Wave I of the credit crisis, the capital cavalry did arrive in the form of sovereign wealth fund injections from China and the Middle East. Even then, the banks in question were forced to offer substantial coupons on the convertible bond issues which formed the capital injections. But we have now moved through Wave II of the crunch and arguably into Wave III. There has been no further news from the Middle East. Sovereign wealth funds will have been nervously watching more recent developments, and are no doubt cautious about jumping in too hastily once more. And in the US-allied Arab Emirates they are presently engaged in heated arguments as to whether they should unpeg their currencies from a spiralling US dollar – a move which will only serve to exacerbate the dollar’s fall.
In China it has been announced that its sovereign wealth fund or funds have withdrawn from making partial investments in listed offshore companies. China has been stung by its much heralded participation in the listing of private equity firm Blackstone, which occurred just prior to the beginnings of the credit crunch. The private equity leveraged buyout market is now all but defunct, and shares in Blackstone have fallen from US$35 in June to US$15 today.
So who is left to save the US financial system?
The problem is, however, that to allow the US financial system to fail would be to allow the global financial system to fail, thus throwing the whole world into a deep and dark Depression.
So while the Fed’s action on Bear Stearns is arguably still within the reasonable bounds of intervening in the free market without usurping it, there has already been anticipation that the G7 will need to intervene directly and collectively into foreign exchange markets in order to save the US dollar. The last time this occurred was in 1998, on the collapse of LTCM. At that point the dollar had fallen to below 100 yen. It has remained above that level ever since – at least until Friday, when it closed at 99.01 yen.
And on Monday, President Bush has convened a meeting of the President’s Working Group on Financial Markets. This group includes Treasury secretary Paulson, Fed chairman Bernanke, and the heads of the Securities Exchange Commission and the Commodity Futures Trading Commission. It is also colloquially known as the “Plunge Protection Team”, and is supposedly entrusted with the task of intervening to save the US markets if that is what’s necessary.
So for the average investor it remains to be seen just what might happen from here. It is likely that things can still get worse. Next week the US investment banks begin reporting their expected first quarter earnings. Under the circumstances, Bear Stearns has brought its announcement date forward to Monday from Thursday. Thereafter the other banks will report this week and next. But if things do get worse then it is unclear just how much of a free market will be allowed to prevail.
Since the beginning of the credit crunch there have been two oft-used analogies drawn upon.
Research house GaveKal has, since the beginning, evoked the analogy of dynamite fishing. When one throws a stick of dynamite into the water, first the little fish float dead to the surface, and then the bigger fish. But ultimately there is a possibility that a whale may rise. If a whale rises, suggests GaveKal, then that will probably signal the final chapter of the crisis. History suggests that once the biggest victim goes belly-up, there can be none further. Is Bear Stearns that whale? Or is it just the whale of Wave II of the credit crisis. GaveKal had early suggested Northern Rock may prove to be the whale, but it only brought to a close credit crisis Wave I.
The other analogy, popular with renowned commentator Dennis Gartman, involves cockroaches. The argument is that where ever you find one cockroach you know there must be more lurking. If Bear Stearns is simply a cockroach, then this story has not yet reached its final chapter.
