Wall Street's Worst Week And How It came to that

THE carnage of the past fortnight may have an unreal air to it, but the damage is all too tangible—whether the seizure of Fannie Mae and Freddie Mac by their regulator, the record-breaking bankruptcy of Lehman Brothers (and the sale of its capital-markets arm to Barclays), Merrill Lynch’s shotgun marriage to Bank of America or, most shocking of all, the government takeover of a desperately illiquid American International Group (AIG).

Contagion has spread far and wide, on Thursday September 18th central banks launched a co-ordinated attempt to pump $180 billion of short-term liquidity into the markets. HBOS, Britain’s biggest mortgage lender, also sold itself to Lloyds TSB, one of the grandfathers of British banking, for £12.2 billion ($21.9 billion) after its share price plunged. The government was so anxious to broker a deal that it was expected to waive a competition inquiry.

The rescue of AIG was justified on the grounds that letting it fail would have been catastrophic for financial markets. As it happened, even AIG’s rescue did not stop the bloodletting. On Wednesday shares in Morgan Stanley and the other remaining big investment bank, Goldman Sachs, took a hammering. Even though both had posted better-than-expected results a day earlier, confidence ebbed in their stand-alone model, with its reliance on flighty wholesale funding. An index that reflects the risk of failure among large Wall Street dealers has climbed far above its previous high, during Bear Stearns’s collapse in March (see chart).

It is a measure of the scale of the crisis that, by the evening of Wednesday, all eyes were on Morgan Stanley, and no longer on AIG, which only 24 hours before had thrust Lehman out of the limelight. After its share price slumped by 24% that day, and fearing a total evaporation of confidence, Morgan attempted to sell itself. Its boss, John Mack, reportedly held talks with several possible partners, including Wachovia, a commercial bank, and Citic of China.

Though officials are putting on a brave face, they could be forgiven for feeling at a loss as one great name buckles after another and investors flee any financial asset with the merest whiff of risk. Even the politicians have been stunned into inactivity. Congress probably will not pass new financial legislation this year, admitted Harry Reid, the Senate majority leader, because “no one knows what to do.”

At times, the responses appear alarmingly piecemeal. Amid a fresh clamour against short-sellers—Morgan Stanley’s Mr Mack accused them of trying to wrestle his stock to the ground—the Securities and Exchange Commission, America’s main markets regulator, brought back curbs on “naked”, or potentially abusive, shorts. It also rushed out a proposal forcing large investors, including hedge funds, to disclose their short positions. Calstrs, America’s second-largest pension fund, said it would stop lending shares to “piranhas”.



As in August 2007, when the crisis began in earnest, money markets were this week seizing up. The price at which banks lend each other short-term funds surged, leaving the spread over government bonds at a 21-year high. A scramble for safety pushed the yield on three-month Treasury bills to its lowest since daily records began in 1954—the year President Eisenhower introduced the world to domino theory.

Aptly enough, the crisis is spreading from one region to the next. Asian and European stockmarkets suffered steep falls. Another weak spot is the $62 trillion market for credit-default swaps, which has given regulators nightmares since the loss of Bear Stearns. It did not fall apart after the demise of Lehman, another big dealer. But it remains fragile; or, as one banker puts it, in a state of “orderly chaos”.

Consumers are already twitchy in America, where bank failures are rising and the nation’s deposit-insurance fund faces a potential shortfall. The failure of Washington Mutual (WaMu), a troubled thrift, could at the worst wipe out as much as half of what remains in the fund, reckons Dick Bove of Ladenburg Thalmann, a boutique investment bank. WaMu was said this week to be seeking a buyer.

No less worrying are the cracks appearing in money-market funds. Seen by small investors as utterly safe, these have seen their assets swell to more than $3.5 trillion in the crisis. But this week Reserve Primary became the first money fund in 14 years to “break the buck”—that is, to expose investors to losses through a reduction of its net asset value to under $1—after writing off almost $800m in debt issued by Lehman.

Any lasting loss of confidence in money funds would be hugely damaging. They are one of the last bastions for the ultra-cautious. And they are big buyers of short-term corporate debt. If they were to pull back, banks and large corporations would find funds even harder to come by.

At some point the Panic of 2008 will subside, but there are several reasons to expect further strain. Banks and households have started to cut their borrowing, which reached epic proportions in the housing boom, but they still have a long way to go. Furthermore, it is far from clear, even now, that banks are marking their illiquid assets conservatively enough.



The pain is only now beginning in other lending. “We may be moving from the mark-to-market phase to the more traditional phase of credit losses,” says a banker. This next stage will be less spectacular, thanks to accrual accounting, in which loan losses are realised gradually and offset by reserves. But the numbers could be just as big. Some analysts see a wave of corporate defaults coming. Moody’s, a rating agency, expects the junk-bond default rate, now 2.7%, will rise to 7.4% a year from now. Like many nightmares, this one feels as if it will never end.

From Economist Sept 18th 2008

What Went Wrong With Lehman, AIG...

What Went Wrong With AIG And Wachovia, And What Could Go Wrong With Bank Of America....

By Money Morning on September 16, 2008

It was a rough weekend for the U.S. financial system. Investment banker Lehman Brothers Holdings Inc. (LEH) collapsed and, as I predicted last week, the problems were not confined to Lehman.

As Money Morning detailed yesterday, Merrill Lynch & Co. Inc. (MER) has been taken over in a rescue by Bank of America Corp. (BAC), while the mortgage bank Washington Mutual Inc. (WM) and the derivatives-happy insurance company American International Group Inc. (AIG) remain in deep trouble. But what does it mean for the rest of us, as investors in particular?

Looking, first, at the investment banks themselves, the main problem as I discussed last week was that the so-called “Big Five” investment banks (soon to be the “Big Two”) were thoroughly over-levered – with total assets-to-capital ratios of 30:1 or more – compared with the traditional brokerage house ratio of less than 20:1



.

Investment banking is an intrinsically cyclical business, but Wall Street’s greedy-and-aggressive top management forgot about that as they chased profits and bonuses during a stretch in which money was always easy to obtain. The commercial banks – even giant Citigroup Inc. (C) – were fortunately much less levered. For once, we must all bless government regulations, which are much stricter for deposit-taking institutions – meaning the government rules have so far prevented big commercial banks from following the investment banks into collapse.

AIG shouldn’t have had problems, at all; it’s primarily an insurance company, and those firms typically operate with very little leverage. However, when you look at AIG’s balance sheet, it has leverage of about 15:1 – similar to the big commercial banks – and it has also made a specialty of speculative trading in derivatives. That was an attractive business for many years but like other such businesses has recently run into trouble. AIG is currently seeking a federal bailout; it is fairly unlikely to get it – although an AIG bankruptcy would certainly cause turmoil in the various derivative markets.

On the commercial banking side, things aren’t very rosy either, despite the fact that big commercial banks are less levered. Citigroup has had huge subprime problems, but is so large and internationally diversified that, in the long run, it may be able to ride out the storm. JPMorgan Chase & Co. (JPM) appears solid, and its top executives must, right about now, be congratulating themselves for having received a $30 billion subsidy from the Fed to take over Bear Stearns – before the government turned ornery and parsimonious.
Wachovia Corp. (WB) had historically been one of the strongest banks in the U.S. market, but due to its spectacularly ill-timed $20 billion purchase of a California home mortgage company in 2006, it now has serious asset quality problems.

Bank of America is an interesting case. It has a retail banking franchise similar to that of Wachovia that had been active in home mortgages and had the usual problems. It also made a big home-mortgage-market push with its purchase of Countrywide Financial Corp., but that purchase was undertaken back in January, when prices were far below those of 2006, so Bank of America probably got a bargain. On the other hand, Countrywide had been the largest and most aggressive of the home-mortgage lenders, so there is a very decent chance that its portfolio is substantially worse than others, possibly giving Bank of America an agonizingly difficult decision of whether to continue supporting it if new problems continue to appear.

As for BofA’s proposed buyout of Merrill Lynch, one must admire the cool and savvy of Bank of America Chairman Kenneth D. Lewis in rejecting the more-obvious possibility of bailing out Lehman – in favor of the much-more-attractive opportunity presented by Merrill Lynch.
Merrill Lynch has the largest retail brokerage operation in the United States – providing it with a huge branch network; it thus provides superb synergy with the primarily retail-oriented nationwide branch network of Bank of America. The only caveat is that with $1 trillion in assets Merrill is a big bite to swallow. And with the Merrill buyout following Countrywide, as it does, there’s always the chance for some post-deal indigestion.

Going forward, I’m happy to say, it’s not all gloom and doom, meaning we must be approaching the end of what we’re calling the “fail-and-bail” cycle.
Both Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS), the two remaining investment banks, appear less vulnerable – although in Goldman’s case its ability to sail serenely through the first year of the current mortgage-fallout morass is a bit more disquieting than reassuring, suggesting there could be hidden problems.

Overall, however, it may be well-worth looking at the financial-services firms that seem likely to survive – particularly in the insurance area, where risk management is generally better than in banking (because it’s a more-central part of the insurance business), or in Asia, where growth continues and the exposure to U.S. financial problems is limited.