The financial markets are in perhaps the most tumultuous week of our lifetime.
The Dow Jones Industrial Average has dropped by more than 400 points twice this week.
Two major bulge bracket investment banks will no longer exist.
Lehman Brothers, unable to convince Washington that it too is too big to fail, is under bankruptcy. Merrill Lynch agreed to be bought by Bank of America. AIG the world’s largest insurer was fortunate enough to convince the NY Fed that it is too big to fail and received an $85B bailout loan from the Fed (10x of the capital Lehman needed), which came at the cost of 80% of its equity.
Investment Banks: Business Model at Risk
With the demise of Lehman and Merrill, the two remaining bulge bracket banks, Goldman Sachs and Morgan Stanley are under extreme pressure. There share prices are plummeting; the credit default swap market is pricing their debt at 60-70c/dollar. Both Goldman and Morgan released profitable quarterly results which topped analyst estimates. Morgan Stanley kept the decline in its earnings to just 7%, a tremendous achievement given the upheaval in the markets. They do not have any significant remaining exposure to the toxic debt which bought down Lehman and weakened Merrill, AIG and Bear Stearns. However, the problem lies in the cost to raise funds.
Without access to the capital provided by the depositor base of a commercial bank, the investment banks are at the mercy of the debt markets.
After forcing Lehman into bankruptcy, the equity market is telling Morgan Stanley and Goldman Sachs to merge with a bank with a depositor base to provide access to capital.
The Lehman bankruptcy also forced counterparties and prime brokerage clients to review their relationship with the two banks.
Deutsche Bank decided to limit the credit default swap trades that expose it to risk of failure of these banks.
As a result counterparties to these banks starting buying CDS protection on the banks themselves as a way to hedge their exposure. News that many prime brokerage clients were also pulling their funds the IBs also contributed to the weakness in their stock price.
Credit Markets Seized
The failure of Lehman and the intensive care treatment needed by AIG has spooked the participants in the bond markets. Banks are unwilling to lend to each other since they do not trust the collateral they are lending against. The TED Spread, an indication of the stress in the banking system (and measures the difference between three month T-Bill and the three month LIBOR rate) exceeded 300 bps (3%) today which is higher than that on the Black Monday stock market crash of 1987. This was caused by a collapse in the T-bill yield to close to zero, as fund managers fled money market funds after a major Money Market fund, The Reserve, broke the buck i.e. the value fell below $1 to 97c because it held unsecured debt issued by Lehman Brothers which is being currently marked down to zero. Since the money market funds are seeing redemption, they are not participating in the short term debt market. As a result borrowing costs for companies is also shooting up: Ford Motor Credit Co. paid 7.5% for Tuesday overnight while the typical rate should have been 25 bps above the Fed Funds rate of 2%! Even GE paid 3.5% for borrowing overnight on Wednesday when it typically would pay close to the Fed Funds rate.
Equity Markets
The equity markets will take their cue from the credit markets. A trade which is common right now is to buy bond insurance (CDS) and then short the stock of a firm which is under stress.
This seems to have been the case with Morgan and Goldman today. Across the board, the tightness of credit means that the hedge funds and other equity investors will reduce the leverage they use in their positions and
will have to cut their holdings. An increase in borrowing cost will also reduce the appetite for taking equity risk. Equity markets will also be depressed since higher borrowing costs will reduce the earnings of companies which use short term debt to finance their operations. The equity markets will not start a significant new bull market till the credit markets show signs of healing.
How Will It End?
The credit markets will remain dysfunctional as long as there is a lack of trust among the participants.
The failure of Lehman Brothers and AIG’s bailout has severely shaken the confidence of market participants. As long as the debt related
the real estate market continues to flow in the system, that confidence will remain shaken. There are a large number of OTC derivatives of real-estate debt like CDOs, and CDS on securitized bonds on the books of many firms. Though the OTC market is a zero sum game it can blow up on a firm if they take too much risk on the same side as it did on AIG. It is very hard to get an accurate estimate of how much exposure is out there since OTC instruments are not cleared at a central agency. But getting this risk out of the system is pre-requisite to restoring confidence and liquidity in the debt markets.
In March this year, I had written an article which built the case for forming an entity similar to the Resolution Trust Corporation created to stabilize the market after the S&L crisis, which buys mortgage backed bonds. After the events of this week, the WSJ has an opinion piece written by Nicholas Brady, U.S. Treasury secretary from 1988-1993.
Eugene Ludwig, U.S. comptroller of the currency from 1993 to 1998 and Paul Volcker, the chairman of the Federal Reserve from 1979-1987, which outlines a new version of RTC which would buy and hold mortgage bonds. Rep. Barney Frank who heads the House Financial Services Committee, is actively floating the idea in Congress.
I do hope that Washington acts quickly to restore the confidence of market participants in our financial system. Letting Lehman Brothers go under has unleashed a tsunami; the Federal Government now needs to build sea-walls to contain the damage.