Archive for April, 2008
April 29, 2008 6:04PM
By Elizabeth MacDonald
It’s hard to say what’s tougher for Citigroup’s chief executive Vikram Pandit as he struggles mightily to get Citigroup out of intensive care, as a notably difficult Wall Street analysts meeting bears down on him on May 9.
The bank has been racing to raise capital, with capital infusions and new share offerings, some $40b raised since November. Citi just announced it has widened a new stock offering from $3b to $4.5b.
Besides capital raising, when it comes to fixing Citi, the question for Pandit is, what should take top priority?
Is it cutting the fat marbled thick and wide throughout the beleaguered, obese bank? Unloading assets off of Citi’s sagging $2.2t balance sheet at a time when no one wants them?
Or is it bringing once and for all some semblance of logic to a mindless business model that doesn’t commend itself to reason, a supersize-me hodge podge of an institution, artichoke layers upon layers upon layers of operations, redundancies ad-infinitum, a crazy daisy chain of businesses hung together with masking tape and baling wire, operations bought pell mell starting years ago under former chief executive and chairman Sandy Weill?
Or is it both more and quite truly simpler than that?
Could Pandit’s task also involve an endeavor as simple and clear as rain, what shareholders demanded at Citi’s recent annual investor meeting at the Hilton Hotel in midtown Manhattan?
More accountability at the bank from its executives, more accountability in particular from its richly paid board of directors? In other words, leadership and responsibility from those well compensated to take care of the bank, its customers, its employees, its future? And doesn’t hectically slapping together disparate operations invite zero accountability, a condition that has been dangerously poisoning the bank’s bloodstream for years?
The answer to Citi insiders: the last one indeed.
A growing chorus of Citi insiders back efforts to vote out of their jobs what they feel is a purblind, do-nothing board, a pack of yes men who along with a quiescent band of “office politicians,” its top management, didn’t crack down when Citi execs decided to sink the bank knee-deep into the credit muck, Citi insiders say. Other insiders point to the fact that even Citi itself agrees, as it is now advertising for directors with financial expertise, ostensibly to prepare for the event a Citi director retires, a bank spokeswoman avers.
Citi has “had very little accountability,” what’s needed is a tectonic, corporate cultural shift as “dramatic as the tearing down of the Berlin Wall,” as one Citi insider rather bombastically puts it.
Citi’s board is populated by the current or former chairmen and CEOs of Alcoa, AT&T, Chevron, Time Warner, Dow Chemical, and Xerox. Also sitting on the board is Robert Rubin, chairman of the board’s executive committee, a former US Treasury secretary and former co-chairman of Goldman Sachs, and subject of a decidedly mixed Sunday New York Times profile, “Where was the Wise Man?”
Rubin is now in the crosshairs for sitting right up the hallway from former chief executive Chuck Prince and for seemingly not stopping him from maniacally and dangerously “dancing” in subprime, as Prince himself put it last summer at the height of the credit crisis, as well as for pushing Citi to lever up its balance sheet, and for other criticisms which I’ll get to in a minute, insiders tell me.
At the investor meeting, one shareholder asked: “Where was the board?” Another investor demanded: “I want to know, where were you Robert Rubin?” The investors’ questions were met with a loud round of applause, but little in the way of a response.
In a statement Citi said: “Almost all major financial institutions have experienced significant problems associated with the credit markets and very few investment professionals saw this coming.” It adds that: “Rubin and many others had observed that the financial markets had gone to levels of excess and that may lead to a disruption, but few, if any, saw the confluence of events that led to this extraordinary meltdown in the credit markets.”
Rubin has a largely non-operational role at Citi. He doesn’t oversee a P&L for any division. As he hobnobs with the likes of former US president Bill Clinton and former Federal Reserve chairman Alan Greenspan, Rubin provides guidance to bank executives, works with clients, and is considered to be a sterling name Citi can use to lure clients and smooth out problems with regulators.
Rubin is paid handsomely for his work, Citi sources say. As the Times has reported, Citi has paid Rubin $126.1m since 1999, according to Equilar, a research outfit. Citi confirmed that number.
To be sure, Pandit is winning high marks from Wall Streeters for his rapid moves cleaning up Citi’s botched handling of the housing and credit crisis which led to the ouster of former chief executive Prince last fall. Citi has seen about $145b vaporized out of its market value in a year, as it has been hit with a record $40b in total writedowns and increased credit reserves since the start of 2007.
Under Pandit, Citi has cut its dividend by 40%, moved to slash its workforce by more than 30,000 over the next two years, (a total of 13,000 announced in just the last two quarters), plus he’s restructuring the bank, giving marching orders to his top lieutenants to present a strategy for their units in the coming year. Pandit came to Citi after Rubin got the bank to buy Pandit’s Old Lane hedge fund.
Sources say that it’s out of the question that the bank will be broken up, (”nonsense,” says a bank executive) and instead Citi will unload as much as $200b in assets, nail-bitingly tough to do as there still remains a blackout in the credit markets.
I’ve reported much of this to you before, including the praise Pandit has been winning from Citi insiders and analysts on his plans to turn around the bank and apply the shock paddles to its balance sheet (”The Changes Coming at Citigroup,” March 10.)
Citi’s annual investor meeting was so electrically charged, security guards stopped visitors at the door and checked their bags, relieving them of their fruit, Citi insiders say. The fear was that disgruntled investors or employees would whip things like oranges at executives out of anger, Citi insiders say.
Dodging fruit projectiles was one thing. Enduring withering investor and employee criticism was another.
As the Citi directors, including Rubin, huddled in the front row, Pandit took to the microphone under the hot klieg lights. He talked about his plans to get the damaged bank to take advantage of global growth opportunities, the idea being to hopefully reap new cash flow from new businesses to cover losses from old, souring operations. Pandit also talked about his plans to redirect shareholder capital.
And in particular, Pandit noted how Citi now needs to get rid of its “hobbies,” what some sources at the bank call its self- indulgence in buying companies that don’t exactly fit. Citi sources say that possibly includes selling Quilter, a London-based wealth advisory firm with $10.9b in assets under management which Citi just bought in December 2006. A Citi spokeswoman declined comment.
And Pandit talked about his cost-cutting regime.
Behind the scenes, Citi insiders are talking about Pandit’s crackdown on the use by Citi’s top executives of Citigroup’s corporate jets, a perk enjoyed by executives at companies around the world.
Insiders say executives can no longer willy nilly use a Citi jet whenever they want, to Rubin’s chagrin, Citi insiders say. Citi has a limited number of corporate jets, with a number of senior executives qualified to use them. A Citi spokeswoman says she is unaware of a new regime for the jets, but that the bank is careful in ensuring “corporate aircraft is used appropriately.”
When he is told he can’t use the Citi jet, Rubin routinely calls up Citi executives to complain, angrily threatening to resign, Citi sources say. A Citi spokeswoman adamantly says: “That is untrue.”
On one occasion, Rubin was asked to leave 20 minutes earlier from a Caribbean airport so that Citi could turn that plane as well as its crew around more quickly to save money as they were needed for another Citi job, Citi sources say. Rubin complained and threatened to resign, these bank insiders add. “That’s untrue” too, says the Citi spokeswoman.
Rubin has an aircraft time-sharing agreement with Citiflight, entered into in August 2006, in which he reimbursed Citi for the personal use of the plane, amounting to $578,889 last year and $641,607 in 2006. “That was his idea, to pay for his personal use of the jet,” says the Citi spokeswoman.
Not disclosed are the annual dollar costs of Rubin’s business trips or any other executives’ business trips on the planes. Also not disclosed are the annual sums Citi incurred for Rubin’s personal use of the planes prior to August 2006. And Citi does not disclose the annual sums it pays for other executives’ personal use of its planes, if at all. Other companies fail to make similar disclosures, a problem for corporate governance experts.
The Citi spokeswoman says Citi’s rules prohibited Rubin and others from reimbursing the bank for their personal use of the jets prior to 2006. Citi also didn’t break out business costs for planes and travel because disclosure rules from the Securities and Exchange Commission didn’t require them, the spokeswoman adds.
Given all this, insiders want more disclosures not just for these expenses or, say, how much Rubin actually spends wining and dining clients or government officials, but on “what exactly does he do for Citigroup, what does he do every day, and what does the bank get for its money?,” one executive asks.
Others say Rubin has been instrumental in helping to plug Citi’s balance sheet holes, (though his advice to lever up did blast some divots out of it, they say), pointing to the fact that Rubin flew to the Middle East to help get a capital injection for the bank.
Still, insiders are buzzing that, at a time when Citi is facing an avalanche of criticism over its failure to weed out bad subprime assets, at a time when Citi is forced to dispense with 30,000 workers because its balance sheet is potted with problems, Rubin is focused on weeding out hard blueberries in his breakfast cereal.
Most mornings Rubin eats cereal for breakfast in his office at Citi, sources say. But each time he hits a hard blueberry in his cereal, Rubin gets incensed, bank insiders say. So a worker in the dining room now must spend time checking to make sure Rubin gets no hard blueberries in his cereal, these people note.
“Bob has fresh fruit for breakfast and he pays for it,” says a Citi spokeswoman. All good–so long as no one is whipping it at him.
April 25, 2008 3:57PM
By Elizabeth MacDonald
Former Federal Reserve chairman Alan Greenspan is now squarely in the bulls-eye, held largely to blame for the housing bubble that has blown up in the country’s face, because he and the central bank kept rates down at 1% for too long.
Greenspan has also been laughed out of the room for saying that the Fed can not prick any incipient asset bubbles whatsoever by raising interest rates.
Guess what. The economic data show Greenspan is right, that the Fed is not solely responsible for asset bubbles, though it sure can help foster them. Asset bubbles too are devilishly hard to deflate with rate hikes. Moreover, though the Fed was wrong to keep rates down for so long, thus ballooning the bubble and creating inflation, it’s wrong to scapegoat Greenspan as the sole creator of the housing bubble when other more appropriate villains are getting off scot-free (and walking away with fatcat pay). It’s time to stop scapegoating Greenspan.
Start at the beginning, when Greenspan first talked about “irrational exuberance,” which many took to mean he was referring to the dotcom bubble of 1999 to 2000. Some critics say that, if Greenspan was warning about the bubble back then, why didn’t he do more to stop it?
But Greenspan wasn’t referring to the dotcom bubble.
When Greenspan made that comment in a December 1996 speech before the American Enterprise Institute, he made it not in reference to the Internet bubble, but in reference to the economic downturn in Japan.
Greenspan asked in the speech: “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”
There is no evidence that the market was in bubble territory in 1996 when Greenspan said this oft-quoted line a dozen years ago.
The bubble had yet to inflate in the Internet and telecom sectors until three years later, when the Nasdaq really started to take off in 1999 due to the dotcom mania and due to corporate computer spending to avoid the Y2K mess.
Still, the thinking is, Greenspan should have seen the dotcom bubble and raised rates to stop it.
But the Fed did in fact raise interest rates six times from June of 1999 through May 2000, until the Fed funds rate topped out at 6.5%, at that time the highest level in nine years.
However, tech investors scoffed at the Fed’s rate hikes when the dotcom mania was in full swing from 1999 to 2000, noting that tech companies wouldn’t be hurt by these rate increases because they had microscopic debt on their balance sheets.
And non-tech stocks were never in a bubble during from 1999 to 2000. Knock out the soaring tech and telecom stocks from the S&P 500, and the stocks left were actually turning down when the S&P 500 hit its all-time high in March 10, 2000, as Jeremy J. Siegel, a finance professor at Wharton University has pointed out.
Moreover, from that peak in March 2000 through the end of November 2006, non-tech stocks had an annual return of 8.2%, clearly not a bubble return, Siegel adds.
And what would have happened to these non-tech stocks if the Fed had raised rates even higher and more rapidly beginning in late 1999 or early 2000?
Siegel says that these non-tech, ‘brick and mortar’ companies “would have borne the brunt of the tightening” and their stock valuations would have been pounded down even lower. He adds that the economy could have tipped into a deeper recession, worse than when the tech bubble finally blew up.
Greenspan was wise to cut rates in the early part of this decade, Siegel says. That’s because the country was battling both a recession, due to a desolating dotcom implosion, as well as 9/11, plus Enron and WorldCom was bearing down on the stock market. The bear market didn’t let up until March 2003. Remember, Wall Street was screaming for even deeper cuts at the time.
Now for the housing bubble. The critics charge that Greenspan tarried too long to hike rates while the housing bubble was ballooning. The Fed first started knocking down rates in January 2001, from 6.5% eventually to a puny 1% in June 2003. The Fed then kept that 1% rate until June 2004, eventually hiking it to 5.25% in June 2006, where it sat until Buzzsaw Bernanke began slashing it last year. Critics say by keeping the rate at 1% for a year, the Fed artificially swamped the system with liquidity and inflated a more lethal echo bubble, the housing bubble.
But that thinking misses the mark.
House prices were rising because mortgages were becoming cheap not just because of the Fed rate cuts.
Around the world a tsunami of money printed by central banks overseas was pouring into hedge funds, private equity funds, sovereign wealth funds, you name it, money that sought a safe haven after the Internet bubble burst. To be sure, the Fed here is rightfully criticized for printing too much money.
But central banks overseas are more prone to gunning the printing presses as they tend to be more beholden to politicians desperate to keep a lock on power by appeasing their populations, notably in emerging economies–Russia, India, China, all have seen annual monetary growth of 20% or more.
That money came flooding to US shores and into long term treasurys, knocking down these yields, which mortgage rates are tied to, and which the Fed doesn’t control.
Yes, adjustable rate mortgages are tied to short-term rates.
But the Fed started hiking rates in 2004, well before the subprime mess started to escalate in 2005.
Look at the government data, and you’ll see that subprime mortgages made up less than 10% of mortgage originations in 2003, a number that ran up to 28% in 2006–when the Fed stopped raising rates.
And isn’t it true that a housing bubble had taken hold in England, Spain, Ireland and Australia, where central bankers have different rate regimes and where central bankers were largely holding the line on lowering rates?
Yes the Fed cops should have used its regulatory powers to stop miscreant subprime lenders who had gone off the rails. And yes Greenspan should not have told consumers, many of whom were unsophisticated, in 2004 to get ARMs instead of long-term, traditional 30-year loans. Especially when the Fed sheriffs were not on the stick watching shady lenders. Greenspan advocated ARMs in 2004 by citing a Fed study suggesting borrowers could have saved tens of thousands of dollars in the prior ten years if they had these loans.
Also, it’s unfortunate that Greenspan at that time seemed to encourage lenders to cook up more mortgage products. “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage,” Greenspan had said.
But it’s wrong to solely blame Greenspan for the subprime mess. Blame Wall Street and hotshot, derelict lenders too.
When Congress opted not to lift the dollar amount of the mortgages that Fannie Mae and Freddie Mac could buy and repackage as securities on the secondary market early in the prior decade, Wall Street gladly dove in.
Wall Street bought those loans from places like Countrywide (CFC), sliced those loans up into all sorts of exotic securities even the Street could not understand, and then sold them as Frankenstein, mortgage-backed securities to investors. Remember, we are talking about sharks who could sell fertilizer to the guy who cleans up after the elephants in the circus.
Countrywide then used that money from those securities sales to make even more loans, creating an ever-growing, steroid-boosted hamster wheel of profits, until the wheels came off that company.
In turn, Wall Streeters willy-nilly assigned values to this $2t of asset-backed debt based on their own internal models, in turn cooking up the earnings it booked off of these securities sales. It then wrote itself big fat bonus checks off these goosed-up earnings and shoved a lot of these junk securities off its balance sheet into structured investment vehicles, or SIVs, to protect its earnings even further (though that move is falling apart).
Time to rethink the blame game.
April 24, 2008 1:25PM
By Elizabeth MacDonald
Big guns in the stock market are trying to dodge the thunderbolts thrown down from Mount Washington DC over Wall Street’s creation and handling of the credit crisis.
They’ve come up with a new central clearinghouse that would oversee for the very first time credit derivatives, beginning with credit default swaps. This is yet another historic move arising from the Great Credit Crunch. Credit derivatives right now are cleared through a central clearinghouse, and they also tend to fly under the regulatory radar.
But investors now ought to ask, will a new clearinghouse for these credit derivatives be enough? What does this mean for investors? Are the stars in correct constellation for a new Wall Street order? And can Wall Street regulate itself?
While market historians can give you a list of Wall Street’s botched attempts at self-regulation longer than your arm, a growing chorus of them say it’s about time for this new modus operandi.
But a big obstacle to the new clearinghouse is the fear by the Street that it could cut into trading profits–never mind the outsized costs of the Street’s mismanagement to investors and taxpayers. And as Wall Street tries to heal itself without government intervention, doing so doesn’t come without other obstacles that the industry itself is erecting.
The new clearinghouse for credit default swaps comes about as banks and investment houses have written off a total of about $215b to date in degraded inventory from bad derivatives, with tens of billions of dollars more in writedowns expected. Goldman Sachs (GS) says the amount will top out at a desolating $460b, and the fire engine red alarm is already clanging in Washington, as lawmakers watch with accelerating alarm.
The idea for a new clearinghouse for credit derivatives is an issue we’ve been reporting about since December at Fox Business (”What Congress Must Ask the Federal Clean-up Crew,” “The Reality Check that Bounced,” “How Congress Can Fix the Crisis”).
It’s a call for change that has gotten louder after the near collapse of investment bank Bear Stearns (BSC). The plans for a central mechanism for credit default swaps come as fears have grown that there are still more ailing counterparties beyond Bear Stearns that could create shocks to the system, at a time when the thinly regulated $45t credit default swap market alone is larger than the US government bond and housing markets combined.
The hope is that by dragging these credit derivatives out of the shadows and into the sunlight, that doing so will sharply curtail any future writedowns that have rocked Wall Street and shaken Washington.
The thinking goes that the move will bring better and more timely pricing, more transparency, greater capital efficiency, and reduced risk in the trades of these opaque securities.
A new clearinghouse might, just might, stop dead in its tracks another expensive rescue of Wall Street by the Federal Reserve, as the central bank has made costly moves to revivify the financials deadened by Frankenstein securities.
Dragging all derivatives out from the shadows could also prevent embarrassing hat in hand visits to get money from sovereign wealth funds as well as screaming investors at shareholder meetings, as executives’ once sparkling reputations have been seweraged. Wall Street hopes that coming up with this move ostensibly on its own would stop pesky Congressional scrutiny, which the Street loathes.
Here’s the deal. A group of large Wall Street firms now plan to start offering a central counterparty clearinghouse for these credit derivatives later this year. The plan is for an over-the-counter clearing house run by the Chicago-based Clearing Corp., which would be regulated by the Commodities Futures Trading Commission. The Clearing Corp. is backed by Credit Suisse (CS), Goldman Sachs Group (GS), Citigroup (C), J.P. Morgan Chase (JPM) and Deutsche Bank (DB). The CME group, which runs the biggest futures exchange, has already moved toward a similar plan for interest rate swaps.
Only companies with solid capital and dependable trading histories in clearing trades would be allowed to do business with this new central counterparty and get protected from the risk of a trader or investor failing to meet a trade. The new clearinghouse would guarantee payment on the trades it executes, and in turn reduce counterparty risk. And since it would be the counterparty, the banks’ exposure would have zero risk weighting.
But obstacles are on the rise.
The credit derivatives industry already is fighting any regulation. Historically, over-the-counter trading in these securities has been private.
Wall Street talk is that the dealers with big positions in these trades will either ignore or fight the move because they don’t want to be regulated. Insiders like to keep these trades in the shadows because they can charge colossal fees from deals they can rig themselves without any meddling. A new clearinghouse could cut into those fees.
Another obstacle to standardizing trading in these derivatives is the very nature of the securities themselves. Take bond derivatives. They are more esoteric than straightforward stocks. More so credit default swaps.
Also these complex securities tend to trade in bigger lots, they come in a much wider variety than regular stocks, plus historically they tend to have less liquidity. And past attempts to trade credit derivatives on other exchanges have failed.
The bottom line is, if the market doesn’t bring all derivatives trading into the sunlight, the regulators will force them to do so. And if they don’t, they should.
April 22, 2008 1:17PM
By Elizabeth MacDonald
It’s an election year, US workers are under duress and NAFTA bashing has hit the boiling point.
But try to affix a bulls’ eye of blame on NAFTA, even just for job losses, and you’ll find it’s a moving target.
Both Democratic presidential hopefuls Hillary Clinton and Barack Obama promise they will get the US to back out of NAFTA unless it’s amended if they win the White House. Clinton now says her husband did “make mistakes” when signing NAFTA into law, adding “we have to change the basic provisions.” President George W. Bush and the leaders of Canada and Mexico are defending NAFTA and its $930b in cross-border trade at a summit meeting today in New Orleans.
Millions of Americans, many with thoughtful positions, oppose what they call a globalist agenda. For instance, GOP presidential candidate and Congressman Ron Paul opposes both the World Trade Organization and NAFTA, saying they are not about so-called “free trade…in practice,” but are really about free trade for special interests (such as agriculture, Big Pharma and financial services).
The fear is NAFTA is merely a delivery mechanism to lock in a sweeping corporate rights agenda, with frightful talk of more trucks from Mexico given wider latitude on US highways, a supposed new NAFTA Superhighway cutting through the US to connect Mexico to Canada, even talk of a new North American Union, all of which many say would be dreadful for this country and all of which is just now buzzing through the blogosphere.
It’s time to get a fresh take on this controversial issue.
First, job losses. The US added 22m private sector jobs since NAFTA was enacted. According to stats from the Bureau of Labor Statistics, the US had 93.1m private sector jobs in December of 1993, the month before NAFTA went into effect. Private sector jobs now stand at 115m in March 2008, notes Fox Business senior economist Mark Lieberman.
To be sure, real hourly wages are moving at a glacial pace, up from $13.66 in December 1993 to $15.08 today, in constant 2003 dollars.
But you can’t blame slow wage growth solely on NAFTA. More jobs were lost to China than Mexico, economists note, with China’s low pay having an effect on wages here.
Also, economists now say that any jobs lost to NAFTA were made up in other sectors of the US economy.
Better pay in the private sector would be better, of course, and it’s not such a good thing that taxpayer funded public sector jobs are growing. The fear is it’s easy for the US government to artificially create job growth by hiring bureaucrats to dig holes and refill them (what one analyst calls the inverse of Joseph Schumpeter’s economic theory about creative destruction, the government is all creation and no destruction).
Next up, the US trade deficit arising from NAFTA. Media commentator Pat Buchanan, a protectionist with an open-pored hostility to free trade, recently wrote a letter to a newspaper decrying the fact that “where Canada’s sales to the US, around $320b in 2006, amount to nearly 25% of its GDP, US sales to Canada, about $260b, amounted to about 2% of our GDP. If we shut the border tomorrow, there is no doubt who goes belly up.”
Buchanan adds: “Why are Americans upset? Since NAFTA, but by no means solely because of NAFTA, we have run $5,000b in trade deficits.”
But Donald J. Boudreaux, chairman of the economics department at George Mason University in Fairfax, VA says you should look at it this way. Since NAFTA, $5,000b worth of capital has flowed into the US, capital that has “helped to create and modernize many US companies, to fund research and development, to train workers, and to ease the burden imposed on Americans by Uncle Sam’s profligacy,” Boudreaux says. “Does Mr Buchanan really lament this capital inflow?”
And while protectionists are on the march free traders are not on the run. Instead, they are scrutinizing what the data really say. John Engler, president of the National Association of Manufacturers and former three-term governor of Michigan, points out in an editorial in The Wall Street Journal that 95% of the $62b increase in the US’s NAFTA deficit, a trade deficit that now stands at $140b, up from $77b in 2000, is due to energy imports.
We need this oil from Canada and Mexico. Who else is going to step in. Venezuela? Iran?
Engler also notes that after you strip out energy, the remaining trade deficit due to NAFTA has hardly budged since 2000 and that the US has exported an equal amount of agricultural and manufactured goods to NAFTA countries. And Engler asks why complain about that $3.5b when our trade deficits with Europe and China are far bigger?
US exports still comprise 25% of the US’s economic growth rate, analysts note. The US remains one of the largest exporters in the world, selling $1.6t in goods and services abroad last year–the fourth straight year of double-digit export growth, says US Commerce Secretary Carlos Gutierrez.
The Congressional Budget Office says the impact of NAFTA on US GDP has been miniscule. On average, the US’s GDP has grown 3.7% since 1993 and the economy has seen sharp drops in unemployment. Trade now accounts for 27% of American economic output annually, vs about 20% in 1993.
Canada has become a vital trading partner since NAFTA debuted. It is the largest trading partner for 36 to 50 US states, and Pennsylvania exports more to Canada than its next seven markets combined.
It’s been pointed out that the eight Great Lakes states including Ontario represent a big 30% of North America’s employment and output and a robust 36% of its manufacturing jobs. It’s been noted, too, that each day, about $900m worth of goods travel between Ontario and the US’s Great Lakes partners. Each year $122.8b worth of goods, 6.5m trucks and 6m cars cross the Detroit-Windsor gateway alone–the busiest in the world.
This, at a time when the region is hurting badly from the downturn in the US automotive sector.
And listen to the warnings about the can of worms the US would open up if this country renegotiated of NAFTA. Already it’s being reported that Mexico would present its own demands on easing legal migration or protecting corn farmers.
“If we are going to have a serious negotiation, it’s not going to be one-sided,” says Luis de la Calle, a former NAFTA negotiator for Mexico who is now a political consultant. “Let’s put labor and the environment back in NAFTA, but in exchange for what?”
Could Canada and Mexico also demand truly open borders, would Mexico then demand that any border fence be halted, could both demand special immigration exemptions and guest worker programs?
Could US agricultural growers face economic fines while other countries sign free trade agreements with our competitors?
As for workers losing jobs, aren’t we to blame for inadequately educating and training our workers to compete in the global economy and dooming them to a life of low-paying jobs?
How many jobs would the United States lose if it were to quit the global marketplace?
Won’t the jobs of the future increasingly come from selling our goods and services to a world economy that is growing inexorably?
And when are we going to outsource expensive, overpaid CEOs?
April 18, 2008 4:47PM
By Elizabeth MacDonald
Some bad economic numbers out this week, a rise in jobless claims, and also the Federal Reserve said economic growth has slowed in 75% or nine of its 12 districts since February, up from two-thirds in its last report.
So is the US economy headed for a national nervous breakdown? And when will we see the end of the Stygian gloom in the financial sector? Have we seen the worst of it?
Before we get to the answers, don’t get lost in the weeds. A broad-zoom perspective is needed.
The US economy has been growing at breakneck speed for five years. We’ve added the equivalent of the GDP of Great Britain and something like two Canadas and five Saudi Arabias since 2003, though Congress has put virtually the same amount in spending on the backs of taxpayers and entrepreneurs, proving it still has no more sense than a flock of geese. The world is only in the first stages of true globalization, evident by the growing share of profits from overseas at multinationals.
And a slowdown will bring much needed rationality, especially with heedless back-to-back bubbles, the housing and credit mania being the biggest of all, which we are still in the thick of, having come fast on the heels of the dotcom and telecom implosion.
Yes we are in a downturn, but economists and analysts I talk to say it will be short and shallow, similar to the last two recessions which were relatively quick and not so deep. The ‘90-’91 recession and the 2000 to 2001 downturn lasted eight months.
These pros say that the growing consensus of a turnaround by the end of the year is right. Inflation though is running at a dangerously high 4% annual rate, even higher in food, energy, tuition and health care costs, hurting consumers. The Fed faces a growing chorus of criticism to do more to bolster the weak dollar.
Also we are still in the middle of the financial sector writedowns. Some good news here: The bond market has been in a blackout since late last summer due to the housing and credit market crisis, but the lights are just starting to slowly come back on, notes economist John Rutledge, though, post-bubble, the snap has long gone out of the yellow suspenders down on Wall Street.
A word of caution: Despite what you may hear, a recession is not necessarily defined by two back-to-back quarters of negative growth.
The National Bureau of Economic Research (NBER), the nonprofit organization of mostly academic economists that calls a recession, does not use that definition of two consecutive quarters of negative growth. Also, the late 2000 to 2001 recession did not have two back-to-back quarters of negative growth.
Instead, NEBRA gets to call a recession based on its take on a wide range of data, including things like income growth, industrial production and jobless claims. Problem is, we won’t know for some time whether we were in a recession. NEBRA has called recessions often nine months or more after they have ended.
Watch the labor data, which NEBRA scrutinizes closely and says provide the broadest monthly indicators for the economy. Jobless claims this past week on a rolling four-week average basis came in at 376,000, far below the number seen in prior recessions.
Can the jobless numbers though signal an upswing in economic activity? Dennis Gartman of the closely followed, must-read Gartman Letter says yes, that’s been true in the past. He says investors should watch for that spike in the rolling four-week jobless claims, as a sharp rise has historically preceded an upswing within a month or two in every recession in the US since the late ‘50s. He now says that jobless claims could rise toward 500,000 to 550,000, before the economy sees an upswing.
By Gartman’s estimates, jobless claims are still low compared to prior recessions. Also, in the 2000 to 2001 downturn, jobless claims spiked to about 405,000, says Fox Business’s senior economist Mark Lieberman, before turning down several months later, which is when the economy started to resurface. In the ‘90-’91 downturn, jobless claims rose relentlessly from less than 300,000 to 429,000, Lieberman says. But that then marked a turning point, and the recession ended in early ‘91.
Similarly, Gartman says that in the ‘81-’82 downturn, initial jobless claims spiked at 660,000, then came the turnaround soon after. Same for the ‘73-’75 recession, 660,000 came late in the game then the upturn quickly followed.
Clearly we are no where near those numbers yet and maybe the spike won’t be that bad. Also, since December the economy has shed on average almost 80,000 jobs a month. In most recessions a rate of 150,000 to 200,000 is normal.
And watch this: Historically recessions have been caused by the Fed tightening monetary policy to battle inflation, price hikes exacerbated by oil shocks, says economist Edward Yardeni. However, the Fed now is clearly opening a gushing hydrant with historic liquidity measures, but its interest rate cuts, which cause the dollar to drop in value, of course is helping to cause oil to hit record highs, since oil is priced in dollars.
Bernanke, a student of The Great Depression, knows full well that the Fed’s monetary contraction during the early ’30s helped trigger that collapse (on top of the disastrous Smoot-Hawley tariffs).
The Fed tightened in the ’70s to fight inflation arising from LBJ’s guns and butter fiscal policies. Inflation also arose after LBJ strong-armed the Fed to get it to print money to pay for the Viet Nam War. The tightening wasn’t enough, inflation soared to 11.5% by March 1980, and the Fed hiked rates to 20% in December 1980, and a recession arose.
Oil shocks also helped trigger inflation and ignited recessions in ‘73 and ‘79. Remember the Arab oil embargo of October 1973, which came about due to the US, western Europe and Japan’s support of Israel during the Yom Kippur war of the late ’60s? That embargo hastened the recession in the early ’70s, which saw the rise in power of the oil cartel known as OPEC (founded in Iraq in 1965, Venezuela first moved toward establishing the cartel in 1949).
The ‘79 oil shock, Yardeni notes, was brought on by the revolution in Iran which deposed the Shah and saw Ayatollah Khomeini gain power.
The last two recessions were caused by the S&L crisis and the Internet and telecom bubbles, and again lasted about eight months each.
Today’s downturn is a housing and credit crunch exacerbated by record oil prices. The Federal Reserve and the government are intent on keeping this one as short and shallow as possible, with an unprecedented package of both fiscal and monetary stimulus actions as well as liquidity injections for Wall Street.
That has some churlishly wondering whether the central bank is now in danger of becoming a government-sponsored enterprise for Wall Street, sort of like a Fannie Mae or Freddie Mac for the traders.
How long will the housing downturn last? Goldman Sachs looked at 24 house price busts with declines of more than 15% since the ’70s across 15 countries. On average, real house prices tended to fall around 30% and only bottomed out after six years, the investment house says.
Look at it this way. Standard & Poor’s/Case-Shiller widely followed 20-city composite index of home prices fell 10.7% in January from a year ago. Average house prices dropped 23% on an annualized basis over the three months ending in January. Since analysts say house prices will likely fall 30% or more from their peak, we’ve got a ways to go. However, housing starts in March fell a bruising 11.9% to 947,000, on the heels of February’s revised 1.065m. And housing permits fell 5.8% to 927,000, the lowest level since sometime in ‘91.
All of this is a rational cleaning out of the excess in housing, and it is a good thing. Gartman has a target to which housing starts must drop to before a turnaround is evident: below 750,000 on an annualized basis.
But no way are we in a Depression, despite what you hear, of course, from many despairing traders and officials on Wall Street saying it sure feels like one. Plenty of Wall Street executives now appear to be walking around in a stark awake coma of despair, or as if they are clothed in the sack and ash of wisdom, (more like Triple Sec and cigar ash).
In the ’30s unemployment got as high as 30%. Unemployment today is still around 5.1%. Setting aside the Stygian gloom at the financials, earnings in other sectors remain well above where they stood at the last market peak in 2000.
So sit back and watch in this political season the furious search for scapegoats, they being the oil and Wall Street fat cats, the overpaid reprobates of colossal riches whom many want to see headed for the tumbrel.
And watch how the new US president taking office next January will face a hot domestic debate over whether to create bigger budget deficits to deal with a downturn–if we’re still in it by then–or to curtail spending, or to rescind Bush’s tax cuts.
Remember, the US was a creditor nation up until the ’80s, but no longer, as red ink swamps the country’s books.
We can forget government-backed reforms of health care for now, the country can’t afford it, especially given that both S&P and Moody’s now threaten to downgrade the entire US government. S&P’s threat is due to Fannie and Freddie’s dangerously leveraged condition, with a potential taxpayer bailout of the two costing 10% of GDP or $1.4t. Also, like Thelma and Louise, Social Security and Medicare are both headed for a cliff with taxpayers in the back seat, as Pat Buchanan rightfully says.
April 17, 2008 11:32AM
By Elizabeth MacDonald
Merrill Lynch’s latest earnings report, which disclosed its third quarterly consecutive loss, saw wildly different ranges reported in the business media as to the size of its actual, total writedown.Merrill booked a $1.96b loss, but you may be confused seeing reports of anywhere from $6.6b to $9.7b in writedowns. My finance sources at Merrill walked me through the numbers, so did a PR staffer at the firm.
The writedown is $6.5b. Merrill got there with a neat, perfectly legit move, more on that in a minute.
A separate item: Merrill is laying off 2,900 workers, not 4,000 as you may be seeing. That 2,900 is on top of the 1,100 Merrill already announced and let go last quarter, most of which came from its disastrous purchase of First Franklin. That brings the cumulative total let go to date to 4,000, which is 10% of Merrill’s 40,000 headcount which excludes investment advisors who work on commission. My sources at Merrill tell me the 4,000 is likely much bigger, as retirement packages are increasingly handed out, with execs on the level of managing directors walking out the door.
Back to the writedown, here’s how Merrill kept it to $6.5b.
Merrill sluiced $3.1b in net pretax writedowns for securities backed by shaky Alt-a residential mortgages held at its US banks through an obscure financial statement line item called “other comprehensive income.” That $3.1b would have brought the $6.5b up to $9.6b, but here’s the thing. By slotting that amount in this line item, Merrill doesn’t have to book the writedown in earnings. Instead it goes to the balance sheet and hurts book value.
Don’t be thrown by this. What’s going on is, Merrill is saying its units are going to sit tight and they are not going to sell these securities just yet. The firm is saying that it will sit on these assets until the markets turn around.
If it did sell these securities now, Merrill is essentially saying it would have to recognize that $3.1b writedown on its income statement. Translation: Again, Merrill is waiting for the markets to calm down because there could be value in these securities. And it doesn’t need the hit to profits now, as Merrill’s $14b in net losses over the past nine months erased what the brokerage earned in 2005 and 2006.
Watch other banks and firms mimic this perfectly legit accounting maneuver in coming days, to rebel against rigid accounting rules. The move is a neat-end run around stiff “fair market value” accounting rules that I’ve repeatedly warned you about that is causing massive writedowns that could be as inflated as the profit figures they tossed off during the bubble (”What’s Really Rocking the Stock Market,” “The Answer to Who’s Next on Wall Street,” “What the Fed Chairman Really Said“).
The accounting rules are the subject of so much controversy here and around the globe, that you’ve got the likes of the IMF, Federal Reserve Chairman Ben Bernanke, US Senator Charles Schumer (D-NY), France’s finance minister Christine Lagarde, George Soros, and economists far and wide getting into heated debates over them.
So here’s the breakdown of Merrill Lynch’s writedown, according to my guys at Merrill:
The first-quarter writedowns included $2.6b to account for the plunging value of Merrill’s mortgage-related bonds, including collateralized debt obligations. Merrill also cut the value of bond insurance contracts by $3 billion, and reduced the value of leveraged loans by $925 million. Again, it stuck $3.1b in losses from securities backed by Alt-A mortgages in that line item that doesn’t affect its earnings.
Ok, back to the reason for the big heated controversy over the writedowns plaguing the markets. Here’s the deal. Because there is no market for these securities right now, the writedowns so far are based on guesswork. And auditors are being pretty tough because they are fearful of another post-Enron, Arthur Andersen-type takedown by the government and because they are increasingly being criticized for sanctioning sizable profit figures during the housing bubble.
Even though the credit market has largely frozen over, the rules say the banks must book prices on these bonds as if they were being sold today. You can’t get a price tag when there is no market. You can’t mark to market when there is no market to mark to.
This is starting to sound like an Abbot and Costello routine. This isn’t mark to market. It’s mark to madness.
Again, companies must price tag any securities they have on their books by getting a value for them as if they were going to sell them today. When they can’t get a price tag on this junk, they must use internal models to come up with their own numbers, which is essentially the equivalent of sticking up a wet finger in the wind.
The problem is, because management can use their own “mark to myth” accounting to price these zombie securities, they often rely on the ABX index, which is comprised of credit default swaps, again, which are essentially bets backed by any trader’s best guess of what these Frankenstein securities are really worth.
The ABX does not reflect the fair or true value of these assets, since panic has taken hold of it, and so it does not realistically take into account that the risk of default may be much lower than the index implies. Still it’s used, and still, it has led to billions of dollars in writedowns.
The ABX is stuck on a hamster wheel that’s turning into a death spiral. Announcements of writedowns cause the ABX index to fall further, which in turns means that other firms need to make writedowns.
Those values arising from using things like the ABX index are dumped into a bucket on the balance sheet called “level 3″ assets. Merrill Lynch did not disclose its level 3 assets in its most recent earnings release, opting to disclose them when it has to file its earnings report to the Securities & Exchange Commission, at least a month away. Stinks, yes, that we are kept in the dark. Goldman Sachs’ level 3 assets surged 39% to $96.4b at the end of February from $69.2b in November. Morgan Stanley’s level 3 assets rose 6.1% to $78.2b last quarter. Lehman’s level 3 assets rose 1.3% to $42.5b.
Enough is enough. Move away from reporting date based measurements of market price and start measuring the average market price for these zombie securities over a period of time, six or 12 months.
Using an average price will increase confidence, since the price will not be affected by short-term, choppy day to day events.
And this mess ought to settle once and for all an important regulatory debate. The market cops ought to force these firms to list these derivatives on a market exchange once and for all and stop these quarterly shenanigans.
Yes easier said than done, I get it. But these geniuses can cook up these Frankenstein securities, there’s got to be a way they can come up with a regulated exchange for them. Sunlight is the best disinfectant.
It’s not enough to leave it like this, that, if investors believe these underlying assets are going to rise in value, they can bid up the banks’ stocks.
Time for common sense. Until then expect to see more firms mimic Merrill’s accounting move, and watch them sit on these zombie securities until the market gets its head on straight.
April 16, 2008 12:39PM
By Elizabeth MacDonald
Top executives of Goldman Sachs (GS) and Morgan Stanley (MS) now say respectively that the financials are in the fourth quarter or ninth inning of the credit mess.
Yes, and all of the financials’ profit reports are as sweetly fresh as lilacs after rain, and their stock prices are really not careening around worse than the Jamaican bobsled team.
An admitted accounting geek, I have reported on quality of earnings for more than a decade. No way, no how am I an expert, when I hear that, it feels like my brain is starting to run out of my ears. I am just a journalist. But having researched this and talked to the pros as much as I can, my thinking on this is clear as a cold country creek.
There is still plenty enough voltage and not enough shock absorbers in the financials’ balance sheets to leave any Wall Street executive feeling as withered as a salted snail.
Which is why you’ll see the more circumspect Wall Streeters like Richard Fuld, chief executive of Lehman Brothers (LEH), and his chief financial officer Erin Callan carefully couch what’s going on by saying that, while the current financial crisis may be past its nadir, problems remain.
And which is why it’s passing strange that John Thain, chief executive of Merrill Lynch (MER), has been saying his beleaguered brokerage doesn’t need more funds after raising nearly $12.8b, although the Wall Street Journal says you can expect to see $6b-$8b in writedowns when it reports earnings tomorrow.
I must get this out of the way first. What’s really intolerable is the combination of finger wagging brimstone behavior and self righteous piety on what the world needs to do to fix the credit crisis coming from the likes of George Soros, a billionaire who has built his fortune on the backs of past crises, and a certain high level central banker instrumental in helping create this one, you know who I mean, weighing in like a self-serving cuckoo clock as well (as Abe Lincoln once said, “he can compress the most words into the smallest number of ideas of any man I ever met.”)
We are not out of the woods just yet. Banks are rapidly recapitalizing with infusions from sovereign wealth funds (some SWFs have seen their stakes drop 20% or more), from private equity firms, and either by selling assets or issuing new shares. Suffice it to say investor pain remains. Not just pain in the form of shareholder dilution–the negative G-forces in the form of damaged credit on bank balance sheets have created a Black hole from which no dividend can (or should) escape.
Here are the statistics. Anywhere from $360b to $460b of adjustable-rate loans are scheduled to reset this year. About 9m borrowers are upside down in their mortgages. Auction notices rose 32% year over year, a sign that defaulting homeowners are just walking away, market watcher Richard Suttmeier says. A cold calculation–borrowers, even those with decent credit scores, find it easy to walk away from their houses when their loans are close to or surpass the market value of the property.
And as the value of securities tied to mortgages nosedives, banks and investment houses will face more writedowns, which so far have totaled at least $245b since the beginning of 2007. Some estimates put the eventual cost at $460b. The IMF puts the credit losses overall at $945b. It’s anyone’s guess now. UBS (UBS) still has ropey assets on its balance sheet, some $31b. Goldman Sachs (GS), $96.5b, Morgan Stanley (MS), $78.2b.
So no more talk of innings or basketball quarters. This feels more like a basketball game’s shot clock.
But here’s what should most concern you. Hedge fund Greenlight Capital’s David Einhorn, as sharp a pencil as any when it comes to reading the financial statements, says investors may choke when they take a closer look at what’s really sitting on the financials’ balance sheet.
Remember how in the past couple of months how Carlyle Capital was on the brink of collapse, he asks? It used its balance sheet assets to do more borrowing, levering itself 30 to one against its assets. Same leverage ratio for Merrill. Same for Bear Stearns.
But Carlyle’s portfolio had triple-A rated government securities, historically the safest paper around, Einhorn notes. Chilling.
What’s even more perilous is what Einhorn found out that’s really going on with a critically important valuation metric used to assess the health of banks and brokerages. It’s called return on equity, the equity portion similar to what is an individual’s net worth. Einhorn says that banks count things such as preferred stock and subordinated debt as equity when calculating their leverage ratios. That’s like adding in, instead of subtracting out, your mortgages and auto loans to arrive at your own net worth.
If those items are knocked out as they should be, then the financials’ leverage to common equity is even higher than thirty times, Einhorn says.
And the financials consciously levered themselves to eye-watering levels because that is what they were incentivized to do, to maximize executive compensation, Einhorn says. More leverage means more revenues which means more compensation, especially at investment banks which pay out 50% of their revenues as bonuses are backpay.
And Einhorn adds that the banks and brokerages’ levered balance sheets hold items much dicier than government securities. They have stocks, bonds, various loans waiting to be securitized, pieces of structured finance transactions, derivative exposures of staggering notional amounts and related counter party risk, they have real estate, private equity.
Back to the IMF’s $945b figure for expected losses. That’s vs $750b in losses fm Japanese economic crises of 1990s. That $945b breaks down as follows: $556b for US residential loans and securities; $240b on commercial real estate securities. Corporate loans including leveraged loans are expected to account for $120b in losses, consumers add another $29b.
That $945b is about 8% of the US’s GDP vs 15% of Japan’s GDP. But whereas Japan’s banks bore almost all the losses, now places as far afield as Norway, the Artic, and entities such as pension funds, insurance companies and hedge funds will bear most of the losses from the credit crunch. Spread the pain, right?
So how long will it take The Great Credit Crunch to unwind? One 2003 study of post war housing busts in rich countries indicates that housing crashes coupled with banking crises last about four years. The housing busts in Sweden and Norway in the early ‘90s acted like an anvil on their balance sheets for years.
A bright spot: the IMF expects global growth to slow to a 3.7% growth rate from 4.9% in 2007. Not so bad, given the five years of hectic growth the world has seen–and still coming off a huge base. Besides, any slowdown might be a good thing, as it would dampen inflation now coming a cropper (I like that term, coming a cropper) in emerging markets.
April 3, 2008 6:31PM
By Elizabeth MacDonald
Could Bear Stearns (BSC) have survived if the Federal Reserve had opened its discount window to it sooner? The answer: Doubtful. Was it right to rescue Bear Stearns (BSC)? The answer: Yes.
The dramatic details of the collapse of Bear Stearns, an 85-year old institution, will be taught in business schools for years to come. It’s a tale still unfolding–it’s a story that’s a must read for investors.
And it’s a story loaded with controversy. Here’s one of the biggest points of contention.
Bear Stearn’s chief executive officer Alan Schwartz said in testimony before Congress that the Federal Reserve could have stopped the fifth-largest U.S. securities firm from collapsing if the central bank had opened up its discount window sooner to lend money directly to investment banks, including Bear.
The Fed did so on March 14, after $10b was sucked out of Bear in one day, putting the firm on the brink of bankruptcy. JPMorgan Chase (JPM) stepped in and is now buying Bear for just $10 a share, down drastically from Bear’s peak of $170. JP only did so after it got a $30b loan from the Fed, backed by Bear securities that the two sides say were valued at $30b as of March 14.
JP Morgan has agreed to absorb the first $1b of losses if the value of the assets declines, but taxpayers are at risk for the remaining $29b.
“It is highly, highly unlikely in my personal opinion that we would be in the situation we find ourselves in today” had the Fed opened its discount window sooner, Schwartz told members of the Senate Banking Committee. Opening the discount window to non-commercial banks was an historic move the Fed has not made since the Great Depression.
Let’s recap. Bear Stearns had $360b in assets and liabilities. It had $12b in shareholder equity, or net worth, to support that book of business. That’s operating on a shoestring. The bonds on its book were getting crushed by the subprime crisis, so much so that two of Bear’s own hedge funds went belly-up last July.
“We only allow sound institutions to borrow against collateral” at the Fed’s discount window, Timothy Geithner, president of the New York Federal Reserve, said in testimony. “I would have been very uncomfortable lending to Bear given what we knew at that time.”
Even if the discount window was opened to Bear sooner, the credit rating agencies were ready with their battle axe of a downgrade, and Bear would have sucked that window dry as it was hemorrhaging customers and cash.
Keep in mind Geithner’s quote for now, it’s important. Because the question is, if the Fed wasn’t comfortable with Bear’s collateral assets at its discount window, how can the Fed now be comfortable with the $30b in Bear securities used as collateral to back its $30b loan to JP to facilitate the deal? More on that in a minute.
What’s chilling is talk of the dangerous cascade of wipeouts that would likely have taken place if the country’s fifth largest investment house was allowed to collapse.
If the Fed didn’t rescue Bear, a bankruptcy “would have touched off a chain reaction of defaults at other major financial institutions,” shaking the confidence in the credit markets, and hurting the mortgage market, the muni-bond market, even the student loan market, says JPMorgan Chase’s CEO Jamie Dimon. As Fed chairman Ben Bernanke says, thousands of counterparties to trades at Bear would have been slammed too.
Let’s start at the beginning.
Though many say subprime writedowns at HSBC early in 2007 were the canary in the coal mine signaling the coming credit crisis, it was the collapse of Bear’s own two hedge funds, which had invested in subprime securities, last July that ignited the downward spiral in the credit markets still rocking the world of finance today. Bear Stearns had to bail out the funds and take possession of many of their holdings after Merrill Lynch (MER) hit the fund with margin calls. The SEC immediately began monitoring Bear’s capital position.
Bear then hung its hat on a deal with China’s Citic Securities, where both sides of the aisle planned to swap $1b worth of investments in each other. Thinking that deal (which eventually never materialized) plus its roughly $20b in capital was enough to get by with a $360b balance sheet, Bear meandered along. It’s unclear if Bear approached others for a capital infusion, and if potential investors turned away not liking what they saw.
Then Bear’s slow bleed began early this year. The firm’s capital position dwindled to $8.4b in January, then rose to $21b in March, notes Christopher Cox, chairman of the SEC.
Soon, fixed income and stock traders began hearing rumors that European financial institutions had stopped doing business with Bear.
And traders really started to back off in February through early March.
Hedge funds that had used Bear to borrow money and clear trades were withdrawing cash from their accounts, and large investment banks stopped accepting trades that would expose them to Bear. The firm’s liquidity evaporated, with cash balances insufficient to cover maturing debt. Cash reserves dwindled to $5.9 bn from $18.3 bn. And it owed Citigroup $2.4 bn, reports indicate.
JPMorgan’s chief executive Jamie Dimon has said Bear Stearns called him on the evening of March 13 (his birthday), saying its cash was drying up, that it could not meet its obligations the next day and that it needed emergency help. JPMorgan then contacted the New York Federal Reserve, Dimon said.
On a 5 a.m. conference call on the morning of March 14, Geithner spoke with Treasury secretary Henry Paulson, Fed chairman Ben Bernanke and other officials to figure out a course of action. The endgame: avoid bankruptcy at all costs. The ripple effects of a bankrutpcy would be catastrophic, as Bear operated one of the biggest clearing houses. JPMorgan, being Bear’s clearing bank for its repo deals, was in on the process. The Fed gave Bear a 28-day, $25b non-recourse loan, via JPMorgan. Bear thought it could take the next 28 days to find a buyer for the firm.
But that Friday, billions more dollars were withdrawn from Bear Stearns. Its financial resources plummeted to $2b as customers, trading partners and investors fled. Bear was on the brink. Bankruptcy was imminent.
That Friday, any possibility that Bear could go it alone evaporated after three credit ratings agencies downgraded Bear Stearns. That sealed Bear’s fate for good. Customer flight accelerated, as contracts governing counterparty trades with Bear stipulate that those contracts must be broken in the event of a downgrade. Collapse was imminent if Bear didn’t find a buyer by that Sunday night.
That weekend, marathon negotiations began. Another buyer was “prepared to write a multibillion check to invest in equity,” but since that deal would have required another financial institution to help finance a buyout, it fell apart, Schwartz testified. Though he didn’t identify the potential buyer, word is the interested party was J.C. Flowers, the private equity shop.
Fearing panic selling when the Asian markets opened late Sunday night, Bear Stearns’s negotiating leverage “went out the window,” said Schwartz. JP’s Dimon then balked at the thought of his firm taking on the colossal amount of Bear’s liabilities, and rejected a deal. The Fed then stepped in with its initial $30b loan, and then JPMorgan agreed to buy Bear Stearns for $2 a share, or $236m. JPMorgan increased its offer to $10 a share a week later amid a revolt by the smaller firm’s shareholders, picking up a business with $360b in assets and liabilities.
“I tell people that buying a house is not the same as buying a house on fire,” Dimon testified (interestingly enough, the Fed lent Bear $25b under its new program of direct lending to investment banks, separate from the $30b to do the deal–$13b of the $25b was paid back over that weekend, with the Fed earning $4m in interest).
The Fed came up with as novel a rescue as it could. Using a creative read of section 13A of the Federal Reserve Act, the New York Fed agreed to lend JP $30b over 10 years at a small 2.5% rate, a loan backed by a similar amount of Bear Stearns’ assets. Never before had the Fed taken on mortgage-backed securities. If that portfolio drops in value, JP takes the first $1b in losses. If the portfolio zeroes out, the Fed takes a $29b hit.
And here’s what’s key. “By agreeing to lend against a portfolio of securities, we reduced the risk that those assets would be liquidated quickly, exacerbating already fragile conditions in the markets,” Geithner says. A fire sale would have created chaos in an already crazy market. Expect an orderly unwinding of those assets over a number of quarters.
Now the debate is just what is in that $30b pool of assets, given that the Fed is taking on this credit at a time when the government is already levered to the hilt, what with what is going on at Fannie Mae and Freddie Mac. The New York Fed hired Black Rock, 49% owned by Merrill Lynch, to cherry pick the best assets off of Bear’s books to use as collateral. Both sides signed a confidentiality agreement covering those assets–why tip your hand to the market and invite unwanted arbitrage?
Only broad descriptions are available. The Bear assets are collateralized mortgage obligations, the majority of which are obligations backed by the likes of Freddie Mac, as well as asset-backed securities with things like adjustable rate mortgages, as well as commercial mortgage-backed securities, collateralized bond obligations, and cash assets consisting of investment grade securities rated BBB- or higher.
But how sound is that $30b worth of collateral?
JP’s Dimon testified: “We could not and would not have assumed the substantial risks of acquiring Bear Stearns without the $30b facility provided by the Fed.” That comment led Sen. Robert Menendez to ask: “JP Morgan would have never gotten involved [in the deal] but for your [the Fed's] guarantee” that it would swallow $29b in Bear’s assets and not hit up JPMorgan for other collateral if those Bear assets zero out. Menendez wondered, is that a vote of confidence in these assets?
And remember what Geithner said at the outset, that “only sound institutions” can borrow against collateral at the discount window and that he would have been “uncomfortable” lending to Bear.
What suddenly turned Bear’s assets golden for the $29b loan, what turned those sows ears into silk purses over night?
Another issue is poor oversight. Clearly, the crazy quilt of banking regulations, many of which pre-date the Great Depression of the 1930’s, have not kept up. Critics argue that lax regulatory oversight was partly to blame for the subprime mortgage catastrophe that is now a global financial crisis.
But was there any talk in Congressional hearings of forcing investment banks to set aside much more in capital reserves? There was a little.
Any talk of forcing investment banks to pay premiums into an FDIC-style insurance pool, given that they can now access Fed money at the discount window? Yes, investment banks don’t take on deposits like commercial banks, instead, they operate on short-term funding in the repo market. Still, if derivatives can be devised with apparent ease, why not regulatory protections?
And was there any talk of forcing lenders to keep on their books the riskiest strips of their securities backed by mortgages they originate, an incentive to exert some oversight over delinquent borrowers? Not a whisper.
And if the Federal Reserve is acting pre-emptively to avoid recessions by cutting rates, will it pre-emptively yank the punch bowl from the drunks by hiking rates in good times?
And why can’t the regulators come up with guardrails that will pre-emptively stop such crises from blowing into the markets in the future? Yes Fed examiners now poring through the books at Morgan Stanley (MS), Merrill Lynch (MER), Goldman Sachs (GS), and JPMorgan Chase (JPM) work, but it’s oversight done after the fact. What can be done ahead of time?
Is the Fed creating “moral hazard” by letting Wall Street firms make big risky bets, knowing they will get a taxpayer-backed rescue if they fail? As is becoming uncomfortably common, the lender of last resort is not the Federal Reserve. It’s the US taxpayer.
April 1, 2008 4:08PM
By Elizabeth MacDonald
Who knew Liza Minnelli had it in her when she said the following: “Religion is for people who are afraid of hell–spirituality is for people who have been in it.”
That quote came to mind on the news that Jimmy Cayne, chairman of the disgraced Bear Stearns (BSC), was consulting Jewish tradition to learn life lessons about the near-death experience of his firm.
As with most anyone who has endured outsized cataclysms of biblical proportions, I am now hearing from traders down on Wall Street that all they can do now is hold hands and pray.
But as for those who get paid to run the show, who their employees say did little to cauterize the bleeding, by, for example, raising capital for their distressed firms, let’s hope Washington sees through the newfound scruples of any such plaster-saint sentimentality.
That goes for the regulators, too. Soon taking to the microphones once again on Capitol Hill to talk about their repair jobs in the housing crisis are Federal Reserve chairman Ben Bernanke, Treasury Secretary Henry Paulson, and Christopher Cox, chairman of the Securities & Exchange Commission.
May common sense prevail. It’d be a winged bird of hope to think you won’t witness any narcoleptic, after-the-fact posturing, which at this late date ought to make you feel like you are chewing on aluminum foil.
Because what is occurring now is preposterous.
The financial system has been rocked back on its heels by booms and busts every decade or so since the late 19th century. But the past ten years has seen a plague of them practically every other year.
The Asian flu crisis, the Russian debt crisis, the blow-up of the hedge fund Long Term Capital management, the dotcom implosion, the telecom crash, and now the meta-crisis of them all, the housing and credit meltdown. The US saw that the regulatory system was clearly broken back in 1995. Bureaucratic apathy, the idea that free markets don’t need guardrails, have brought both investors and taxpayers to the brink. Free markets, yes. A free for all, no.
The financial system has been on a drunken leveraging spree for the past decade, which could take longer than ten years to delever and unwind. And like fire up a rope, the debt spree has already roasted Bear Stearns (BSC) and threatens to take out other big players as well.
Such leveraging has created outsized profits and executive pay. Though the financial services industry’s share of total corporate profits stood at just 10% in 1980s, it grew to 40% at its height in 2007 thanks to the borrowing spree. Everyone likes an asset bubble on the way up, but when they blow, watch out.
Banks and investment houses have written off a total of about $215b to date in degraded inventory from the credit crisis, with tens of billions of dollars more in writedowns expected. Goldman Sachs (GS) says the amount will top out at $460b.
By the end of 2007, two-thirds of the subprime writedowns were booked at just ten banks and brokerages. They still have something like 60% of total exposures to bad subprime credit and about half the exposure to leveraged loans as well.
Sovereign wealth funds have lost nearly 40% of the $50b they’ve invested in places like Citigroup (C), Merrill Lynch (MER) and UBS (UBS). UBS has been hit the worst. It just announced $19b more in writedowns, with the total there now at $37.4b. The Swiss bank has already raised funds from Singapore’s SWF, which is why it’s jokingly now called the Union Bank of Singapore. More writedowns are expected at places like Citigroup and Merrill Lynch; Deutschebank says it expects to write down $4b in its first quarter.
But foreign money is balking, so expect more ultra-dilutive new equity offerings like the $4b just announced at Lehman Bros. (LEH), a new $15.1b equity offering at UBS, and the planned $20b total for mortgage finance giants Fannie Mae (FNM) and Freddie Mac (FRE) (a sum that is about a whopping two-thirds of their market caps).
It’s past the midnight hour. Congress ought to ask what regulators are doing to avoid the costly taxpayer-funded clean-up and investor dilution later on. Taxpayers deserve to get answers from the Paulson-Bernanke-Cox regulatory cleanup crew on the following:
*Mr. Paulson, under the new plan from the Treasury, the Federal Reserve will have much more power to regulate investment banks, but the plan says it will only curtail the risks when their actions “pose a threat” to the financial system. Why only when these outfits “pose a threat” to the system? Why not around the clock? What if just one bank or brokerage is engaging in excessive risk? Will the federal sheriffs ride in to Dodge City then?
*Mr. Paulson, under the new plan, how exactly will private equity firms and hedge funds be regulated, if at all? Will you at minimum force them to publish their balance sheets, so Wall Street can truly see how dangerously leveraged some of these shops are that they are lending to? And why aren’t these pools of capital regulated?
*Mr. Paulson and Mr. Cox, subprime loans only began to be securitized earlier in this decade. Does the Treasury plan do anything to stem the risky practice of bundling toxic subprime mortgages and selling them as Frankenstein securities rubberstamped with high credit ratings? The credit rating agencies got paid lots of money by Wall Street to hand out triple A ratings like Kleenex to truly bad securities. What are you doing to stop this dangerous practice? Why not force the credit rating agencies to publish an updated quarterly report card of their prior calls going back fifteen years?
*Mr. Paulson and Mr. Cox, do you plan to require that trading in credit derivatives be hauled out of the shadows and into the sunlight by having such trades brought on to a major exchange?
*Mr. Bernanke, Mr. Paulson and Mr. Cox, please walk us through the rescue of Bear Stearns (BSC). Let’s start with March 14th, when Bear was essentially given a 28-day loan from the Federal Reserve to fix itself before the Fed-orchestrated JPMorgan Chase (JPM) deal came to pass. This marked an historic break–it was the first time the Fed let 20 unregulated investment banks access to loans from the Fed’s discount window. In effect, the Fed was now running with the wolves on Wall Street. Shouldn’t investment banks be forced to keep the same amount of capital reserves on the balance sheets as do commercial banks if they can now access the discount window?
*At the 11th hour, the ratings agencies then cut Bear’s rating to junk status, causing counterparties to stop trading with Bear and fueling a run on the bank–counterparty contracts stipulate that any time a firm is downgraded to junk status, any such contract governing a counterparty trade is broken, forcing these outfits to stop doing business with Bear Stearns (BSC). Do you know the answer to why this move at the 11th hour?
*To complete its shotgun wedding with the severely damaged Bear Stearns (BSC), JPMorgan Chase (JPM) got the New York Federal Reserve to backstop, via a non-recourse loan, $29b of the most illiquid securities on Bear Stearns’ balance sheet. Non-recourse, meaning JP is not on the hook for it.
A sweet deal hammered out by JPMorgan Chase (JPM) head Jamie Dimon, who sits on the board of the New York Federal Reserve. Isn’t this a conflict of interest?
*Mr. Bernanke, a record amount of government funds was used to bail out Bear Stearns (BSC), more than what was put at risk in the bailout of Continental Illinois in 1984, analysts note. The Fed promised to lend $29b to JP Morgan at a dirt cheap 2.5% over 10 years, which is renewable, so as to get JP to digest Bear’s damaged balance sheet. JP then used Bear’s collateralized debt obligations and other damaged assets as collateral.
So, Mr. Bernanke, the central bank now owns $29b in illiquid securities from Bear Stearns–meaning, as some analysts rightfully put it, the government has nationalized Bear’s losses by taking on this credit risk, on top of the credit risk it’s already taken on from Fannie and Freddie Mac (see next bullet point).
Is this a truly dangerous precedent? And what exactly is the nature of the assets JP used as collateral for the loan? Taxpayers only know that most of the investments were mortgage-backed securities and “related” items–does that include commercial real estate or Alt-A mortgages? Why the poor disclosure when the Fed ostensibly says it is now about transparency? Don’t taxpayers have a right to know? What discount to par were these assets marked down to? How much cushion is built into their current valuations? Were these exposures hedged, reducing potential taxpayer losses?
*This is the 75th anniversary of the New Deal and the creation of the Federal Home Loan Bank board. The socialization of Bear Stearns’ losses and of housing finance has meant taxpayers are bearing credit risk in ways never before seen in the history of this country, through the government’s implicit guarantee of the mortgage finance companies Fannie Mae (FNM) and Freddie Mac (FRE).
Both have had a history of accounting misdeeds, totaling $11b. Both have been reporting record losses. But now the government is loosening their capital reserve standards so they can take on $200b more in mortgage debt as to stop the housing crisis. Already they both have a total of a microscopic $80b in reserves to back an eye-watering $1.7t. Taxpayers will foot the bill for their incompetence, as both have credit pipelines into the US Treasury. Should Fannie and Freddie be completely privatized? Should regulators at minimum stop Fannie and Freddie from paying out any dividends whatsoever?
*Mr. Bernanke, since the late ‘80s the Fed has been cutting off financial crises at the pass by acting pre-emptively, meaning, moving quickly to cut rates before disaster strikes. Since July 2007 the Fed has cut rates to 2.25% from 5.25%. Will you take pre-emptive action in good times to raise rates and reduce the expectation now entrenched on Wall Street that out-of-control bankers and brokers that the Fed will rescue them no matter what? Are you running out of ammunition to deal with the credit crunch?
*Mr. Cox, has the SEC studied whether the fair value rules are overstating losses on Wall Street? Do companies have a point when they say that a big slug of the losses they now post under fair value rules may never materialize since they won’t sell the assets until their value recovers? Or is this 20-20 complaining?
*To all three-shouldn’t you force lenders to keep a slice of the riskiest part of any debt securities they sell, from mortgage-backed bonds to securities backed by leveraged loans, on their balance sheet so they have an incentive to make sure no bad loans are made and that borrowers pay back their risky debt?
*As for investment banks now getting their mitts on Fed money via the discount window. Shouldn’t you force investment banks to pay an insurance-style premium similar to what the Federal Deposit Insurance Corp. charges regular banks to cover the cost of bailing out their deposits?
The way it could work is, those with solid capital and lower risk sluicing through their operations would pay less into the insurance pool. Isn’t it only right that the likes of Bear Stearns (BSC), Lehman Bros. (LEH) and Goldman Sachs (GS) pay a premium into the system if they get to now, risk-free, effectively foist their pathologically risky bets onto the rest of society? Bear didn’t pay a cent for its government bailout, so it’s no surprise to see Wells Fargo (WFC) tossing its hat into the ring hoping to get a merger deal backed by such free money as well.
*To all three, the Environmental Protection Agency set up a superfund to deal with hazard waste cleanup. Is it time for a housing superfund to buy defaulting toxic mortgages now poisoning the system, replacing them with more accommodating loans?
*To all three, given the deficit financing of this bailout, are you not creating another vicious cycle in the bond market that will cause mortgage rates to remain high, as loans are tied to long term bond rates? Are you at all concerned higher inflation is bearing down on the economy at a time when Social Security and Medicare are near bankrupt, when the first baby boomer got to retire this past January 1?
*And to all three–when will this government come out and support a strong dollar?
