Wall Street east from Nassau Street
Ilargi: Last Friday I said in We have spent our future: " It is clear that after this weekend, as the state of Texas will be hit by a storm the size of ... the state of Texas, -possibly large- parts of it will never recover, nor ever again be the same. There is a metaphor in there for the Wall Street banking system. After this weekend it will never be the same."
Well, that is very much true. Wall Street as we’ve known it in our lifetimes is no more, and it will never return. Allowing investment banks and commercial banks to become one single two-headed beast has been a predictable disaster, and the factor most responsible for the mayhem we’re all in.
Still, stealthily, under cover of the blinding noise over Lehman’s demise, the Fed has introduced a new book of tricks aimed at prolonging the model for a while longer, no matter that it’s obviously dead. And Bernanke, in order to achieve it, has resorted to illegal practices. He’s "drawn a line" all right, but not the one you think.
Banks can now get loans through the Fed’s newly enhanced "permanent emergency" credit windows, and pose as collateral equities (stocks) and even your deposits. Yes, you heard that right. That is the condition underlying Bank of America’s purchase of Merrill Lynch. BoA can -and will- use the money in your bank account to continue Merrill’s activities, the same ones that led to Lehman’s death: securitization, swaps and derivatives.
That is one frightening development. And so, for that matter, is accepting stocks for T-bills. What if those stocks plunge, as so many are doing lately? What if companies go bankrupt? In the end, through the Treasury, it’s once again the taxpayer who’s going to be presented with the bill.
You would think that the central banks and Treasuries in the world would see the light and the signs on the wall, and refrain from putting even more of the people’s money at risk. You need to think again.
Central banks today are pumping credit like mad into the markets. Like all similar actions in the past two years, it will not save anything, or make any difference other than that the system gets to roll on for a few more months. The system cannot be saved, but it can still suck more profits out of the public purse. If this is not perverse, I don’t know what is.
The exact fall-out from Lehman’s downfall won’t be known for quite a while; nobody really knows what assets they have, nor who are the counterparties to all the bets they have outstanding.
Besides the obvious big US candidates to fall within the next few days, and it looks very much like that is the new timeline we have to watch, such as AIG (down 50% today), WaMu and Wachovia, there are two other fields to keep an eye on.
Smaller US banks, many hundreds of them, are exposed to -potential- dangers that will start to take down victims at an accelerating rate. What I think may be even more susbstantial when it comes to impact, is the pressure on banks and other financial institutions outside the US. UK banks got hit badly today, and the same happened all over the European continent.
Wherever you are in the world, there are no safe banks anymore. When you hear a government spokesman or bank CEO talk about their banks and banking systems being "well capitalized", don’t believe a word they say.
There are incredible amounts of losses yet to come, far more than we’ve seen so far, and they have all, to one extent or another, had their sticky fingers in the same cookie-jar.
Update 6.00 PM EDT: DJIA Closing numbers
Wall Street model broken by credit crisis
The future of Wall Street is up for grabs -- and changing by the minute. In the course of a few hours Sunday, Lehman Brothers Holdings Inc, the fourth-largest investment bank hobbled by toxic real estate assets, was left for dead and may file for bankruptcy before Monday.
Merrill Lynch, the No. 3 investment bank and weakest remaining firm after $40 billion of write downs, rushed into the arms of Bank of America Corp for $29 a share -- less than half its 52-week high but almost $12 higher than its closing price Friday.
These moves, coming after the U.S. government's takeover of Fannie Mae and Freddie Mac and six months after the meltdown of Bear Stearns and its shotgun marriage to JPMorgan Chase & Co, renew questions of what Wall Street will look like in an environment of lower leverage and reduce appetite for risk.
Now there are questions whether any of the independent firms will still be around. Certainly, for those that survive the current 100-year storm, Wall Street will look a lot different.
"It seems perfectly clear leverage is going down, that banks will be more careful who they do business with, and that there is a desire to be more of an agent than a principal," said Donald Marron, head of private equity firm Lightyear Capital and former CEO of PaineWebber Group. "There will be a trend toward specialization. It's hard to be in too many different places. Firms will concentrate on their strengths."
After more than 13 months of a global credit crunch, the rules of the marketplace have changed. Capital is harder to come by and risk must be kept on a shorter leash. The engines that powered record profits for years -- leveraged deal finance, mortgage securities and all kinds of complex debt instruments -- have all seized up.
In recent months, Lehman CEO Dick Fuld and Merrill CEO John Thain had both said they could weather the storm. Now, recent events show it may be only the largest banks, such as Bank of America and JPMorgan Chase, that have the capital and deposit base to withstand rising flood waters.
Analysts also question whether No. 1 investment bank Goldman Sachs Group, which has avoided major damage so far and earlier this year considered acquiring a commercial bank to reduce reliance on market funding, can confidently stand above the crowd.
Goldman, which releases its third quarter results Tuesday, is widely expected to report lower profit with revenues down across the board. Morgan Stanley, the second largest, has been busy shedding assets since its brief flirtation with "the Goldman Model" three years ago, which prompted greater principal risk taking just as the market was peaking, and a Lehman-style expansion into the mortgage business.
Since suffering massive mortgage trading losses late last year, Morgan Stanley has been shrinking the balance sheet and pulled in its horns. When Morgan reports results on Wednesday, investors will decide whether they have come down far enough.
"There is a new way coming, but the old way is gone," said Robert Doll, chief investment officer at BlackRock Inc. "I think parts of the old model have been destroyed, or at least cyclically challenged. We'll have to figure it out when the dust settles."
Investors meanwhile have already seen the future of Wall Street in the form of small boutique advisory firms such as Lazard and Greenhill & Co. These smaller firms do not engage in trading or lending but rather focus on advice, much like the way Wall Street's big investment banks operated until the 1980s.
Having avoided credit losses or having assets mired on their balance sheets, listed and closely held boutiques are gaining advisory-business market share and snagging top-tier bankers now available amid the turmoil.
In a world where capital is constrained and relationships again paramount, their old school model suddenly looks very attractive to bankers and clients.
"I think we're going to see boutique firms growing in importance, the Greenhill type M&A firms as well as hedge funds that specialize in human capital-intensive trading," said Bill Wilhelm, a finance professor at University of Virginia's McIntire School. "We see dominating those firms with the view there are limits to what they can do."
Wall Street crisis deepens
Wall Street was in turmoil on Monday after Lehman Brothers filed for bankruptcy protection and Merrill Lynch agreed a $50bn takeover by Bank of America. Confidence in financial institutions around the world was shaken as central banks introduced a series of emergency measures to ease the crisis in the global financial system.
Equity markets fell heavily and debt spreads widened as banks, investment managers and insurance companies came under heavy selling pressure. BofA’s bold bid for Merrill came as the world’s top banks abandoned efforts to save Lehman and set out to build a firewall against further financial chaos with a $70bn liquidity pool to support other vulnerable institutions.
The moves capped a weekend of high drama that could lead to one of the most radical reshapings in Wall Street history. The Federal Reserve said it was making it easier for financial institutions to access Fed liquidity by easing terms on its borrowing facilities and accepting a much wider range of assets as collateral.
The Fed meets to decide on interest rates on Tuesday. It widened the set of assets eligible as collateral for loans of Treasuries to include all investment grade paper, and raised the size of these Treasury loans to $200bn. The Fed also suspended rules that prohibit banks from using deposits to fund their investment banking subsidiaries.
The Fed’s intervention was followed on Monday by the European Central Bank and the Bank of England. The ECB allotted €30bn ($42.04bn) in one-day liquidity at a marginal rate of 4.30 per cent and an average rate of 4.39 per cent. Altogether 51 banks bid €90.27bn. Meanwhile, the Bank of England said it would offer extra reserves to help stabilise conditions in sterling money markets. The Bank said it would auction £5bn through an exceptional fine tuning open market operation.
The weekend’s dramatic events undermined confidence in financial stocks across Europe. Banks and insurance companies were the heaviest fallers on Monday while gold prices jumped higher as investors sought the safety of the precious metal. The Markit iTraxx Crossover index, which measures the cost of insuring European junk-rated credit derivatives, widened 17 per cent on Monday to 640 basis points as the likelihood of defaults was perceived to be higher.
Monday’s market reaction will be closely watched by regulators and banking executives to gauge investor sentiment towards the credit crunch that has wreaked havoc on the financial sector for more than a year. BofA’s rapid U-turn, which saw it abandon talks to buy Lehman and move to Merrill in the space of a few hours, will throw the spotlight on Morgan Stanley and Goldman Sachs. The two could soon become the only independent investment banks in the US.
Merrill’s board voted on Sunday night to approve BofA’s takeover all-stock bid, which was pitched at $29 a share. That is a premium of 70 per cent on Friday’s closing price of $17.05. Merrill’s shares have fallen nearly 70 per cent this year. The sudden turn of events came at the end of a weekend which saw top Wall Street executives locked in increasingly desperate talks over the future of Lehman and the state of the financial sector with Hank Paulson, US Treasury secretary, and Tim Geithner, president of the New York Federal Reserve.
However, bankers familiar with the talks said a rescue plan for Lehman had been seriously undermined after suitors Barclays of the UK and BofA, had walked away. Barclays pulled out in the afternoon after the US government refused to provide a guarantee to enable Lehman to continue trading until a deal had been completed. Lehman said during the New York night that it would file for bankruptcy.
The filing is likely to cause thousands of job losses among Lehman’s 25,000-strong staff. On Sunday night a number of employees were seen leaving Lehman’s Manhattan headquarters with boxes stacked with their possessions, stationery and even some paintings. In a separate move, regulators had prepared the ground for a Lehman bankruptcy by asking its derivatives counterparties to settle trades between themselves in a special trading session in the afternoon.
Merrill’s decision to enter talks with BofA, which has long coveted its rival’s large retail brokerage business, came after it became apparent that Lehman’s woes could spread to the rest of the investment banking sector in the coming weeks. John Thain, Merrill's chief executive, who was attending the Lehman crisis talks, approached some rivals asking them whether they would be interested in bidding for his firm, according to people close to the situation.
Morgan Stanley, BofA and some foreign banks were contacted but many of them declined to pursue the talks because they had insufficient time to pore over Merrill’s complex trading books, they added. Merrill, Morgan Stanley and BofA declined to comment. A takeover of Merrill would be a victory for Ken Lewis, BofA’s chief executive, who has long wanted to combine the lender’s commercial banking operations with Merrill’s army of retail brokers.
However, a deal could saddle BofA with more troubled assets. The bank bought the stricken mortgage-lender Countrywide and a purchase of Merrill would force it to clean up the bank’s trading books, which have already cost Merrill some $52bn in writedowns and credit losses.
Mr Thain, the former Goldman Sachs executive and former head of the New York Stock Exchange who joined Merrill last year after the departure of Stan O’Neal, is almost certain to leave the firm if the BofA takeover goes through. He is a fervent supporter of John McCain, the Republican presidential candidate, and some experts expect him to seek a political career.
Lehman demise could end speculative raid on taxpayers
Letting Lehman Brothers fail is the lesser of two evils facing U.S. financial regulators trying to stop a textbook trading ploy dead in its tracks -- a private sector raid on the public purse. U.S. authorities have already been forced to pledge some $230 billion this year to restore calm in the wake of speculative attacks on investment bank Bear Stearns and Federal mortgage agencies Fannie Mae and Freddie Mac.
Market veterans say the classic trade was set to be repeated in the weeks ahead if any form of official assistance had been involved in a deal to save or restructure Lehman, the 158-year old finance house which fell victim to traders aggressively selling its stock in a bid to book a slice of profit supplied, or ultimately guaranteed, by the government.
"It's the taxpayer versus the speculator," Paul Markowski, president of New York investment advisory firm Global Research Partners, told Reuters. "The speculator doesn't always win, but clearly in this case the speculator has increased the bill of the U.S. taxpayer."
Speculators have a track record in correctly scenting the willingness of official institutions to commit public funds to try to sustain an ultimately unsustainable situation.
Friday's 31 percent plunge in the share price of U.S. insurer American International Group, which has been hit by $18 billion in losses over the past three quarters from guarantees it wrote on mortgage derivatives, suggests traders were already on the hunt for their next victim after Lehman.
So too does a rapidly stitched together weekend deal that will see Bank of America Corp buy Merrill Lynch & Co Inc, the world's largest financial brokerage that has written down the value of its assets by more than $40 billion over the last year.
Hedge fund manager George Soros cemented his reputation by famously "breaking the Bank of England" in 1992, forcing the central bank to spend billions to defend the pound's place in the European Union's exchange rate mechanism before the British government withdrew sterling from the scheme.
Currency traders employed similar tactics in Asia in 1997, scenting blood when they realized huge foreign currency borrowings were incompatible with the region's fixed and quasi-fixed exchange rates. Their huge bets against the currency pegs saw successive central banks empty their coffers trying to defend the indefensible and forced International Monetary Fund bailouts for the region of more than $100 billion -- money that traders had essentially sucked out of the system.
If a second successive weekend of talks between bankers and officials from the U.S. Treasury, Federal Reserve and Securities and Exchange Commission to keep the U.S. financial system functioning smoothly had resulted in more public funds being committed to a single institution, it could have pushed wide open the door to the oldest trade in the book.
"What is good is that the Fed dug in its heels, refusing to be dragged into a bailout. This was a test for the Fed and the Fed passed it," said Robert Brusca, chief economist at Fact and Opinion Economics in New York.
While there was no direct money for Lehman, the Fed did unveil several fresh initiatives on Sunday to support markets, broadening the type of collateral financial institutions can use to obtain loans from the central bank and increasing the amount of Treasury securities it auctions on a regular basis to help foster liquid markets.
Edward Grebeck, chief executive officer of Tempus Advisors in Stamford, Connecticut, reckons there is a bill and it's clear who is paying. "The Fed is using, one way or another, a printing press to bail out the banks." The U.S. government's seizure and backing of multi-trillion dollar mortgage lenders Fannie Mae and Freddie Mac last weekend essentially added $1.6 trillion to the debt burden, pushing it up to 44 percent of national output or around $6.3 trillion.
Meanwhile the sheer supply and demand dynamics of that shift suggest that the market rates of interest the U.S. government -- and ultimately the taxpayer -- will have to pay to finance the additional debt must rise. The credit crisis "would be an interesting sporting event if it weren't so costly," said Mark Grant, managing director of structured finance at Southwest Securities, based in Dallas.
"We are not just going through deleveraging, but through a castration of capital not seen during my lifetime."
Deposit insurance system may face WaMu test
Attention has focused on the danger presented by the failure of Lehman Brothers. But the failure of a commercial bank such as Washington Mutual can have systemic consequences if it threatens a run on other weak banks. Washington Mutual - the sixth largest bank in the US - has lost more than a third of its market value recently as investors fear it lacks liquidity and capital to survive the credit crisis.
The failure of a bank its size would test the strength of the US deposit insurance system and its ability to maintain the confidence of the nation's savers. The US Federal Insurance Deposit Corporation covers the first $100,000 in deposits held by each individual in a given bank. As of June 30, 64 per cent of the total $7,000bn deposits were insured in the US - a much larger proportion than in the UK at the time when Northern Rock. the commercial bank, failed.
Nonetheless, this still leaves $2,500bn in uninsured deposits. If a high-profile failure causes these uninsured deposits to shift abruptly in a flight to safety, it could be highly destabilising for the banking system. The US could be forced to adopt a de facto blanket guarantee on all bank deposits, as the UK did on a temporary basis during the Northern Rock crisis.
There are other precedents. At the start of the Asian financial crisis in the 1990s, the International Monetary Fund opposed extending deposit guarantees. But the IMF soon changed tack and told crisis-hit countries to issue full guarantees. A formal blanket guarantee in the US would require legislation.
But under a 1991 law, the FDIC could seek a systemic risk exemption to cover all the deposits of a failing institution, subject to the approval of its board, a supermajority of the Federal Reserve governors, and the Treasury secretary in consultation with the president.
The FDIC has no desire to invoke this authority - which has never been used; would be unpopular with taxpayers; and would carry a cost in terms of moral hazard. The FDIC is respected for its operational effectiveness. But its $45bn deposit insurance fund is underfunded according to its own guidelines, at 1.01 per cent of insured deposits.
The FDIC is preparing a capital replenishment plan that would involve raising premiums paid by banks. But analysts fear it may have to draw on its $70bn Treasury credit lines. Alan Avery, a partner at Arnold and Porter, said a single failure - if big enough - "would cause the FDIC to immediately draw on the Treasury credit".
Washington Mutual had $143bn in insured deposits on June 30 - about three times the size of the deposit insurance fund, but less than half of its $307bn assets.
Fed Expands Lending Facilities in Bid for Stability
The Federal Reserve will expand its lending facilities in the wake of the likely demise of Lehman Brothers Holdings Inc., taking a wider array of securities, including equities, as collateral for its loans, the central bank said late Sunday.
The move, another landmark step in the Fed's efforts to address the deepening credit crisis, is meant to calm markets as they head into one of the most perilous trading environments in decades with Lehman's massive market positions on the verge of being unwound. It also capped a weekend of brinksmanship with Wall Street.
After the rescues of Bear Stearns, Fannie Mae and Freddie Mac, Fed and Treasury officials were determined to avoid bailing out another struggling financial firm. They drew the line at Lehman and stood their ground through a high-strung weekend of negotiations, insisting they wouldn't put public funds at risk to finance the rescue of another financial institution.
The expansion of short-term lending facilities showed that while they were unwilling to back another bailout, they are still struggling to find ways to ensure broader market stability and are prepared to take new steps to do that. After the collapse of Bear Stearns in March, the Fed said it would make short-term emergency loans to investment banks under a lending facility called the Primary Dealer Credit Facility.
Late Sunday, the Fed said it would take a broader array of collateral from firms for the facility, including equities. Another facility, in which firms can swap risky securities for safe Treasury bonds, was also expanded. As of Wednesday, no firms had used the primary facility since July.
But amidst the uncertainty created by the likely demise of Lehman Brothers and the deal for Merrill Lynch & Co. by Bank of America Corp., there could be a rush to borrow from the Fed as trading resumes Monday. Bankers say the unwinding of Lehman Brothers' many trading positions could create a large need for short-term funds.
Fed officials have been concerned for months about the resilience of a short-term secured lending market known as "repo" loans. It is the lifeblood of the brokerage industry, through which firms fund their day-to-day operations. Repo lending is used by banks, brokers and hedge funds. Typically, a borrower hands over securities as temporary collateral for a loan. In normal times, the cheap funding is widely available.
"The steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets," Fed Chairman Ben Bernanke said in a prepared statement. All along, U.S. officials have been caught in a bind. If they go too far to support markets, bankers could become conditioned to expect a rescue whenever they wobble.
If they don't go far enough, the financial crisis could get even worse. "If I were at the Fed, I would be hoping for an opportunity to show the world that the Fed will not rescue every ailing institution but will let some go," said Douglas Elmendorf, a senior fellow at the Brookings Institution.
Lehman's collapse will send deep and painful ripple effects across the markets. The firm sat on $33 billion of commercial real-estate assets and $13 billion in residential mortgages at the end of August; a liquidation could mean forced sales of those and other assets, which could knock down the value of other firms' holdings.
Lehman is also deeply intertwined in many other markets -- most notably the vast market for credit-default swaps, in which it is a top-10 player. Even as they were holding the line about being involved in funding a rescue, Fed staff members over the weekend were working with Wall Street credit traders to help sort through their positions with Lehman in this market. Officials also were involved in discussions during the weekend of brinksmanship that brought agreement Sunday night on the sale of Merrill to BofA.
Fed officials have some confidence that they are better prepared to deal with the fallout from a failure than they were when Bear Stearns failed, and the Fed arranged a shotgun wedding to J.P. Morgan Chase & Co. The emergency lending facilities it set up after Bear could help cushion the blow to the market if Lehman now fails. But some areas, like swap trading, are still a huge source of uncertainty.
Market conditions until Friday had been mixed. The broader stock market so far has been relatively stable through this latest round of turmoil. But short-term lending rates such as the London Interbank Offered Rate, or Libor, are elevated relative to expectations for the Fed's benchmark federal-funds rate, but have been stable in recent weeks. Risk premiums on junk bonds also are back to levels they hit in March.
But trading Monday could change all of that, particularly in the credit-default-swap, or CDS, market, in which firms trade contracts tied to corporate default risks. It is an immense market that trades against $62 trillion of debt. Officials worry that the collapse of an investment bank could send problems cascading through the financial system by way of this market. The Fed has been pushing Wall Street to create a new clearinghouse to diminish that risk, but it isn't in place yet.
Sorting out Lehman's CDS positions promises to be difficult and time-consuming, because many of the contracts have different terms and maturity dates. In a survey last year by Fitch Ratings, Lehman was listed among the 10 largest CDS counterparties by number of trades and the amount of debt to which the contracts were tied.
European Central Banks Ready to Inject Billions
Major European central banks prepared on Monday to inject billions into global money markets to ensure that the weekend’s turmoil on Wall Street does not spread to the rest of world’s financial systems. The European Central Bank said that it lent 30 billion euros or $42.7 billion at 4.25 percent, in an almost identical repeat of an episode that started the financial crisis in Europe in August 2007.
Then, as now, the central bank was worried that banks would abandon the interbank lending market, a vital financial conduit in which banks lend to one another to keep the financial system running on a daily basis. However the central bank.’s latest injection was far less than the 94.8 billion euros it put into money markets in August 2007.
The central bank said it was “ready to contribute to orderly conditions in the euro money market” and that it would lend as much cash as banks wanted at its benchmark interest rate of 4.25 percent. The Swiss National Bank offered money at 1.9 percent, and said it would act “flexibly and generously.”
The Bank of England will also lend 5 billion pounds over the next three days at 5 percent. The loans will mature on Thursday, when the British central bank conducts its regular refinancing operation. “Following the announcements overnight, the Bank of England will be monitoring carefully the conditions in sterling money markets and will take appropriate actions if necessary to stabilize those markets,” it said in a statement.
Central bankers believe that a purging of losses and some bankruptcies will be necessary for the financial crisis to end. But the pace and scope of the changes in the United States over the weekend has opened the door to fresh turmoil with policy implications worldwide.
Some central banks are also banking supervisors, but all of them have to be worried about the potential for losses in the financial sector to result in a lending squeeze to the rest of the economy. So far, that has not been a problem in Europe.
The central fear in the current scenario would be that the bankruptcy filing by Lehman Brothers, combined with potential losses linked to the American International Group insurer, would drag down European banks. The extents of their exposure to the American crisis is hard to know.
“Is this part of the healing process _ some institutions need to go to get over this _ or does this have the potential to be a new source of uncertainty?” said Ken Wattret, chief Europe economist at BNP Paribas in London. The Bundesbank, Germany’s central bank, said German banks have “manageable” exposure to Lehman Brothers, Reuters reported.
In any case, European central banks — the lenders of last resort — seem to have opted for a policy of preventive action, rather than waiting for Wall Street’s woes to cause new cracks in the financial foundation. However, the central banks have resisted aggressive interest rate cuts as a solution to the financial crisis, an approach the Federal Reserve has embraced.
The Fed’s response at a meeting due to begin Tuesday is now a central question among investors, but few are daring to hope the central bank will cut rates. “The E.C.B. would probably need to be convinced that credit markets have seized up or see a vicious downward spiral in equity markets to participate,” said Jacques Cailloux, chief Europe economist at Royal Bank of Scotland, according to Reuters.
Mr. Wattret at BNP Paribas said: “There is an increasing pressure on central banks to act. The Fed is more likely to cut rates than the E.C.B. What the Fed doesn’t want is a sustained drop in house and equity prices at the same time. The E.C.B. won’t be at the forefront of cutting rates because it remains focused on inflation.”
Christine Lagarde, the French finance minister, said that European authorities pondered responses to the unfolding events in the United States at a meeting of finance ministers and central bankers at a weekend meeting in Nice, France.
“All the monetary, banking and treasury authorities have been consulting for several days, we worked again last night and the mechanisms are in place, the central banks are on alert, there is no panic,” she told Europe 1 radio.
Fed's PDCF, TSLF Pawnshop Limits Increased; Section 23A Rules Violated
The Fed is acting to prevent a spillover from the Lehman collapse, taking a series of emergency liquidity actions explained in Fed braces markets for likely Lehman collapse.The U.S. Federal Reserve on Sunday launched a series of emergency measures to calm financial markets and ease any trading disruptions that could arise from a collapse of investment bank Lehman Brothers.
One of the biggest changes the Fed made was to accept equities as collateral for cash loans at one of its special credit facilities, the first time that the Fed has done so in its nearly 95-year history.
The most striking new Fed action was its decision to accept equities as collateral for cash loans under its Primary Dealer Credit Facility for investment banks. Until now, collateral was limited to investment-grade debt securities.
"The Fed's action allows dealers to pledge an asset class that is a significant part of the Street's securities positions," said Tony Crescenzi, chief bond market strategist, Miller, Tabak & Co in New York, giving them significantly more access to loans if they need them.
The Fed also said it was increasing the total amount that it offers under a separate program that lends out liquid Treasury securities to $200 billion from $175 billion. It will also begin holding auctions under this program more frequently.
In a third step, it said it will temporarily allow commercial banks to extend liquid funds to their brokerage affiliates for assets that would normally be accepted in tri-party repurchase agreements.
It said this would be permitted only until January 30, 2009, apparently reflecting the Fed's hope that stressed repo markets would be operating more normally by then.
Bernanke Violates Federal Reserve Act Section 23A
Allowing banks to extend funds to their brokerage affiliates is in violation of Federal Reserve Act Section 23A.Section 23A of the Federal Reserve Act ( Act ), originally enacted as part of the Banking Act of 1933, is designed to prevent the misuse of a bank's resources through non-arm's-length transactions with its affiliates and to limit the ability of a bank to transfer its federal subsidy to its affiliates.
Bernanke's willingness to break the law is in strict accordance with Fed Uncertainty Principle Corollary Number Four.The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it's easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.
Supposedly the Fed "will temporarily allow commercial banks to extend liquid funds to their brokerage affiliates for assets that would normally be accepted in tri-party repurchase agreements."
For starters I doubt it will be temporary. But the main point is the Fed is taking steps that it knows to be blatantly illegal.
Banks Fear Next Move by Shorts
In May, David Einhorn, one of the most vocal short-sellers on Wall Street, made no secret he was betting against Lehman Brothers.
Now, some investors are afraid that fund managers like him will take advantage of the climate of fear stirred up by the troubles of Lehman to target other weak financial firms whose declining share price would bring them rich rewards.
At emergency meetings over the weekend, the heads of major financial institutions urged Timothy R. Geitner, the president of the New York Fed, and Treasury Secretary Henry M. Paulson Jr., to consider having the Securities and Exchange Commission reinstate a temporary rule to limit the risky but potentially lucrative practice of betting on a firm’s falling share price, according to two people who were briefed on, but did not attend, the meetings.
They are concerned that short-sellers might fix their gaze on big financial institutions like Merrill Lynch and the insurance giant American International Group, which also need billions of dollars in capital to strengthen their businesses.
In July, the S.E.C. briefly halted a practice known as naked short selling after speculators placed large bets that shares of Fannie Mae and Freddie Mac, the troubled mortgage giants, would decline. That also made it harder to short the stocks of 19 financial institutions, including brokerage firms like Lehman Brothers and Morgan Stanley, although the curb wound up having little impact on the price of their shares.
The investment tactic of betting a stock will slide is not new, of course. But it has become particularly controversial in the last year, when Wall Street firms started to be targeted as the credit crisis turned the financial sector upside down. Short sellers and their free market supporters say they have done nothing wrong.
If anything, they say, they have merely spotted problems at financial institutions ahead of everyone else, making them a useful early warning system for the rest of the market. Critics believe they have contributed to the speed of the decline of any number of financial shares.
Short-selling against financial institutions has proven particularly lucrative for hedge funds. Mr. Einhorn’s accusations that Lehman was failing to properly account for its marks on troublesome holdings, which appear to have presaged the bank’s early report of a $2.8 billion loss for its second quarter, has presumably netted him a handsome return.
Lehman’s shares were already under pressure when he took the microphone at a large industry gathering in May to lay out his case against the investment bank. The firm, he told the crowd, had used “accounting ingenuity” to avoid large write-downs and remained tainted by bad commercial real estate investments.
Mr. Einhorn stood to profit by convincing people of his view: He had been betting against Lehman’s stock — it stood at around $40 when he spoke — since July 2007, when they traded for around $70 a share. On Sunday, Lehman filed for bankruptcy protection.
While Lehman’s shares have declined as investors lost confidence in its ability to repair its balance sheet, in the four months after Mr. Einhorn’s remarks, short-selling played a role in the erosion. A rapid plunge in the shares to below $4 last week ultimately created the conditions that brought the 158-year old firm to its knees on Sunday.
For all his boldness, Mr. Einhorn is aware of the havoc that bank failures can create. “We would not win if Lehman went down and took the whole financial system with it,” Mr. Einhorn said in an interview in June. “An actual collapse of Lehman — that would not be a good thing.”
Other hedge fund managers recognize the dangers and the harm that is befalling bank employees who have been paid in their companies’ stocks . “My children, their playmates’ fathers work at Lehman,” said one manager who is short Lehman and asked to remain anonymous, citing the sensitivity of the situation.
“Obviously I had nothing to do with what happened, and the idea that I profited, and they got clobbered, and
I’ve got to see them on Monday is awkward. I feel badly for them.” Mr. Einhorn was never shy with his criticism of Lehman. He pointed to the bank’s investments in two real estate companies, Archstone and Sun Cal, and said Lehman had not marked its mortgage assets down enough. “Lehman is one of the deniers,” he said in the June interview.
He first mentioned Lehman in a speech in October when he pointed out that the company had shifted $9 billion of mortgage securities into the “hard-to-value” category on its balance sheet. In April, he appeared unsure whether Lehman would suffer any time soon, saying “given that Lehman hasn’t reported a loss to date, there is little reason to expect that it will any time soon.” To many, Mr. Einhorn simply saw the writing on the wall early.
And, hedge fund managers say, Lehman executives failed to realize how much credibility Mr. Einhorn has in the investor community. Lehman might have fared better if it raised capital or took write-offs far earlier, as Mr. Einhorn suggested. But to some in the world of finance, Mr. Einhorn and investors like him are dangerous.
“It is really like taking a baseball bat to someone who is down,” said Jim Hardesty is president of Hardesty Capital Management in Baltimore. “A bunch of these guys with very large bats are circling around certain companies and banging them over and over again. It is unsportsmanlike conduct.”
Mr. Hardesty is among the investors who believe the S.E.C. made a mistake in allowing the temporary curb to slow the impact of short-selling to expire. Hedge fund managers who focus on shorting companies stand out in the industry in an otherwise terrible trading year. Hedge funds are down more than 4 percent but short-focused hedge funds are up 9.76 percent, said Hedge Fund Research, a firm in Chicago.
Ironically, Mr. Einhorn’s fund, Greenlight Capital, is down 4.3 percent this year through Aug. 22, according to HSBC (he also invests in stocks, as well as shorting them). His is a so-called long-short fund, which means he invests $2 buying shares in companies for every $1 he places shorting other companies. One company he took a positive view on in recent years was New Century, one of the first subprime mortgage lenders to file for bankruptcy.
AIG shares plummet, debt protection costs surge
Shares of American International Group fell nearly 40 percent in pre-market trading after reports that the insurer had turned to the Federal Reserve for $40 billion in bridge financing to ward off a liquidity crisis and ratings downgrades.
The up-front cost of insuring $10 million of AIG's debt for five years jumped to $3.05 million from $1.3 million on Friday, in addition to annual payments of $500,000, according to Markit Intraday. The insurer, which has incurred $18 billion in losses over the past three quarters from guarantees it wrote on mortgage derivatives, was hit on Friday by Standard & Poor's putting the company's credit ratings on negative watch, indicating a possible downgrade.
Over the weekend, AIG executives and New York state insurance regulators scrambled to hatch a plan that would boost AIG's liquidity. It was not clear early on Monday when AIG would reach a plan. A spokesman did not immediately return a call seeking comment. AIG shares have fallen about 80 percent since the start of the year.
Several analysts, in research reports on Monday, warned that the company is unlikely to resemble itself after a much-anticipated restructuring. AIG has been considering "a wide range of options," the company said, including selling off valuable assets.
AIG, until recently the world's largest insurer, does business in 130 countries and territories around the world, selling insurance to 74 million customers worldwide. It has also an aircraft leasing arm, an asset management business and a financial products unit. The latter holds a credit default swap portfolio that has triggered the large mortgage losses.
AIG Scrambles to Raise Cash, Talks to Fed
Insurer American International Group Inc., succumbing to relentless investor pressure that drove its shares down 31% on Friday alone, is pulling together a survival plan that includes selling off some of its most valuable assets, raising more capital and going to the Federal Reserve for help, people familiar with the situation said.
The measures are aimed at staving off a downgrade by major credit-rating firms. AIG executives worried that such an action would set off a chain reaction that could be fatal to the firm. The insurer, which has already raised $20 billion in fresh capital so far this year, was seeking to raise an additional $40 billion to avoid a downgrade.
During a weekend scramble to shore up its finances, AIG turned down a capital infusion from a group of private-equity firms led by J.C. Flowers & Co. because an option tied to the offer would have effectively given them control of the company, an 89-year-old giant that does business in nearly every corner of the world.
The proposed option would have allowed the firms to acquire AIG for $8 billion under certain conditions. That price is just one-fourth of AIG's current market value.
When AIG's board rejected the capital infusion, the company's recently appointed chairman and chief executive, Robert Willumstad, took the extraordinary step of reaching out to the Federal Reserve for help. Mr. Willumstad asked New York Federal Reserve President Timothy Geithner if the Fed could backstop some asset sales.
Two other private-equity firms -- Kohlberg Kravis Roberts & Co. and TPG -- offered to inject capital into AIG if the Fed agreed to provide the insurer with a bridge loan until its restructuring plan was completed. AIG viewed the request to the Fed not as a bailout but rather as a temporary measure that would give the insurer some breathing room until it was able to dispose of the assets.
As of late Sunday, the Fed had yet to decide whether to offer the assistance. The Fed usually deals with banks and brokers, and it wasn't clear what it could do. An AIG spokesman had no comment. The Fed may not draw the line with AIG's request for support as clearly as it has with Lehman, distinguishing between its lending programs and the use of taxpayer funds. But any Fed action to help the firm still would have a high bar.
Central bank officials took an extraordinary step in expanding the discount window to securities firms earlier this year. Expanding it to other firms would be another big step, though it could be considered if a case can be made for how such a lending lifeline would be critical to overall financial stability.
The assets AIG intends to sell include its domestic automotive business and its annuities unit, according to people familiar with the matter. It also looked into selling its aircraft-leasing arm, International Lease Finance Corp., but it isn't clear whether action on ILFC will be part of the emergency steps.
AIG also considered shifting assets from its regulated insurance business to its holding company, which would help the holding company respond to demands for cash or collateral. But that plan was met with resistance from regulators and by late Sunday it appeared unlikely it would come together.
The rush for cash represents a remarkable comedown for AIG, whose role in global finance is in many ways as critical as investment banks such as Lehman Brothers. AIG's troubles were one of the subjects at the weekend meeting of Wall Street chiefs and regulators at the New York Fed.
Eric Dinallo, the insurance superintendent in AIG's home state of New York, took a significant role in the talks over the weekend, according to a person familiar with the matter. One key issue, the person said, was the proposed shift of assets. Insurers typically face stringent regulations on how they use their assets, as regulators seek to make sure that they can meet their obligations to policyholders.
The turmoil in housing and credit markets has hammered AIG, largely because of contracts it sold protecting others against losses tied to subprime loans and other risky assets. AIG's stock has fallen nearly 80% this year. It reported a second-quarter net loss of $5.36 billion last month after a first-quarter loss of $7.81 billion.
Among its challenges: It doesn't have access to the Fed's lending window, as some other troubled financial firms do. It could face significant claims from Hurricane Ike, which battered the Texas coast over the weekend. It had to pay a stiff premium in August when it borrowed money in the corporate bond market.
As recently as Thursday, AIG said it was sticking to a schedule to unveil its strategic plan on Sept. 25. But its shares fell 31% on Friday alone. Late that day, Standard & Poor's warned that it could cut AIG's credit rating by one to three notches, citing concerns that AIG would have difficulty raising capital. Such a step would make it more expensive for
AIG to borrow and further undermine investor confidence in the company.
Earlier this year, AIG considered selling or spinning off ILFC, the aircraft-leasing arm, but it decided against the idea in June. Since then, AIG's position has deteriorated, making it more likely that it would try again to unload the unit.
AIG could also raise cash by selling its investments in Blackstone Group LP, which is also helping to advise the insurer on its restructuring. AIG owns a stake in Blackstone worth about $700 million.
It also has roughly $1 billion in investments in Blackstone's funds, according to regulatory filings, that it could sell in the secondary market. It's not clear whether AIG has buyers lined up for any of the assets it wants to sell. Also unclear is how much interest private-equity firms would take in an AIG investment, and whether they have enough capital to make a dent in AIG's problems.
"The numbers are too daunting," said a senior executive at a large private-equity firm. Given AIG's huge balance sheet, "we just don't have enough capital to fill the hole."
Over four decades, former Chief Executive Maurice R. "Hank" Greenberg built AIG into one of the world's largest financial firms. He made major acquisitions, and pushed AIG into businesses beyond the world of traditional insurance. For years, investors paid a hefty premium to buy AIG shares. Now AIG is not even the most valuable insurer in the U.S., as measured by market capitalization.
A 2005 accounting scandal precipitated Mr. Greenberg's departure. He has denied wrongdoing. A protégé, Martin Sullivan, ran the company until this summer when he was replaced under shareholder pressure with Mr. Willumstad, a former Citigroup Inc. executive who has been AIG's chairman since 2006.
When Mr. Willumstad said in June that he would release his turnaround plan in a few months, some wondered whether that gave him enough time to get his hands around such a multifaceted enterprise. But rapid shifts in the market have forced his hand.
Mr. Willumstad reached out to Mr. Greenberg after taking over in June, But a spokesman for Mr. Greenberg said the former CEO wasn't involved in the weekend talks, "though he repeatedly offered to assist in anyway he could" -- suggesting that Mr. Willumstad was pursuing his own strategy.
The aircraft-leasing arm could be part of his efforts. Founded in 1973, ILFC boasts a fleet of more than 900 airplanes valued at more than $50 billion. It is the largest single customer for both Boeing Co. and European Aeronautic Defence & Space Co.'s Airbus. Given that ILFC logged record operating income of $352 million in the second quarter, its value may be relatively high at the moment compared to some other AIG units.
S&P said AIG had enough money to pay claims and post collateral, if needed -- an important statement, given that AIG could have to post billions of dollars if it got downgraded. AIG had over $1 trillion in assets at the end of the second quarter. Its shareholders equity -- assets minus liabilities -- stood at about $78 billion at that point.
Can the Fed Help AIG? Will It?
It’s one fire after another for the Federal Reserve. As it sought to address the Lehman Brothers crisis over the weekend, the next big problem became insurer American International Group, Inc., which is reaching out the central bank for a loan. The request raises a host of questions, but the three most important are: Can the central bank lend to AIG? Will the Fed do it? And should it?
The answer to the first question is pretty clearly, “yes.” AIG doesn’t have access to the primary dealer credit facility, the Fed’s lending program for investment banks. The facility was set up in the wake of the collapse of Bear Stearns to allow securities firms that interact with the Fed daily but don’t fall under its direct banking supervision to have access to discount-window lending usually reserved for depsitory institutions. But, the Fed has the power to broaden access.
According to Section 13, paragraph 3, of the Federal Reserve Act, the central bank can lend to “any individual, partnership, or corporation” under extreme circumstances and under certain conditions. This is the paragraph that the Fed used to justify its intervention in the Bear Stearns deal, and also served as the basis for the PCDF, which has been extended to January 2009.
The paragraph has a controversial history and the Fed has denied direct lending before, such as a 1975 request from the city of New York. In the end, the central bank just acted as a fiscal agent for the government’s eventual loans to the city. The answer to the question of whether the Fed will act on its authority is less clear. The Fed may not resist AIG’s request for support as clearly as it has with Lehman Brothers, distinguishing between its lending programs and the use of taxpayer funds.
But any Fed action to help the firm still would have a high bar. Central bank officials took an extraordinary step in expanding the discount window to securities firms earlier this year. Expanding it to other firms would be another big step, though it could be considered if a strong case can be made for how such a lending lifeline would be critical to overall financial stability. The terms on any loan must come from the Fed’s Board of Governors, which must approve the move.
Another complication lies in the wording of that key paragraph in the Federal Reserve Act. The Act states that before agreeing to a loan “the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions.” That might be a deal breaker with AIG, which turned down a capital infusion from a group of private-equity firms led by J.C. Flowers & Co. because an option tied to the offer would have effectively given them control of the company.
Finally, there is the question of whether the Fed should get involved. On the one hand, the Fed is dedicated to doing all that it can to maintain financial stability. If it deems AIG’s survival crucial to the overall health of the economy, it may need to step in, as it did earlier this year with Bear Stearns. However, further expanding the discount window to another class of firms has the potential to open a Pandora’s Box of companies looking to the Fed for funding.
Representatives of General Motors have already been sniffing around for government money, making Fed officials uncomfortable about public perception of the central bank’s role. If the Fed extends lending beyond its usual counterparties, they’ll be deeper into the question of where to draw the line. The central bank’s resources are great, but they aren’t infinite.
US government blocks Fannie, Freddie CEOs' exit packages
The federal government will not pay the ousted chief executives of mortgage finance companies Fannie Mae and Freddie Mac up to $24 million in exit packages.
The Federal Housing Finance Agency notified former Fannie Mae CEO Daniel Mudd and former Freddie Mac CEO Richard Syron that such "golden parachute" payments will not be paid. The housing agency, which took control over the companies earlier this month, made the announcement on Sunday.
"It would have been unconscionable to award these inflated salaries, particularly when the leadership of Fannie and Freddie can hardly be given good grades," Sen. Charles Schumer, D-N.Y., said in a statement. Mudd had been due to receive up to $8.4 million in compensation, while Syron was due to receive up to $15.5 million, according to calculations by David Schmidt, a senior consultant at executive compensation consulting firm James F. Reda & Associates.
Representatives of both Syron and Mudd declined to comment Monday morning. Mudd received $12.2 million in compensation in 2007, and Syron was paid $19.8 million. Herbert Allison was named the new chief executive of Fannie, and David Moffett the new CEO of Freddie as part of the government's bailout of the two huge mortgage financing agencies.
Fannie and Freddie own or guarantee about $5 trillion of the nation's outstanding mortgages, roughly half the nation's total. James Lockhart, the housing agency's director has said that compensation for the new executives will be "significantly lower than the outgoing CEOs
Goldman, Morgan Stanley face post-Lehman funding issues
Analysts expressed concern about the funding supporting the surviving independent Wall Street investment banks Monday, following the sale of Merrill Lynch & Co. and the bankruptcy filing of Lehman Brothers Holdings Inc..
Lehman's "apparent demise and the likely damage to its bondholders indicates significant spread-widening for independent broker-dealers and probably considerably narrower access to funds," Merrill Lynch banking analyst Guy Moszkowski said in a research note Monday.
Long considered two strongest of the major Wall Street investment banks, Goldman Sachs Group Inc. and Morgan Stanley now face increased selling pressure on their shares, according to analysts, as the departure of the investment banks' weaker competitors throws into question the viability of their independent business models.
Goldman shares fell 7.7% in recent premarket action to $142.37, while Morgan Stanley shares were off 9.7% to $33.61.
Moszkowski advised Merrill's clients to stop buying Goldman shares and cut his rating on the stock to neutral from buy. He said tighter credit market funding will drive a "tidal wave" of asset deleveraging and write-downs during the fourth quarter. He said Goldman's profitability next year likely will be harmed as a result and cut earnings estimates and his price target on the stock, to $159 from $187.
Also predicting funding problems for the major brokers and the financial system in general, banking analyst Dick Bove of Ladenburg Thalmann said Goldman and Morgan Stanley each may have to merge with a commercial bank to survive. "We are in uncharted territory but it seems likely that all financial firms that extend credit will be pulling back on their credit lines," Bove said.
"This will make it even harder for commercial firms and individuals to borrow money and it may result in demands for immediate debt repayment. This will harm the economy for an extended period." Bove said Goldman and Morgan Stanley probably would have to make an effort to develop core deposits, most likely by each buying a commercial bank, though he said they each also could be acquired by one, like Merrill Lynch.
Merrill Lynch agreed Sunday to be bought by Bank of America Corp., a giant commercial bank based in Charlotte, for about $50 billion, or $29 a share. Bank of America was considering buying Lehman Brothers as late as Friday but pulled out of discussions, forcing Lehman's Chapter 11 bankruptcy filing Monday.
Ten major banks announced Sunday night that they intended to pool together a $70 billion collateralized borrowing facility that would help them ride out the credit storm. They also agreed to work together to mitigate the fallout from exposure to Lehman's derivatives. The group included Bank of America, Goldman, Morgan Stanley, Merrill Lynch, Barclays PLC , Citigroup Inc., Credit Suisse Group, Deutsche Bank AG, JPMorgan Chase & Co. and UBS AG .
Lehman Files Biggest Bankruptcy Case as Suitors Balk
Lehman Brothers Holdings Inc., the fourth-largest U.S. investment bank, succumbed to the subprime mortgage crisis it helped create in the biggest bankruptcy filing in history.
The 158-year-old firm, which survived railroad bankruptcies of the 1800s, the Great Depression in the 1930s and the collapse of Long-Term Capital Management a decade ago, filed a Chapter 11 petition with U.S. Bankruptcy Court in Manhattan today. The collapse of Lehman, which listed more than $613 billion of debt, dwarfs WorldCom Inc.'s insolvency in 2002 and Drexel Burnham Lambert's failure in 1990.
Lehman was forced into bankruptcy after Barclays Plc and Bank of America Corp. abandoned takeover talks yesterday and the company lost 94 percent of its market value this year. Chief Executive Officer Richard Fuld, who turned the New York-based firm into the biggest underwriter of mortgage-backed securities at the top of the U.S. real estate market, joins his counterparts at Bear Stearns Cos., Merrill Lynch & Co. and more than 10 banks that couldn't survive this year's credit crunch.
"There is likely to be a domino effect as other firms and individuals who relied on Lehman for financing feel the effects of its meltdown," said Charles "Chuck" Tatelbaum, a bankruptcy lawyer with Adorno & Yoss in Florida and former editor of the American Bankruptcy Institute Journal. "The whole thing is frankly frightening for the U.S. economy."
Lehman's filing was made by lawyers from New York-based Weil Gotshal & Manges, led by bankruptcy lawyer Harvey Miller. The case was assigned to U.S. Bankruptcy Judge James Peck, according to court records. Peck was sworn in as a judge in January 2006. Before taking the bench, he served as co-chair of business reorganization at Schulte Roth & Zabel, and prior to that was a partner at Duane Morris, according to the court's web page.
Lehman shares at 9:39 a.m. dropped 92 percent in New York trading to 29 cents from their $3.65 close on Sept. 12. UBS AG, HBOS Plc and Axa SA led a decline of more than 3 percent for European stock markets on speculation a forced sale of Lehman's assets may lead to further writedowns at other banks.
Benchmark gauges of corporate credit risk rose by a record in Europe, and traded at an all-time high in North America as investment banks sought to minimize losses from Lehman's collapse. U.S. two-year Treasuries climbed, pushing yields below 2 percent for the first time since April, as investors sought the relative safety of government debt.
Lehman bondholders may get about 60 cents on the dollar if the investment bank is forced into liquidation, analysts at CreditSights Inc. said. The filing is by Lehman's holding company and won't include any of its subsidiaries. Lehman owes its 10 largest unsecured creditors more than $157 billion, including debts to bondholders totaling $155 billion.
The largest single creditor listed in today's filing is Tokyo-based Aozora Bank Ltd., owed $463 million for a bank loan. Other top creditors include Mizuho Corporate Bank Ltd., owed $382 million, and a Citigroup Inc. unit based in Hong Kong owed an estimated $275 million. Lehman listed $639 billion of assets. New York-based Citigroup and The Bank of New York Mellon Corp. are among trustees for bondholders who Lehman owed about $155 billion.
London-based Barclays, which emerged as a leading candidate to acquire Lehman, pulled out first yesterday, saying it couldn't obtain guarantees from the U.S. government or other Wall Street firms to protect against losses on Lehman's assets. Bank of America Corp. withdrew about three hours later, before saying it would acquire New York-based Merrill Lynch. Brokers sought yesterday to consolidate trades linked to Lehman to minimize the impact of a bankruptcy filing.
Founded in 1850 by three immigrants from Germany, Lehman has managed to avert previous potential disasters and was among the handful of U.S. financial firms that had endured for more than a century. Fuld, the longest-serving CEO on Wall Street, attempted to shore up the firm's finances in the second quarter by raising $14 billion of capital, selling $147 billion of assets, increasing cash holdings and reducing reliance on short-term funding to create a buffer against a bank run.
Instability in the financial and credit markets left Lehman officials struggling to keep the firm afloat, Ian Lowitt, the firm's chief financial officer, said in a court filing in the bankruptcy case. Liquidity problems plagued Lehman earlier this year, he said. "This loss of liquidity created a chain reaction of adverse economic consequences," Lowitt said.
Lehman, which has about 25,000 employees worldwide, last week reported the biggest loss in its history and said it planned to sell a majority stake in its asset-management unit, spin off real-estate holdings and cut the dividend in an effort to shore up capital and regain investor confidence. The efforts failed to stem speculation that the firm's mortgage holdings would lead to more losses.
"The uncertainty, particularly among the banks through which the company clears securities trades, ultimately made it impossible for the company to continue to operate its business," Lowitt said in the filing. The firm had sought about $4 billion for the asset-management unit, he added.
The U.S. Treasury and the Federal Reserve negotiated with Wall Street executives for the past three days in New York, trying to strike a deal that would prevent the investment bank from failing before markets open today. Treasury Secretary Henry Paulson indicated that he didn't want to use U.S. taxpayer funds to ease a sale of the company.
Fuld, 62, is exploring the sale of its broker-dealer operation and continues to hold talks on the sale of its asset- management unit, including fund manager Neuberger Berman, the company said today in the statement. The U.S. Securities and Exchange Commission said customer accounts at Lehman are protected and agency staff will remain at the brokerage firm in the coming weeks.
Securities rules require segregation of Lehman's securities and cash, and accounts are covered by insurance provided by the Securities Investor Protection Corp., the Washington-based agency said last night. SEC employees working inside the broker's office will continue that assignment, the agency said.
"We are committed to using our regulatory and supervisory authorities to reduce the potential for dislocations from recent events, and to maintain the smooth functioning of the financial markets," said SEC Chairman Christopher Cox in a statement yesterday.
Brokerage units that fail usually are handled by the SIPC, which appoints a trustee to liquidate the business and protect its customers. Lehman's customer accounts may also be farmed out to other firms that may protect cash and securities, on the model of the failed junk-bond firm Drexel Burnham Lambert, which filed for bankruptcy in 1990.
Lehman's trades in commodities, derivatives and other financial instruments may be unwound by the bank's counterparties, said Andrew Rahl, co-head of bankruptcy in New York at law firm Reed Smith and a specialist in financial companies. A liquidation of the brokerage unit might be "a big mess" if Lehman used customer accounts to raise cash, and sale and repurchase agreements had to be unwound, Rahl said.
The trigger for SIPC to take over the Lehman brokerage would be a freezing of customer accounts, or a Chapter 11 filing that implied the unit was insolvent and its customers might not be able to access their property, the official said. "First there will be chaos and then an adjustment process as losses distribute themselves through the market," said Gilbert Schwartz, a former Federal Reserve attorney and now a partner at Schwartz & Ballen in Washington.
"There won't be any lasting turmoil. Treasury and the Fed have determined that markets have adjusted to the situation since Bear Stearns. If every time a big institution went bust the markets expected the government to step in, no one would ever adapt." Ladenburg Thalmann & Co. analyst Richard Bove wasn't as sanguine. "We will be entering uncharted territory," he said. "Forcing liquidation will set off problems in other companies and markets everywhere."
Rival banks and brokers yesterday held a session for netting derivatives transactions with Lehman to reduce uncertainty in that market. That move means canceling trades that offset each other, the International Swaps and Derivatives Association said in a statement. The ISDA includes 218 banks, brokerages, insurance companies and other financial institutions from the U.S. and abroad.
In the U.K., the Financial Services Authority asked banks to disclose their exposure to Lehman, spokeswoman Teresa LaThangue said in a statement today. Any sale of Lehman's investment management units is subject to court approval and creditor scrutiny under bankruptcy rules, according to Tatelbaum.
"Bankruptcy severs all counterparty contracts, and therein lies the systemic risk," said David Kotok, chief investment officer of Vineland, New Jersey-based Cumberland Advisors Inc., which manages $1 billion. "This would be the first time we've tested how much damage will be done by a bankruptcy."
Lehman 2007 Bonuses?
Lehman paid out around $5.7 billion in bonuses in 2007. Are those bonuses safe? Maybe not. The bonuses might be recoverable as fraudulent transfers---transfers made while insolvent without receiving reasonably equivalent value. (UFTA 5(a)).
Thus, the key question is whether Lehman was solvent when it paid out the bonuses? (The statute of limitations goes back past 2007, fwiw.) On an equity basis, almost assuredly yes, but on a balance sheet basis, that might be a closer call, depending on how things like MBS and CDOs are valued.
If Lehman was not solvent when it paid the bonuses, then I think there's a fraudulent transfer. It's hard to see how a bonus could ever be paid in exchange for reasonably equivalent value, when an employee has already been paid a salary for their efforts. There are various defenses to FTs, but none would seem to apply here at first blush.
Of course, it takes a challenge by a creditor whose claim arose before the bonuses were paid, but per the rule of Moore v. Bay (which I am teaching tomorrow), it only takes one of them, owed a single cent, in order to challenge all the bonuses. The lack of a creditor might protect the bonuses, but as creditors look to carve up what's left of Lehman, the thought of recovering a decent chunk of $5.7 billion is going to look very appealing.
Industrial Production in U.S. Falls Most in Three Years
Industrial production in the U.S. fell in August by the most in almost three years as the slowdown in consumer spending prompted automakers to cut back. The 1.1 percent decrease in production at factories, mines and utilities was more than forecast and the biggest since September 2005, Federal Reserve figures showed today. Car output slumped 12 percent, the most in a decade.
Producers are hurting as the housing recession, shrinking credit and rising unemployment lead consumers and businesses to cut spending. The plunge in output, one of the measures that determines whether a recession has begun, fanned concern the economic slowdown will intensify following the collapse in financial markets that claimed Lehman Brothers Holdings Inc.
``We're seeing more pervasive weakness in manufacturing, going beyond autos,'' said Sal Guatieri, a senior economist at BMO Capital Markets in Toronto. ``The weakness will continue this month as the economy is taking a lurch downward. This is another report that points to a recession.''
U.S. Treasury securities, which had soared earlier in the day as Lehman filed for bankruptcy and traders forecast the Federal Reserve will cut interest rates as soon as tomorrow, maintained gains following the report. The benchmark 10-year note yielded 3.53 percent at 9:39 a.m. in New York, down from 3.72 percent late in the day on Sept. 12.
Industrial production was forecast to drop 0.3 percent, according to the median estimate of 68 economists surveyed by Bloomberg News. Projections ranged from a gain of 0.2 percent to a drop of 0.8 percent. July's reading was revised down to a 0.1 percent gain from the 0.2 percent previously estimated.
Capacity utilization, which measures the proportion of plants in use, decreased to 78.7 percent, the lowest level since October 2004. Capacity was estimated to fall to 79.6 percent, according to the Bloomberg survey median. Economists track plant operating rates to gauge factories' ability to produce goods with existing resources. Lower rates reduce the risk of bottlenecks that can force prices higher. The utilization rate has averaged 81 percent over the past 30 years.
Factory output, which accounts for about four-fifths of industrial production, dropped 1 percent after a 0.1 percent increase the prior month, the report showed. Production at utilities fell 3.2 percent, reflecting a cooler August than usual, economists said. Mining output, which includes oil drilling, decreased 0.4 percent. Shutdowns in the Gulf of Mexico as Hurricane Gustav approached may have contributed to the drop. Shutdowns ahead of Hurricane Ike will probably hurt mining output this month.
The slump in motor vehicle and parts production followed a 2.5 percent gain the prior month, the report said. Carmakers assembled just 8.19 million autos at an annual pace last month, the fewest since April 1991. Production of consumer durable goods, including automobiles, furniture and electronics, fell 6 percent.
Earlier today, a report from the New York Fed showed manufacturing worsened this month in that region. The Empire State general economic index fell to -7.4, the lowest reading since June, from 2.8 a month earlier. A reading of zero is the dividing line between growth and contraction.
Factories may slow further as sales weaken. Purchases at U.S. retailers fell 0.3 percent in August following a 0.5 percent decline in July as Americans retrenched in the face of mounting job losses and record foreclosures, Commerce Department figures showed last week.
Carmakers are struggling. General Motors Corp. and Ford Motor Co., the biggest U.S. automakers, dragged the domestic industry to its 10th straight monthly sales decline in August as consumers snubbed trucks because of high fuel prices. Ford this month further pared production plans for the rest of 2008.
``Not only is the U.S. in a recession, but the rest of the world is slowing down,'' Ford Chief Executive Officer Alan Mulally said during a speech on Sept. 8 in Dearborn, Michigan. ``I've never seen anything quite like it.'' Manufacturers are also cutting payrolls. Factories eliminated 61,000 jobs last month, the biggest decline in five years, Labor figures showed on Sept. 5. The drop included a loss of 39,000 jobs in auto-making and parts industries.
Other recent reports show American manufacturers have become more cautious as consumer spending weakens. The Institute for Supply Management's factory index fell in August for the first time in three months, the group reported on Sept. 2. Consumer spending, the biggest part of the economy, will stall this quarter, while economic growth will slow to a 1.2 percent annual rate, less than half the prior quarter's pace, according to a Bloomberg survey from Sept. 2 to Sept. 9.
The Fed's Next Move: Money Supply
While most of the business media is focusing on Lehman and troubled financials, they are forgetting about this week’s Fed meetings and how monetary policy will respond to the crisis. After almost 6 months of shrinking real money supply (nominal money supply adjusted for inflation), Fed policy makers are going to decide whether to push the economy by once again increasing real money supply.
The last 6 months of shrinking real money supply has created a scarcity of funds that halted the drop in the value of the US dollar and deflated the commodity bubble. However, too few dollars also attenuated the credit crisis. Monetary policy didn’t cause Freddie and Fannie’s failure, Lehman’s meltdown or Washington Mutual and AIG’s problems.
But the coincident timing of these failures is a result of 6 months of restrictive money supply causing investor risk premiums to increase and the weakest institutions being “closed” out of the market. For the last year the Fed has been trying to walk the economy across a monetary policy tightrope and knows that if we lean too far one way or another the economy will fall and break.
As our journey across the monetary tightrope started, the Fed pushed us by injecting liquidity into the financial sector through its “emergency” facilities so that troubled banks, brokerages and insurers could work out their problems without hurting each other. Increasing money supply (i.e., lots of liquidity being pumped into the banks) and a falling Fed Funds Rate bought time for the banks and brokerage to raise capital and deleverage.
But, by the middle of March, the dollar was tanking, commodity prices were beginning to spin out of control and the US risked triggering global runaway inflation. Beginning in the spring of 2008, the Fed started to push the economy in the direction of a more restrained monetary policy. Money supply growth stopped and the Fed made it clear that they were done cutting the Fed Funds Rate. The US Dollar strengthened, the commodity bubble deflated but stress in the financial sector returned.
Now the economy is looking into a black hole of uncontrolled banking failures, potentially shrinking money supply, deflation and wealth destruction. Because of the fragile, and potentially insolvent status of many financial companies, if the Fed is too restrictive it risks creating a “domino effect” of financial failures which will destroy money supply and cause a depression.
Many economists, such as Milton Friedman, have written extensively that the Great Depression could have been avoided if the Fed had focused on maintaining the amount of money supply as bank failures took place. Instead, during the Hoover Administration bank failures resulted in more bank failures and the financial sector deleveraged at an uncontrolled pace. Money supply plummeted and by the time the Fed realized what had happened it couldn’t stop the damage.
As we move forward into 2009, if we fall off of the monetary tightrope on one side the economy is facing a deflationary cycle and a possible depression, and on the other side the economy is facing runaway inflation and a possible depression. So it is important for the Fed to keep us on the tightrope and keep us from falling. The Fed needs to increase money supply and cut the Fed Funds Rate, but not by too much.
On the other hand, the Fed needs to be an aggressive inflation fighter and keep monetary supply reasonably restrictive, but not by too much. The next move of the Fed will be to increase money supply which hopefully will have the effect of inflating (at least for a while) the banking sector. The Fed Funds Rate may be cut as well in an effort to pump operating profits into the banking sector.
For the week ending September 1, seasonally adjusted M2 (a broad based measure of money supply) remained essentially unchanged from the week ending March 24 and on a non-seasonally adjusted basis is actually lower than the week ending March 24. This trend of no money supply growth will not continue for much longer, or the Fed risks repeating the mistakes of the Hoover era Fed.
China Cuts Rates as U.S. Turmoil Adds to Global Risks
China cut interest rates for the first time in six years and allowed most banks to set aside smaller reserves as worsening credit-market turmoil and weakening export demand dimmed the outlook for economic growth.
The People's Bank of China reduced the one-year lending rate to 7.20 percent from 7.47 percent, effective tomorrow, and lowered the reserve ratio at the nation's smaller banks by 1 percentage point. The changes were in a statement on the central bank's Web site today.
Lehman Brothers Holdings Inc. filed for bankruptcy today and Merrill Lynch & Co. agreed to be sold, adding to evidence that the credit crisis is deepening and threatening the global economy. The slowest inflation in 14 months has given China room to cut borrowing costs and protect jobs in the world's fourth- largest economy.
"Policy makers see the probability of a recession in the U.S. is higher now, so the outlook for Chinese exports has deteriorated," said Darius Kowalczyk, chief investment strategist at CFC Seymour Ltd. in Hong Kong. "This is the beginning of an easing cycle in China." He was the only one of seven economists in a Bloomberg survey last week to predict a rate cut this year or in the first quarter of 2009. The announcement came on a holiday, with markets closed.
The rate cut is "to help solve important problems in our economy for its continued stable and fast development," the central bank said. Inflation cooled to 4.9 percent in August, export growth slowed and industrial production expanded by the least in six years, according to data released last week. China's economy expanded 10.1 percent in the three months to June 30 from a year earlier, the fourth straight quarter of slower growth.
In the U.S., banks including JPMorgan Chase & Co., Goldman Sachs Group Inc. and Citigroup Inc. formed a $70 billion fund to ensure market liquidity as Lehman filed for bankruptcy and Bank of America Corp. agreed to acquire Merrill. The Federal Reserve has widened the collateral it accepts for loans to securities firms and boosted its program for lending Treasuries to bond dealers. It may reduce the benchmark interest rate tomorrow to 1.75 percent from 2 percent, according to the futures market.
China's central bank pushed the reserve requirement for lenders to a record 17.5 percent in June. The biggest banks are excluded from the reduction. Those exempted are: Bank of China Ltd., Industrial and Commercial Bank of China, Agricultural Bank of China, China Construction Bank Corp., Bank of Communications Co. and Postal Savings Bank of China. The requirement for smaller banks drops by 1 percentage point from Sept. 25. In areas affected by the Sichuan earthquake, the reduction is 2 percentage points.
The central bank left the key deposit rate unchanged at 4.14 percent, narrowing banks' margins on loans. Economists were split on whether the rate cut would cause the yuan to rise or fall. Mark Williams, of Capital Economics Ltd. in London, said "using interest rates to stimulate growth is pretty good for further yuan appreciation."
Falling interest rates are "obviously negative for the yuan," said CFC Seymour's Kowalczyk. The currency has climbed 6.8 percent against the dollar this year, the best performer among Asian currencies. It closed at 6.8450 against the U.S. currency in Shanghai on Sept. 12.
Zhu Baoliang, the chief economist at the State Information Center, a government research agency, said August's weaker economic data probably prompted today's moves, rather than events in the U.S. Capital Economics' Williams said it was "suspicious" that the central bank acted when the Shanghai Composite Index seemed set to drop below 2,000. It closed on Sept. 12 at 2,079.67 after slumping 60 percent this year on concern that measures to tame inflation will erode company profits.
The property market could be headed for a "meltdown" as home prices and sales decline, Morgan Stanley said Sept. 12. China's policy makers have already loosened loan quotas -- restrictions on how much banks can lend -- and raised export-tax rebates for garments and textiles to help exporters and small businesses.
Oil Falls to Six-Month Low as Refineries Escape Major Damage
Crude oil fell to a six-month low in New York and gasoline tumbled amid signs that refineries along the Gulf of Mexico coast will soon resume operations after escaping major damage from Hurricane Ike.
About 20 percent of the U.S.'s oil refining capacity was shut, limiting fuel deliveries and prompting the Department of Energy to release 309,000 barrels from its strategic reserves. New York Mercantile Exchange electronic trading opened early today to allow traders to respond to Ike.
"It looks like we've dodged another bullet," said Peter Beutel, president of energy consultant Cameron Hanover Inc. in New Canaan, Connecticut. "The refineries in the Houston area seem to have come out of the storm remarkably intact." Crude oil for October delivery fell $1.43, or 1.4 percent, to $99.75 a barrel at 7:55 p.m. on the Nymex. Futures touched $98.46, the lowest since Feb. 26. Prices are up 25 percent from a year ago. Gasoline for October delivery fell 9.46 cents, or 3.4 percent, to $2.6750 a gallon in New York.
CME Group Inc., the world's biggest futures exchange, began Nymex electronic trading of energy contracts at 10 a.m. New York time today. Oil in New York has fallen 33 percent from a record $147.27 a barrel on July 11 as high prices and slowing global economic growth reduce demand for fuels. Sales at U.S. retailers dropped in August for a second straight month and July inventories at American businesses increased the most in four years, Commerce Department reports showed last week.
"Growing fears about the economy are trumping any fears about the damage caused by Hurricane Ike," said John Kilduff, senior vice president of risk management at MF Global Inc. in New York. "The broader issue is the weakness of the financial system. Given the Lehman and WaMu watch, cash looks better than any speculative investment."
Fourteen refineries in Texas and Louisiana, including plants operated by Exxon Mobil Corp., Valero Energy Corp. and Royal Dutch Shell Plc, shut 3.57 million barrels a day of refining capacity as Ike approached the Gulf Coast. Valero said it found "no significant structural damage" at three Houston-area refineries shut before the storm. One Valero refinery had power, the company said. Marathon Oil Corp. and Motiva Enterprises LLC said they're evaluating their plants.
Colonial Pipeline Co. said today it restored operations to its gasoline and distillate pipelines, which carry from the Gulf Coast to the Northeast. Regular gasoline, averaged nationwide, rose 6.2 cents to $3.795 a gallon, AAA, the nation's largest motorist organization, said today on its Web site. Pump prices reached a record $4.114 a gallon on July 17.
Pump prices in the Southeast U.S. surged as the Ike made landfall. Regular gasoline in Georgia rose 16.2 cents to an average $4.025 a gallon, the AAA said today. In North Carolina the regular gasoline climbed 11.1 cents to $3.973 a gallon. "The crude oil price should be lower because with the refineries down, there is nowhere for it to go," Kilduff said. "The drop in product prices may be short-lived because some of these refineries could be down for weeks."
The storm idled about 99.6 percent of oil production and 91.9 percent of natural-gas output in the Gulf of Mexico, the U.S. Minerals Management Service said today. Gulf fields produce 1.3 million barrels oil a day, about a quarter of U.S. output, and 7.4 billion cubic feet of gas, 14 percent of the total, government data showed.
Natural gas for October delivery rose 0.9 cents, or 1.2 percent, to $7.456 per million British thermal units in New York. The Energy Department released 630,000 barrels of crude oil from the strategic reserve to Placid Refining Co. and Marathon Oil Corp. after Hurricane Gustav made landfall in Louisiana on Sept. 1. That brings the total release because of the two storms to 939,000 barrels.
UK unemployment to top two million by end of 2009
Unemployment in Britain will surge by 450,000 to 2.12 million by the end of next year, a level not seen since 1997, when Labour came to power, as the country endures its first recession since the early 1990s, the CBI forecasts today.
In a dramatically revised outlook for the economy, the employers' organisation says that Britain is already in a recession and will not recover until the middle of next year. It adds that homeowners will continue to suffer brutal falls in the value of their property.
The CBI says that the dismal economic conditions will lead to hundreds of thousands of job cuts by the end of 2009, forcing the number out of work above two million and taking the rate of unemployment up from 5.4 per cent to 6.8 per cent.
Richard Lambert, Director-General of the CBI, said: “We are now almost certainly in a mild recessionary phase.”
Earlier this year the CBI said that Britain would avoid recession, but it has drastically cut its forecasts after continued surges in energy prices and an economic slowdown that has been far sharper than expected. The Organisation for Economic Co-operation and Development and the European Commission have slashed their forecasts for the UK to show a recession in the second half of the year.
The British Chambers of Commerce has said that the recession could lead to more than two million people unemployed by Christmas. The CBI also forecasts that the Government will break one of its fiscal rules. It says that government borrowing is set to rise, pushing public net debt to more than 40 per cent of GDP.
The Government has often pledged that it would not breach this threshold over the economic cycle, but there is speculation that Alistair Darling is preparing to change this rule in his Pre-Budget Report next month to give the Treasury room over spending.
This comes days after Mervyn King gave warning that breaking the fiscal rules could lead to higher inflation.
The Governor of the Bank of England said: “The long-term risk is [that] a fiscal framework that is not perceived by financial markets to be credible does put up pressure on inflation expectations, because it undermines the market's belief in the credibility of both the monetary and the fiscal framework.”
The economy ground to a halt between April and the end of June, recording no growth at all, official figures show. The CBI believes that that it is set to shrink by 0.2 per cent between July and and the end of this month and contract by a further 0.1 per cent in the final three months of the year. A recession is defined as two consecutive quarters of shrinking output.
The CBI expects the economy to stall for a further three months at the beginning of next year, before growing marginally by 0.1 per cent between April and June. Mr Lambert said that while he did not believe that conditions would be as bleak as in the early 1980s and early 1990s, consumers and businesses were in for a tough time.
There was more bad news for homeowners as the CBI said that the value of an average house would tumble by about £33,000 from January's peak of £221,130, based on house price figures from the Department of Communities and Local Government. Ian McCafferty, chief economic adviser to the CBI, said: “The existence of the credit crunch has made the adjustment in the housing market more brutal than it would otherwise have been.” He said that the mortgage market would remain clogged up until next summer, as mortgage funding remained scarce.
Lehman latest sign of Street's shrink job
The credit crunch has turned Treasury Secretary Henry Paulson into the middlemensch.
The former Goldman Sachs CEO, who came to Washington as a critic of government intervention in financial markets, is now playing the role of the ultimate middleman, an i-banking shepherd whose central task has become culling weak financial institutions from Wall Street’s herd.
Potential buyers of Lehman Brothers, struggling last week with enormous write-downs of mortgage investments and evaporating investor confidence, reportedly turned to Mr. Paulson’s Treasury Department (along with the Federal Reserve) to help broker a deal. By working toward a deal, Mr. Paulson is reducing the number of big brokerages—and with it, the overall leverage in the financial system—to a more manageable level.
“Lehman shows that [the government] is in the business of brokering the consolidation of Wall Street—very much so,” said Joseph Mason, a former finance economist at the Office of the Comptroller of the Currency and now a finance professor at Louisiana State University.
The Federal Reserve and Mr. Paulson stepped in last March to help broker—and guarantee—J.P. Morgan Chase’s last-minute acquisition of a flailing Bear Stearns. Mr. Paulson last week indicated that regulators might be willing to help negotiate a deal for Lehman, too, but Reuters reported late Friday that Mr. Paulson was “adamant” that no public money would be used in a deal.
“You have to say no somewhere, and Lehman may be as good a place as any to say no,” observed former St. Louis Fed president William Poole, who added that simply putting buyers and sellers together in no way presents the same kind of risk that the Bear Stearns matchmaking did.
Since Bear Stearns’ troubles, Lehman and other investment banks have had access to the Fed’s discount window, a taxpayer-backed lifeline that allows them to take short-term loans using distressed assets as collateral. Fed statistics indicate no borrowing by investment banks in the week ending last Thursday.
Unlike Bear, which was rocked by concerns over its short-term liquidity, Lehman’s troubles revolved around questions about the soundness of its assets. Of all the potential buyers reportedly considering a bid for all or part of Lehman, including Bank of America, Barclay’s, HSBC, J.C. Flowers, Kohlberg Kravis Roberts and China Investment Co., some observers felt a big universal bank would be the best fit because its deposits would provide a much-needed infusion of sturdy assets.
“Ultimately all these monoline investment banks are an endangered species—they have to align themselves with a universal bank or they’re dead,” said Christopher Whalen, managing director of Institutional Risk Analytics. “They’re second-class citizens [because] they don’t have access to the Fed in normal times.”
The scramble to sell the firm came at the end of a week that saw the value of Lehman’s shares fall some 78%. About one-third of that loss came after Lehman decided on Wednesday to offer detailed preliminary third-quarter results more than a week ahead of its scheduled earnings release.
The news was grim. After taking a $5.7 billion write-down on its mortgage investments, Lehman lost $3.9 billion in the three months ended Aug. 31. The firm, founded in 1850 and publicly traded since 1994, when it was spun off from American Express, had never reported a quarterly loss before June.
In a hastily arranged conference call with investment analysts that day, Lehman CEO Richard Fuld announced the company would take dramatic steps in an attempt to save itself. Lehman would spin off from $25 billion to $30 billion in commercial real estate assets, forming a new company called REI Global and issuing its stock to Lehman’s shareholders. It would pay asset manager BlackRock to unwind some $4 billion in toxic mortgage investments in the United Kingdom (see the related story on Page 1). And it would sell a majority stake in its investment management division, including Neuberger Berman, a prized asset estimated earlier this year to be worth as much as $8 billion or more on its own.
Designed to cleanse Lehman’s balance sheet of potentially noxious assets, the moves were intended to reduce the risk that additional write-downs would be needed in the future, Mr. Fuld said.
Mr. Fuld may have coined a phrase when he said the moves would help “de-risk” Lehman’s balance sheet. That means cutting leverage and reducing assets in proportion to shareholders’ equity. A year ago, at the end of the third quarter of 2007, Lehman’s net leverage ratio was 16.1; when the firm unveiled this year’s third-quarter results last Wednesday, it had slashed that figure to 10.6.
Less leverage certainly means less risk. But just as leverage supports dicey investments like the potentially radioactive real estate holdings Lehman said it would rid itself of, it can also greatly boost the potential for profit. And for some businesses at the heart of what investment banks do, like trading and underwriting, leverage is key. Lehman’s share of the debt underwriting market fell this year to 3.2%, from 5.5% last year, according to research firm Dealogic. That dropped it from fifth place among debt bookrunners to 13th.
Lehman also foreshadowed its search for a buyer. “The firm remains committed to examining all strategic alternatives to maximize shareholder value,” it said in the statement announcing its quarterly results, repeating a phrase that’s often interpreted as the equivalent of hanging an “Everything Must Go” sign in a window.
The moves did not calm nervous investors, who continued to dump the stock and forced Lehman to move toward a sale more quickly. “You’ve got a valuable franchise but you’ve also got a risk of write-downs,” said Roger Lister, chief credit officer for U.S. financial institutions at DBRS. “We’ve gone from irrational exuberance to excessive fear.”
Mr. Paulson’s outsized 24/7 job these days is to find a way to curb that fear.
Paulson to face tough questions from Congress
Treasury Secretary Henry Paulson will likely face probing questions Tuesday about taxpayer liability when he makes his first congressional appearance since the government takeover of Fannie Mae and Freddie Mac.
A half-dozen Democrats and Republicans on the Senate Banking Committee, which will be questioning Mr. Paulson, have already voiced skepticism about his assurances that taxpayers are unlikely to foot any megabillion-dollar bills. Coming on the heels of Mr. Paulson’s earlier testimony in July that he saw no immediate need to use his new authority to rescue the mortgage giants, several senators on the panel expressed doubts last week about his credibility.
“Paulson won’t be treated as a hero,” observed Peter Wallison, former Treasury Department general counsel and White House counsel in the Reagan administration.
The Fannie-Freddie takeover plan authorizes the Treasury to buy up to $200 billion worth of stock in the mortgage guarantors to keep them solvent. Mr. Paulson has said it’s unlikely the government will have to use this authority, because its active backing of the companies will assure an infusion of capital.
“I’m skeptical; I’m skeptical, and I’m anxious about all of it,” Sen. Richard Shelby of Alabama, the ranking Republican on the banking committee, told the Public Broadcasting Service last week. “I hope that we don’t have to use the taxpayers’ money here to prop these entities up, but I fear that we will before it’s over with.”
Committee chairman Chris Dodd (D-Conn.) echoed Mr. Shelby’s concerns. Mr. Dodd and other senators also expressed pique that Mr. Paulson successfully appealed to lawmakers in July for authority to spend billions to rescue the companies while assuring them he didn’t intend to use that authority.
“He knew all along he was going to have to use this authority despite what he was telling Congress and the American people at the time,” Sen. Jim Bunning, a Kentucky Republican, said last week.
In the end, Mr. Paulson will try to assure the senators he had little choice but to step in because persistent doubts about Fannie and Freddie’s capital level and its ability to repay debt were roiling U.S. and international markets, observers said.
“We’re in uncharted waters about the economy as a whole and housing finance in particular,” said Douglas Elmendorf, a fellow at the liberal-leaning Brookings Institution who was deputy assistant treasury secretary in the Clinton administration. “What he arranged was an appropriate policy response to a very threatening situation.”
Even so, Mr. Paulson won’t be able to address longer-term questions about Fannie’s and Freddie’s structure, how the takeover will affect mortgage interest rates, and whether it will stabilize financial markets. By putting the companies in a government-run conservatorship, Mr. Paulson has left key decisions to Congress and the next administration.
“This plan will be met with broad acceptance in Congress because it doesn’t prejudge the ultimate fate of Fannie Mae and Freddie Mac,” said Sen. Charles Schumer (D-N.Y.).
That doesn’t mean the lame-duck Treasury secretary won’t be asked harsh questions, including:
1. How big will the tab be?
Whether taxpayers will have to pony up any of the $200 billion that the administration has authorized, and how much, hinges on Fannie’s and Freddie’s performance in the unpredictable housing market. Some experts think that taxpayer obligations may amount to little or nothing, while others say the sky’s the limit.
“It’s impossible to know,” said Josh Rosner, an analyst at the Graham Fisher independent research firm. “It depends on how much worse the financial markets get, how much worse the housing market becomes and how long it stays there.”
In July, the Congressional Budget Office estimated a possible $25 billion federal budgetary cost based on the companies’ projected losses. At the same time, though, it incorrectly predicted that Treasury would not use its authority for a takeover.
Under the administration’s plan, the Treasury will get $1 billion in preferred shares in each mortgage company, plus warrants that if exercised would give it an 80% stake in each company, without putting up any money.
The taxpayers would come in if either Freddie or Fannie becomes insolvent, that is, its liabilities come to exceed its assets. Then Treasury would have to step in to make up the difference by doing the equivalent of buying senior preferred shares at $1,000 a share.
“It’s entirely possible it could turn out to be a profitable investment, as the Chrysler guarantees of the 1980s turned into a profitable deal for taxpayers,” said Alex Pollock, an American Enterprise Institute fellow who was chief executive of the Federal Home Loan Bank of Chicago from 1991 to 2004.
2. What price will Fannie and Freddie management pay?
Mr. Paulson will be appearing on Tuesday with James Lockhart, director of the Federal Housing Finance Agency, which oversees Fannie and Freddie. Other questions the duo may be asked to focus on concern the compensation packages for departing CEOs of the mortgage companies, the prospect of layoffs, and their view of so-called covered bonds as alternative financing vehicles to securitizations typically sold to Fannie and Freddie.
Two Democratic senators on the committee, Mr. Schumer and Jack Reed of Rhode Island, wrote Mr. Lockhart last week urging a review of the pay packages for departing Fannie CEO Daniel Mudd and Freddie CEO Richard Syron. “We find it way out of line,” the senators wrote.
Mr. Bunning introduced legislation to bar the CEOs from getting severance payments. Presidential candidates Barack Obama and John McCain have also criticized the packages.
No final decision on the pay has yet been made. Mr. Mudd could receive more than $9 million in combined severance pay, retirement benefits and deferred compensation, while Mr. Syron may get as much as $15 million (see the Pay Matrix on Page 17).
Adding fuel to the fire is the pay the executives received in recent years, while their companies’ returns hit the skids. In 2006 and 2007, Messrs. Mudd and Syron got packages “that consistently exceeded levels for even large S&P 500 companies,” even as Fannie’s and Freddie’s shareholder returns declined, the Corporate Library, an independent corporate governance research firm, reported Friday.
3. How will Fannie and Freddie be restructured?
Key to an answer will be the success, or lack thereof, of covered bonds as a substitute for the securitization of mortgages with the help of Fannie and Freddie.
The bonds are issued by banks and backed by a pool of mortgages that the banks hold on their balance sheets. In contrast, mortgages are removed from the balance sheets through securitization. The big difference: With covered bonds, banks must replace defaulted mortgages in the pool with performing mortgages. Previously, they washed their hands of securitized mortgages, or at least told investors and regulators they had done so at the time.
Mr. Paulson has previously endorsed covered bonds, which have been widely used in Europe for two centuries, with $3 trillion of them outstanding today. Only two U.S. lenders now issue covered bonds: Bank of America and Washington Mutual, said Jerry Marlatt, a law partner at Clifford Chance who handled Washington Mutual’s issuance of the bonds. Rep. Scott Garrett (R-N.J.) introduced legislation last month to provide protections for covered-bond investors.
Proponents argue that they offer a safer and more efficient form of financing than securitized bonds packaged by Wall Street firms and sold to the mortgage giants. But there are serious questions as to whether investors will show sufficient interest in them. Unlike covered bonds in Europe, which are a general obligation of the issuers and thus backed by all of their assets, covered bonds as envisioned here would limit the collateral to mortgages.
Looking ahead to next year, Congress may consider a number of options for restructuring Fannie and Freddie, if it decides to reshape them at all. Among these options are shrinking the companies and turning them into public utilities, maintaining them more or less as is, or effectively liquidating them by selling off their assets.
Mr. Wallison, a senior fellow at the conservative-leaning American Enterprise Institute, sees in Mr. Paulson’s plan the seeds of a continuation of Fannie and Freddie in their current form.
“It appears Paulson is trying to resurrect the companies and return them to profitability,” he said. “If so, Congress will continue to exploit the companies for contributions and not make any changes.”
If Lehman collapses expect a run on all of the other broker dealers and the collapse of the shadow banking system
It is now clear that we are again – as we were in mid- March at the time of the Bear Stearns collapse – an epsilon away from a generalized run on most of the shadow banking system, especially the other major independent broker dealers (Lehman, Merrill Lynch, Morgan Stanley, Goldman Sachs).
If Lehman does not find a buyer over the weekend and the counterparties of Lehman withdraw their credit lines on Monday (as they all will in the absence of a deal) you will have not only a collapse of Lehman but also the beginning of a run on the other independent broker dealers (Merrill Lynch first but also in sequence Goldman Sachs and Morgan Stanley and possibly even those broker dealers that are part of a larger commercial bank, I.e. JP Morgan and Citigroup).
Then this run would lead to a massive systemic meltdown of the financial system. That is the reason why the Fed has convened in emergency meetings the heads of all major Wall Street firms on Friday and again today to convince them not to pull the plug on Lehman and maintain their exposure to this distressed broker dealer.
This bail-in of investors is the opposite of a bailout of investors like the one that was done in the case of Bear Stearns and Fannie and Freddie. It is thus akin to the bail-in of investors that was done in the case of LTCM in the summer of 1998 and the bail-in of the interbank creditors of Korean banks in the winter of 1997.
Since government bailouts put at risk public money and create moral hazard Treasury and the Fed decided that they need to draw a line somewhere after the bailouts of Bear Stearns creditors, of Fannie and Freddie and all the other actions aimed at backstopping the financial system.
These actions have included the creation of the TAF, TSLF, PDCF, the use of the FHLBs to provide liquidity to distressed mortgage lenders, the provision of Treasury liquidity to the FHLBs, the outright purchase of agency MBS by the Treasury, the swapping of two thirds of the safe Treasuries of the Fed for toxic illiquid securities of banks and non banks, etc. So after having created the mother of all moral hazard with their actions (including the biggest bailout of all, i.e. the rescue of Fannie and Freddie) the Fed and Treasury are playing a chicken game with the financial system.
Tim Geithner told clearly to the heads of all the major Wall Street firms that if they pull the plug on Lehman and Lehman collapses they are next in line for a run on their institutions. So if a buyer for Lehman is not found (or even if it is found and the counterparty lines are still pulled) not only Lehman will collapse but the run will extend to all of the other major broker dealers and banks that are the counterparties of Lehman.
The Fed may delude itself in thinking – as its stress models suggest – that the systemic risk of a collapse of Lehman are less serious than those of Bear Stearns: afterall Lehman is less involved into CDSs than Bear was and now both Lehman and the other major broker dealers have access to the discount window with the PDCF.
A collapse of Lehman instead will have as much of a systemic effect as the collapse of Bear for many reasons: Lehman is larger than Bear was; Lehman is a major player in a variety of key financial markets; all the other major Wall Street institutions are interconnected with Lehman in dozens of different types of counterparty activities; the PDCF support of the Fed is neither unlimited nor unconditional, i.e. investors cannot assume that Lehman or any other broker dealer can borrow unlimited amounts with no conditions from the discount window.
Thus, a collapse of Lehman would trigger a panic and a potential run on all sort of other broker dealers and also on other distressed financial institutions like banks (WaMu) and insurance companies (AIG) and smaller member of the shadow financial system (distressed and highly leveraged hedge funds, etc.).
The reason why Lehman is having a hard time to find a buyer is that it is most likely insolvent. If you had to mark to market the value of it illiquid and toxic assets (the $40 billion of commercial real estate assets, its remaining residential MBS and CDOs, its holdings of real estate private equity funds) Lehman is most likely insolvent (i.e. has negative net worth with liabilities well above its impaired assets).
So leaving aside the potential and now dubious value of its franchise (an option to the value of a much slimmed down financial institution) no financial institution should be paying even a single penny to buy an insolvent firm.
That is why all the potential suitors of Lehman (such as Bank of America and others) are waiting for the government to provide another sleazy Bear Stearns deal where the government would buy at higher than market value the toxic assets of Lehman (the commercial real estate assets for example) so as to make the net worth of the remaining institution positive and worth buying. But such action – borderline illegal in the case of Bear as pointed out by Paul Volcker – would be a scandal in the case of Lehman and severely exacerbate the moral hazard problem.
But here lies the conundrum of this Lehman crisis: no one seems to want to buy for a positive price Lehman unless there is a public subsidy (taking off their toxic assets off the firms’ balance sheet). The government cannot afford to provide the subsidy as the moral hazard problems are becoming severe. But then if on Monday no deal is done Lehman collapses and goes into Chapter 11 court and you have the beginning of a systemic financial meltdown as the run on the other broker dealers will start.
Thus, what Fed and Treasury are trying to do this weekend is another 1998 LTCM bailin or Korea 1997 bailin, i.e. trying to convince all the major institutions to either support a purchase of Lehman or maintain their exposure to Lehman if no buyers is found. Can this bail-in work? It is not clear as there is a major collective action problem: you can’t only convince half a dozen major Wall Street firms to maintain their exposure to Lehman.
You need also to convince all the other counterparties of Lehman (including the hedge funds and the other broker dealers and banks) not to roll off their claims and credit to Lehman. This is a much more messy collective action problem and coordination game than in the case of LTCM and Korea where the number of involved counterparties was more limited (less than 20 in each case).
Paulson and Bernanke and Geithner (the troika managing this financial crisis) have all made public statements in the last few month to the necessity of finding an orderly way to close down – rather than bailout – a major and systemically important non bank financial institutions: the embarrassment and losses for the Fed that the bailout of the creditors of Bear led made it paramount to avoid another Bear like bailout.
That is why they are now playing tough with Lehman and its creditors. But in this game of chicken the Fed and the Treasury may end up being the ones to blink. Faced with the risk of a generalized run on the other broker dealers they may decide that greasing again a deal for the purchase of Lehman may be less costly and less risky than testing whether the system can orderly work out a collapse of Lehman (something that is highly uncertain).
Even in the case of the Bank of America purchase of Countrywide such public subsidy was significant (the FHLB of Atlanta lent to Countrywide over $50 billion and Bank of America has most likely received plenty of tacit forbearance from the Fed to support its takeover of an insolvent Countrywide). So implicitly or explicitly the Fed and the Treasury may decide – however reckless and moral hazard laden that choice may be – to provide some explicit or implicit subsidy to a private purchase of Lehman.
The trouble is that, in spite of all public statements regarding the need to provide an orderly demise of large broker dealers, the Fed and the Treasury have done nothing to create such insolvency regime for such broker dealers. So the only option for Lehman – if a buyer is not found - will be the one of ending up in Chapter 11 and trigger massive losses on its counterparties that will in turn trigger a run on such counterparties.
In February of 2008 I predicted – in my “12 Steps to a Financial Disaster” – that one or two major broker dealers would go bankrupt. A month later Bear Stearns went bust and the collapse of the other ones was avoided for a time by the most radical change in monetary policy since the Great Depression, i.e. the creation of the PDCF that extended the lender of last resort (LOLR) role of the Fed to non-bank systemically important broker dealers (i.e. all of the bank and non bank primary dealers of the Fed).
I next argued in June that such action would not prevent a run on other broker dealers such Lehman as to avoid a run you need both deposit insurance and unlimited and unconditional access to the Fed LOLR support. I also discussed why Lehman was next in line for a collapse and why the PDCF would not prevent a run on Lehman.
I also argued in follow-up pieces that, in a matter of two years, no one of the remaining independent broker dealers (Lehman, Merrill Lynch, Morgan Stanley and Goldman Sachs) would survive as: 1. their business model is now impaired (securitization is semi-dead); 2. they will need to be regulated like banks given the PDCF support and thus have lower leverage, higher liquidity and more capital that will erode their profitability; 3. Their severe maturity mismatch – borrowing very short term and liquid, leveraging a lot and lending and investing in more long term and illiquid ways – makes them very fragile – in the absence of deposit insurance and in the presence of only limited LOLR support by a central bank – to bank like run that are destructive even of illiquid but otherwise solvent institutions.
Thus all such broker dealers need to merge with larger financial institutions that have a commercial banking arm and thus access to stable and insured deposits and to true LOLR Fed support. That process of unraveling of independent broker dealers started with Bear Stearns; now it is moved to Lehman; tomorrow Merrill Lynch will be on line; and Morgan Stanley and Goldman Sachs will be next. No one of them can and will survive as independent entities. So, the Fed and Treasury should advise them all to start finding a large international partner (international as almost no domestic partner is now sound to take them over) and merge with such partner before we get another Bear or Lehman disaster.
The step by step, ad hoc and non-holistic approach of Fed and Treasury to crisis management has been a failure so far as plugging and filling one hole at the time is useless when the entire system of levies is collapsing in the perfect financial storm of the century. A much more radical, holistic and systemic approach to crisis management is now necessary.
What we are facing now if the beginning of the unraveling and collapse of the entire shadow financial system, a system of institutions (broker dealers, hedge funds, private equity funds, SIVs, conduits, etc.) that look like banks (as they borrow short, are highly leveraged and lend and invest long and in illiquid ways) and thus are highly vulnerable to bank like runs; but unlike banks they are not properly regulated and supervised, they don’t have access to deposit insurance and don’t have access to the lender of last resort support of the central bank (with now only a small group of them having access to the limited and conditional and thus fragile support of the Fed).
So no wonder that this shadow banking system is now collapsing. The entire conduits/SIV system has already collapsed with the roll-off of their ABCP financing; next is the collapse of the broker dealers (Bear, Lehman and soon enough the other ones) that rely mostly on unstable overnight repos and other very short term funding for their financing; next will be hundreds of poorly managed hedge funds that will face a tsunami of redemptions; and finally runs on money market funds that are not supported by a large financial institutions or other smaller member of the shadow banking system as well as highly leveraged and distressed private equity funds cannot be ruled out either.
This is indeed the most severe financial crisis since the Great Depression and occurring at a time when the US is falling in a now severe consumer led recession. The vicious interaction between a systemic financial and banking crisis and a severe economic contraction will get much worse before there is any bottom to it. We are only in the third inning of a nine innings economic and financial crisis. And the only light at the end of the tunnel is the one of the incoming train wreck.