I'm going to field this question as I walk out the door because I don't think it's too difficult. Many are wondering why the Obama administration is taking such a hard line with the auto manufacturers while being so tolerant to the banks. Here are five reasons, in no particular order.
1. Banks pose greater systemic risks than the auto manufacturers. Although the effects of auto manufacturers going bankrupt would be immense, it would be worse to let the banks fail.
2. Banks are operationally solvent. Meaning, they have enough money to pay their bills and have only taken money from the Government to comply with regulation. Auto manufacturers can't even pay their bills, which is mostly due to their high labor costs.
3. Auto makers have been losing market share for the last ten years or so. Up until last year, banks have made money every year.
4. The White House is teaming with former Wall Street executives, which may account for why they understand the wall street funk.
5. The automobile industry has a lot more long-term uncertainty surrounding their business model (i.e. cars that run on alternative fuels, etc.). On the other hand, the low interest rate environment has actually helped banks this year as the spread between what they pay the depositors and what they lend is relatively wide. The majority of banks will be profitable this year (by profitable, I mean in a healthy way).
Tuesday, March 31, 2009
Monday, March 30, 2009
Insights from PE Conference Part II
More of the same doom and gloom scenarios with some interesting comments from the former head of the EBRD (European Bank for Reconstruction and Development).
-There are major issues with banks in Europe since it is not uncommon for a bank's subsidiary, which functions entirely separately from its parent, to need additional capital to prevent a failure. Here's the problem, the parent bank is located in a different country. So XYZ bank is headquartered in Poland and has an Italian subsidiary that needs additional capital. Taxpayers in Poland have to put up the money to save an ostensibly Italian bank. That's caused some contention.
-Eastern and Central European consumers are more reselient than U.S. consumers because they are not as demanding. Most Europeans in the developing regions are more resourceful and use to living on meager incomes. So it's unlikely the consumer will be as distressed in those areas as they are in other developing regions.
-Lots of talk regarding the deleveraging of the U.S. consumer. That's a fancy way of saying americans are going to save more. According to a brand new study by McKinsey, every percentage point gained in the personal savings rate translates into $100 Billion of decreased spending, which can be a major drag on the economy. This of course, assumes income growth remains stagnate (which it has since 2000). If incomes increase, then spending can increase and savings can grow.
-There are major issues with banks in Europe since it is not uncommon for a bank's subsidiary, which functions entirely separately from its parent, to need additional capital to prevent a failure. Here's the problem, the parent bank is located in a different country. So XYZ bank is headquartered in Poland and has an Italian subsidiary that needs additional capital. Taxpayers in Poland have to put up the money to save an ostensibly Italian bank. That's caused some contention.
-Eastern and Central European consumers are more reselient than U.S. consumers because they are not as demanding. Most Europeans in the developing regions are more resourceful and use to living on meager incomes. So it's unlikely the consumer will be as distressed in those areas as they are in other developing regions.
-Lots of talk regarding the deleveraging of the U.S. consumer. That's a fancy way of saying americans are going to save more. According to a brand new study by McKinsey, every percentage point gained in the personal savings rate translates into $100 Billion of decreased spending, which can be a major drag on the economy. This of course, assumes income growth remains stagnate (which it has since 2000). If incomes increase, then spending can increase and savings can grow.
Thursday, March 26, 2009
Insights
For the next two days I'll be at the Thunderbird Global Private Equity Conference. The first couple of presentations have been interesting. Here are some tidbits.
Regarding TARP Money. An executive from a large bank that took money from the TARP had to rescind job offers to several candidates because he was informed that banks who recieve money from TARP can't hire non-U.S. citizens. Ouch. Can you say talent flight?
On the Treasury's new plan. Seems like consensus is that the new proposed partnerships (I know, I promised a post on this and will complete it soon) between the governement, banks, and private money, is a logistical nightmare. I can't say I'm surprised. You have three separate parties trying to establish a "fair" price. And everyone has a different agenda.
More shoes to drop. Not to go into detail, but bond spreads are predicting defaults to go from approximately 5% to 15%. That's not great news for employment, and, by extension, GDP.
China's political backlash. Earlier this week China said it was worried about the solvency of the U.S. That should scare most people. China is the largest holder of U.S. treasuries. If China decides to dump them for a safer investment, we would have massive hyperinlation (I know, that's redundant). I don't think that will happen for two reasons. First, there really aren't any other currencies I can think of that are safer and second, they'd be shooting themselves in the foot. China's GDP is like 50% exported and the U.S. is the largest net buyer. Guess what happens if we can't afford their goods due to our hyperinflation?
More to come.
Regarding TARP Money. An executive from a large bank that took money from the TARP had to rescind job offers to several candidates because he was informed that banks who recieve money from TARP can't hire non-U.S. citizens. Ouch. Can you say talent flight?
On the Treasury's new plan. Seems like consensus is that the new proposed partnerships (I know, I promised a post on this and will complete it soon) between the governement, banks, and private money, is a logistical nightmare. I can't say I'm surprised. You have three separate parties trying to establish a "fair" price. And everyone has a different agenda.
More shoes to drop. Not to go into detail, but bond spreads are predicting defaults to go from approximately 5% to 15%. That's not great news for employment, and, by extension, GDP.
China's political backlash. Earlier this week China said it was worried about the solvency of the U.S. That should scare most people. China is the largest holder of U.S. treasuries. If China decides to dump them for a safer investment, we would have massive hyperinlation (I know, that's redundant). I don't think that will happen for two reasons. First, there really aren't any other currencies I can think of that are safer and second, they'd be shooting themselves in the foot. China's GDP is like 50% exported and the U.S. is the largest net buyer. Guess what happens if we can't afford their goods due to our hyperinflation?
More to come.
Sunday, March 22, 2009
Summing up the AIG bonus debate
Hard to watch/listen to any news without hearing about AIG's $165 million dollar bonus payout. I guess I was a little surprised how quickly the story spiraled out of control. My blood started to boil when I heard a prominent democrat (I won't mention HER name but will only say that it rhymes with "smelosi") illustrate what could generously be referred to as a complete lack of insight, knowledge or even a general awareness of the circumstances and points of debate regarding the bonuses AIG paid out to their employees. I'm not making a political statement. This is not a political blog. Many members of congress, on both sides of the aisle, misunderstand the situation but I only heard her comments due to her public profile.
What Happened
AIG received $170 billion from TARP and posted a 4th quarter loss of ~$60 billion. A week ago AIG announced it was paying out $165 million in bonuses to various employees. Total payouts by AIG could reach over $1.2 billion. The difference accounts for additional performance and retention bonuses. Can't wait for that to happen. And you think $165 million is bad?
So here's a smattering from around the web. I tried to find arguements on both sides, but gave up after discovering there really isn't a logical contra-arguement against the paying of the bonuses, mostly just populist rage. Here what strikes me as funny, everybody hates these guys are getting paid, but no one knows for what or for when and everybody hates the 90% tax. Tell me again why we're having this arguement? Is it even productive?
As you can expect, comments range all over, from very sophisticated "These bonuses are terrible but must be paid as a matter of contract" to "Hey, Pa, come n' see what those @#$%* from AIG that knocked up Jenny done did!" Alas, the apparent risks of a computer in every home.
First....
Rick Newman U.S. News explains why we are so outraged.
Myriad experiments in behavioral economics have found that people are willing to pay to punish members of a group whom they believe to be shirkers or free-riders. In other words, people are willing to make themselves worse off (they have to pay their own money) in order to insure that others don’t get undeserved rewards. But when it comes to the A.I.G. bonuses, the costs of clawing them back are trivial at best, while the public satisfaction at seeing what feels like justice being served will be great. Getting all worked up about this money may not, strictly speaking, be rational, but I think that paradoxically, if some of this money is clawed back, it’ll increase the chances that we’ll be able to keep dealing with the ongoing crisis in a rational way in the future.
On to the rational minds...
Andrew Ross Sorkin (Editor, NY Times).
The fundamental value here is the sanctity of contracts. Imagine what it would look like if the business community started to worry that the government would start abrogating contracts left and right. A.I.G. built this bomb, and it may be the only outfit that really knows how to defuse it. If they leave — the buzz on Wall Street is that some have, and more are ready to — they might simply turn around and trade against A.I.G.’s book. Why not? They know how bad it is. They built it. Let them leave, you say. Where would they go, given the troubles in the financial industry? But the fact is, the real moneymakers in finance always have a place to go. You can bet that someone would scoop up the talent from A.I.G. and, quite possibly, put it to work — against taxpayers’ interests.
SmartMoney
For the stock market, this is a rally-killer. Or worse. No one seems to want to determine whether the people getting this money deserve it or not. Maybe some of them don't—maybe some of them are even the bad people who got AIG into trouble in the first place. But maybe some of them do deserve it. Maybe there's one guy or gal who has just done some brilliant trade that has made taxpayers billions, at least offsetting some of the billions in losses. Should that trader not get a bonus? No one seems to care that the 90% tax will apply to all banks that have accepted federal money, not just to AIG. That includes banks like Wells Fargo, who told Treasury secretary Henry Paulson that they didn't even want the money when the Troubled Asset Relief Program (TARP) was enacted last October. Reluctantly, Wells took the money at Paulson's urging, as did other healthy banks such as JPMorgan. Now virtually every employee of every one of them faces a 90% tax on their bonuses. No one seems to care that the Internal Revenue Code is designed to collect federal revenue, not to punish particular classes of people. These employees will simply leave. Or they will turn their brains off. Either way, the taxpayers whose money is at stake in these companies will be hurt—because these companies will crash and burn.A successful economy depends more than anything else on the rule of law. There has to be a stable set of rules governing the interactions between economic players, and between players and the government.
From the Wall Street Journal
If the A.I.G. bonuses looked were the quintessential example of Wall Street self-dealing, the House’s bill looks like a quintessential example of blunt and ill-considered political policymaking. On top of that, one logical consequence of this bill would be that companies will simply pay people much higher base salaries, which takes us in the wrong direction.
Henry Blogett at Clustershock
Today’s frantic passage of the Populist Rage Tax was a new low in the US government’s response to this crisis. It shows just how likely we are to doom ourselves to a decade or more of misery — by choking our markets, closing our borders, turning our banks into tools of social policy, and wrecking what’s left of our economy. If the “TARP bonus” bill the House passed today becomes law, any of the hundreds of thousands of people who work for Citigroup, Bank of America, AIG, and nine other major US corporations will have to fork over 90 cents of every dollar they make that puts their household income over $250,000. That’s household income, not individual income. If you’re married and filing singly, you’ll have to surrender anything over $125,000. Indefinitely.
Eric Etheridge, NYTimes
As the financial crisis has evolved its moral has been simplified, grotesquely. In the beginning this crisis was messy. Wall Street financiers behaved horribly but so did ordinary Americans. Millions of people borrowed money they shouldn’t have borrowed and, not, typically, because they were duped or defrauded but because they were covetous and greedy: they wanted to own stuff they hadn’t earned the right to buy. But now that taxpayer money is on the line the story has changed: innocent taxpayers are now being exploited by horrible Wall Street financiers. The guy who defaulted on mortgages on his six spec houses in the Nevada desert has turned himself into the citizen enraged by the bonuses paid to the AIG employees trying to sort out the mess caused by his defaults.
David Harsanyi at DenverPost
Here's an idea: If you stop nationalizing banks, there will be no need to engage in phony-baloney indignation over bonus payments anymore. Don't we want AIG to succeed and get off the government dole? What sort of employee would work for an entity that doesn't honor its contractual obligations? How many valuable employees will walk away from such a company?
Chris Bowers at OpenLeft describes why the tax needs to be broad
1. Passing Constitutional Muster: Lawrence Tribe has written that, in order for a bonus tax to be constitutional, it must be "sufficiently general to avoid classification as a measure targeting solely a closed class of identified and named individuals." The more narrow the bonus tax legislation, the less likely it will be ruled constitutional. As such, making the bonus tax as broad as possible is necessary to the survival of the legislation.
2. Weeding out thieves from the bailout program: The bonus tax must apply to all participants in the bailout program, so as to guarantee that only those firms and people interested in helping the economy participate. Anyone who considers their personal compensation to be more important than helping the economy needs to be kept as far away from the bailout program as possible.
3. Addressing a broad culture of greed and excessive executive compensation: I agree with President Obama that the bonus scandal is a "a symptom of a larger problem," based on a broader "culture of greed.". As such, if the bonus tax that is aimed only at AIG, then it simply is not good enough legislation. The bonus tax has to make a broad dent in broader problem of excessive financial services industry employee compensation, which is directly connected to our ever widening income inequality. This is one of the best opportunities I can ever remember to pass such a law.
What Happened
AIG received $170 billion from TARP and posted a 4th quarter loss of ~$60 billion. A week ago AIG announced it was paying out $165 million in bonuses to various employees. Total payouts by AIG could reach over $1.2 billion. The difference accounts for additional performance and retention bonuses. Can't wait for that to happen. And you think $165 million is bad?
So here's a smattering from around the web. I tried to find arguements on both sides, but gave up after discovering there really isn't a logical contra-arguement against the paying of the bonuses, mostly just populist rage. Here what strikes me as funny, everybody hates these guys are getting paid, but no one knows for what or for when and everybody hates the 90% tax. Tell me again why we're having this arguement? Is it even productive?
As you can expect, comments range all over, from very sophisticated "These bonuses are terrible but must be paid as a matter of contract" to "Hey, Pa, come n' see what those @#$%* from AIG that knocked up Jenny done did!" Alas, the apparent risks of a computer in every home.
First....
Rick Newman U.S. News explains why we are so outraged.
Myriad experiments in behavioral economics have found that people are willing to pay to punish members of a group whom they believe to be shirkers or free-riders. In other words, people are willing to make themselves worse off (they have to pay their own money) in order to insure that others don’t get undeserved rewards. But when it comes to the A.I.G. bonuses, the costs of clawing them back are trivial at best, while the public satisfaction at seeing what feels like justice being served will be great. Getting all worked up about this money may not, strictly speaking, be rational, but I think that paradoxically, if some of this money is clawed back, it’ll increase the chances that we’ll be able to keep dealing with the ongoing crisis in a rational way in the future.
On to the rational minds...
Andrew Ross Sorkin (Editor, NY Times).
The fundamental value here is the sanctity of contracts. Imagine what it would look like if the business community started to worry that the government would start abrogating contracts left and right. A.I.G. built this bomb, and it may be the only outfit that really knows how to defuse it. If they leave — the buzz on Wall Street is that some have, and more are ready to — they might simply turn around and trade against A.I.G.’s book. Why not? They know how bad it is. They built it. Let them leave, you say. Where would they go, given the troubles in the financial industry? But the fact is, the real moneymakers in finance always have a place to go. You can bet that someone would scoop up the talent from A.I.G. and, quite possibly, put it to work — against taxpayers’ interests.
SmartMoney
For the stock market, this is a rally-killer. Or worse. No one seems to want to determine whether the people getting this money deserve it or not. Maybe some of them don't—maybe some of them are even the bad people who got AIG into trouble in the first place. But maybe some of them do deserve it. Maybe there's one guy or gal who has just done some brilliant trade that has made taxpayers billions, at least offsetting some of the billions in losses. Should that trader not get a bonus? No one seems to care that the 90% tax will apply to all banks that have accepted federal money, not just to AIG. That includes banks like Wells Fargo, who told Treasury secretary Henry Paulson that they didn't even want the money when the Troubled Asset Relief Program (TARP) was enacted last October. Reluctantly, Wells took the money at Paulson's urging, as did other healthy banks such as JPMorgan. Now virtually every employee of every one of them faces a 90% tax on their bonuses. No one seems to care that the Internal Revenue Code is designed to collect federal revenue, not to punish particular classes of people. These employees will simply leave. Or they will turn their brains off. Either way, the taxpayers whose money is at stake in these companies will be hurt—because these companies will crash and burn.A successful economy depends more than anything else on the rule of law. There has to be a stable set of rules governing the interactions between economic players, and between players and the government.
From the Wall Street Journal
If the A.I.G. bonuses looked were the quintessential example of Wall Street self-dealing, the House’s bill looks like a quintessential example of blunt and ill-considered political policymaking. On top of that, one logical consequence of this bill would be that companies will simply pay people much higher base salaries, which takes us in the wrong direction.
Henry Blogett at Clustershock
Today’s frantic passage of the Populist Rage Tax was a new low in the US government’s response to this crisis. It shows just how likely we are to doom ourselves to a decade or more of misery — by choking our markets, closing our borders, turning our banks into tools of social policy, and wrecking what’s left of our economy. If the “TARP bonus” bill the House passed today becomes law, any of the hundreds of thousands of people who work for Citigroup, Bank of America, AIG, and nine other major US corporations will have to fork over 90 cents of every dollar they make that puts their household income over $250,000. That’s household income, not individual income. If you’re married and filing singly, you’ll have to surrender anything over $125,000. Indefinitely.
Eric Etheridge, NYTimes
As the financial crisis has evolved its moral has been simplified, grotesquely. In the beginning this crisis was messy. Wall Street financiers behaved horribly but so did ordinary Americans. Millions of people borrowed money they shouldn’t have borrowed and, not, typically, because they were duped or defrauded but because they were covetous and greedy: they wanted to own stuff they hadn’t earned the right to buy. But now that taxpayer money is on the line the story has changed: innocent taxpayers are now being exploited by horrible Wall Street financiers. The guy who defaulted on mortgages on his six spec houses in the Nevada desert has turned himself into the citizen enraged by the bonuses paid to the AIG employees trying to sort out the mess caused by his defaults.
David Harsanyi at DenverPost
Here's an idea: If you stop nationalizing banks, there will be no need to engage in phony-baloney indignation over bonus payments anymore. Don't we want AIG to succeed and get off the government dole? What sort of employee would work for an entity that doesn't honor its contractual obligations? How many valuable employees will walk away from such a company?
Chris Bowers at OpenLeft describes why the tax needs to be broad
1. Passing Constitutional Muster: Lawrence Tribe has written that, in order for a bonus tax to be constitutional, it must be "sufficiently general to avoid classification as a measure targeting solely a closed class of identified and named individuals." The more narrow the bonus tax legislation, the less likely it will be ruled constitutional. As such, making the bonus tax as broad as possible is necessary to the survival of the legislation.
2. Weeding out thieves from the bailout program: The bonus tax must apply to all participants in the bailout program, so as to guarantee that only those firms and people interested in helping the economy participate. Anyone who considers their personal compensation to be more important than helping the economy needs to be kept as far away from the bailout program as possible.
3. Addressing a broad culture of greed and excessive executive compensation: I agree with President Obama that the bonus scandal is a "a symptom of a larger problem," based on a broader "culture of greed.". As such, if the bonus tax that is aimed only at AIG, then it simply is not good enough legislation. The bonus tax has to make a broad dent in broader problem of excessive financial services industry employee compensation, which is directly connected to our ever widening income inequality. This is one of the best opportunities I can ever remember to pass such a law.
Saturday, March 14, 2009
Banking Paralysis
Some of you could probably tell I've been intentionally avoiding posting on the economy specifically for a few weeks as I was waiting for the stimulus mess to sort itself out. I hoped to post something about President Obama's stimulus package in more detail, but, after following several publications over the last couple of months on the matter, determined there are enough sites out there to explain what the stimulus means to the "average Joe." But I would like to address a couple of items that have come up in conversations/emails. They are 1) What is taking the Banks so long to get their act together and 2) What does a Bank "Recap" mean?. So there's still lots of discussion around financial services. This discussion however, is different than the commentary six months ago. I'm not going to answer these questions in order, or even in one post, but instead lay out, basically, how banks work. Doing this, I think, will help give perspective to the ongoing financial paralysis. I apologize if this sound condescending, but I have no idea who is reading this blog so I will write to the least common denominator.
How Do Banks Make Money
You open a checking and/or savings account with the Bank and they pay you little to no interest. Then, they take your money and lend it out at say 6%. If the Bank pays you 2% on your savings account, they are making 4% on your money. More specifically, they pay you 2% on your savings account and lend your money to home buyers (in the form of a mortgage) for 6%.
What does it mean to "Securitize" a mortgage?
I wrote about this in an earlier post but will briefly summarize here. Let's say your mortgage is with Bank A for $200,000. You pay the bank say $1,500/mo for 30 years in exchange for the $200,000 up front (you're total payment is $540,000 over 30 years). But perhaps Bank B wants to buy your mortgage from Bank A. So Bank A sells the mortgage, for about $200,000. In this role, Bank A acts as an intermediary and only makes money off of closing fees. Your mortgage is now with Bank B, and they have claim to all future payments. Over the last several years Bank B would typically be an investment bank. Not only would they buy Bank A's mortgages, but they would buy mortgages from thousands of banks. Bank B bundles 1,000 (for example) mortgages together and divvies them out in slices of 10 (each slice has payments from 100 mortgages). This slice can now be called a security, or, a CDO (Collateralized Debt Obligation). The price that another bank would pay for this security is based on the perceived riskiness of the underlying payments, or, the credit worthiness of the borrower. At the time, none of the Banks anticipated the steep decline in housing prices.
Bank Capital
When borrowers began to default because they couldn't refinance their homes the Bank holding the CDO had to write the value of that CDO down accordingly based on mark-to-market (or fair value) accounting. The CDO is an asset to the bank that owns it. Future payment streams from mortgages are assets to banks. However, if the value of the Bank's investment was $10 million a year ago, it's now worth $2 million and they must take a $8 million dollar loss. That's what has been going on over the last year. Let's look at how that affects the Bank by providing an example.
Say you wanted to start a Bank and you were able to come up with $20 million dollars in cash from investors in exchange for equity (i.e. stock) in the bank. Then, you went and borrowed money in the form of Bonds for another $80 million. Now you have $100 million to "invest". Remember, with a bond, you pay the bondholder a set percentage each month, say 4%, of the face value of the bond and at the end of ten years you have to make a lump sum payment to the bondholder for the face amount of the bond (you would have thousands of Bondholders with individual bonds for $1,000 each paying 4%/yr). From the Bank's perspective, Bonds are liabilities. They represent a future obligation the Bank has to someone else. Then, with your $100 million, you go out and buy some CDO's that are paying you 6%. That's a great business model. Your CDO's are paying 2% more than you have to pay your bondholders. But if CDO's fall in value by 80% due to defaulting borrowers in the underlying mortgages, your $100 million of CDO's is now worth $20 million. Keep in mind, you still have to pay your bond holders. Now, your assets are less than your liabilities. Meaning, you don't have enough money coming in from your CDO's to pay your bondholders. The Bank is insolvent. I'm over-simplifying here, but you get the picture. This gets us to about Q3 of last year.
One Thing Exacerbates the Problem
There's a timing issue. You may have noticed at the onset that Banks borrow short and lend long (to use standard industry vernacular). A deposit is a short term liability to the bank, whereas a mortgage is a long term asset. At any point in time a Bank may only have 15-20% of all their deposits on hand in cash. Should depositors want to withdraw all their money at the same time the Bank would not be able to liquidate enough assets to pay their liabilities. This is one sort of "Bank Run." We know from the IndyMac fiasco last year, that all deposits are guaranteed by the FDIC up to $100,000. The problem lies in the fact that most Bank's short-term liabilities are not deposit accounts, and are not insured. To meet these obligations, Banks will typically borrow from other banks. But today, Banks are unwilling to lend to eachother because 1) they are worried the bank won't be solvent based on their exposure to CDO's and 2) they want to hang on to their own cash in case they have the same problem. So banks are just staring at eachother. Finally, a derivative product is to blame for the most recent stagnation--the dreaded Credit Default Swap.
Credit Default Swaps Explained
Back to bonds for a minute. If you want to buy a $100 Bond from JPMorgan you would pay JPM $100 (usually) and they would pay you a set interest rate, say 6% for 10 years, at which point they will pay you $100. You make $6/yr for 10 years and get your $100 dollars back, for a total of $160. Not bad, better than a 2% savings account. But there are two big risks. What if JPMorgan can't pay you back? What if interest rates go up and you're stuck at 6%? You could buy a Credit Default Swap for a few hundredths of a percentage point from an insurer to hedge the default risk (but you can't do much about interest rate risk). The insurer would step in and pay you off in the event the company you bought the bond from defaulted. Simply, they are insurance policies. But, since they're derivatives, the swap itself could be sold for a specific value. Let's make it a little more palpable.
Merrill Lynch owns a bond OR a CDO from Lehman Brothers. They do the sensible thing to protect themselves and buy a CDS to insure against a Lehman default. Since Lehman is a huge company, they go to AIG for the insurance and pay AIG .5%/mo in exchange for the coverage. See the problem? CDO's default, Lehman is insolvent, AIG can't make everyone whole (CDS' aren't regulated so "sellers" of the insurance don't have to have reserves). ML is stuck holding the bag. Whereas ML thought they would be made whole via AIG they are now stuck with major losses on their own assets and are themselves, insolvent Now holders of ML bonds or CDO's must mark down their assets and they are insolvent, triggering another payout by insurers of ML to those that had CDS on ML. And by the way, ML sold their own CDS to other Banks, which they will no longer be able to honor. This massive chain reaction is still playing out across the financial sector. A bank may look healthy but they may be depending on an insurance payment from an insolvent bank.
Hopefully I've been able to elucidate the current financial faceoff in a little more detail. AIG was bailed out because they were the largest sellers of CDS in the world. The government is still trying to figure out ways to either get these toxic CDO's and other mortgage backed securities off the Banks balance sheet, or provide additional capital to "Recap" the bank. Both of which I will treat in the next post.
How Do Banks Make Money
You open a checking and/or savings account with the Bank and they pay you little to no interest. Then, they take your money and lend it out at say 6%. If the Bank pays you 2% on your savings account, they are making 4% on your money. More specifically, they pay you 2% on your savings account and lend your money to home buyers (in the form of a mortgage) for 6%.
What does it mean to "Securitize" a mortgage?
I wrote about this in an earlier post but will briefly summarize here. Let's say your mortgage is with Bank A for $200,000. You pay the bank say $1,500/mo for 30 years in exchange for the $200,000 up front (you're total payment is $540,000 over 30 years). But perhaps Bank B wants to buy your mortgage from Bank A. So Bank A sells the mortgage, for about $200,000. In this role, Bank A acts as an intermediary and only makes money off of closing fees. Your mortgage is now with Bank B, and they have claim to all future payments. Over the last several years Bank B would typically be an investment bank. Not only would they buy Bank A's mortgages, but they would buy mortgages from thousands of banks. Bank B bundles 1,000 (for example) mortgages together and divvies them out in slices of 10 (each slice has payments from 100 mortgages). This slice can now be called a security, or, a CDO (Collateralized Debt Obligation). The price that another bank would pay for this security is based on the perceived riskiness of the underlying payments, or, the credit worthiness of the borrower. At the time, none of the Banks anticipated the steep decline in housing prices.
Bank Capital
When borrowers began to default because they couldn't refinance their homes the Bank holding the CDO had to write the value of that CDO down accordingly based on mark-to-market (or fair value) accounting. The CDO is an asset to the bank that owns it. Future payment streams from mortgages are assets to banks. However, if the value of the Bank's investment was $10 million a year ago, it's now worth $2 million and they must take a $8 million dollar loss. That's what has been going on over the last year. Let's look at how that affects the Bank by providing an example.
Say you wanted to start a Bank and you were able to come up with $20 million dollars in cash from investors in exchange for equity (i.e. stock) in the bank. Then, you went and borrowed money in the form of Bonds for another $80 million. Now you have $100 million to "invest". Remember, with a bond, you pay the bondholder a set percentage each month, say 4%, of the face value of the bond and at the end of ten years you have to make a lump sum payment to the bondholder for the face amount of the bond (you would have thousands of Bondholders with individual bonds for $1,000 each paying 4%/yr). From the Bank's perspective, Bonds are liabilities. They represent a future obligation the Bank has to someone else. Then, with your $100 million, you go out and buy some CDO's that are paying you 6%. That's a great business model. Your CDO's are paying 2% more than you have to pay your bondholders. But if CDO's fall in value by 80% due to defaulting borrowers in the underlying mortgages, your $100 million of CDO's is now worth $20 million. Keep in mind, you still have to pay your bond holders. Now, your assets are less than your liabilities. Meaning, you don't have enough money coming in from your CDO's to pay your bondholders. The Bank is insolvent. I'm over-simplifying here, but you get the picture. This gets us to about Q3 of last year.
One Thing Exacerbates the Problem
There's a timing issue. You may have noticed at the onset that Banks borrow short and lend long (to use standard industry vernacular). A deposit is a short term liability to the bank, whereas a mortgage is a long term asset. At any point in time a Bank may only have 15-20% of all their deposits on hand in cash. Should depositors want to withdraw all their money at the same time the Bank would not be able to liquidate enough assets to pay their liabilities. This is one sort of "Bank Run." We know from the IndyMac fiasco last year, that all deposits are guaranteed by the FDIC up to $100,000. The problem lies in the fact that most Bank's short-term liabilities are not deposit accounts, and are not insured. To meet these obligations, Banks will typically borrow from other banks. But today, Banks are unwilling to lend to eachother because 1) they are worried the bank won't be solvent based on their exposure to CDO's and 2) they want to hang on to their own cash in case they have the same problem. So banks are just staring at eachother. Finally, a derivative product is to blame for the most recent stagnation--the dreaded Credit Default Swap.
Credit Default Swaps Explained
Back to bonds for a minute. If you want to buy a $100 Bond from JPMorgan you would pay JPM $100 (usually) and they would pay you a set interest rate, say 6% for 10 years, at which point they will pay you $100. You make $6/yr for 10 years and get your $100 dollars back, for a total of $160. Not bad, better than a 2% savings account. But there are two big risks. What if JPMorgan can't pay you back? What if interest rates go up and you're stuck at 6%? You could buy a Credit Default Swap for a few hundredths of a percentage point from an insurer to hedge the default risk (but you can't do much about interest rate risk). The insurer would step in and pay you off in the event the company you bought the bond from defaulted. Simply, they are insurance policies. But, since they're derivatives, the swap itself could be sold for a specific value. Let's make it a little more palpable.
Merrill Lynch owns a bond OR a CDO from Lehman Brothers. They do the sensible thing to protect themselves and buy a CDS to insure against a Lehman default. Since Lehman is a huge company, they go to AIG for the insurance and pay AIG .5%/mo in exchange for the coverage. See the problem? CDO's default, Lehman is insolvent, AIG can't make everyone whole (CDS' aren't regulated so "sellers" of the insurance don't have to have reserves). ML is stuck holding the bag. Whereas ML thought they would be made whole via AIG they are now stuck with major losses on their own assets and are themselves, insolvent Now holders of ML bonds or CDO's must mark down their assets and they are insolvent, triggering another payout by insurers of ML to those that had CDS on ML. And by the way, ML sold their own CDS to other Banks, which they will no longer be able to honor. This massive chain reaction is still playing out across the financial sector. A bank may look healthy but they may be depending on an insurance payment from an insolvent bank.
Hopefully I've been able to elucidate the current financial faceoff in a little more detail. AIG was bailed out because they were the largest sellers of CDS in the world. The government is still trying to figure out ways to either get these toxic CDO's and other mortgage backed securities off the Banks balance sheet, or provide additional capital to "Recap" the bank. Both of which I will treat in the next post.
Monday, March 2, 2009
We interrupt your program to...
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"DOW reaches a new twelve year low today. Wait...nope, now is its lowest in twelve years, wait, NOW...now...now...no, NOW."
I get it, it's low. Fortunately, this market has done wonderful things for my popularity at social functions. Although I am getting a little cynical. Conversation:
Partygoer: "What do you do for work?"
Me: "I'm a greedy bonus-mongering private equity investment guy."
PG: Blank stare
PG: "Um, how would YOU fix this mess."
Me: "The way I figure it, the wealthiest people in the world right now are the Somali pirates. I think they should apply for Bank Holding Status and expand operations with money they receive from TARP. Since the government isn't asking any questions, I figure they could get to $20 billion or so with TARP money, plus whatever they get through routine plundering. At traditional 30:1 ratios, they could lend up to $600 billion (USD) to help stimulate the economy. The pirates that get sea-sick can go work on Wall St."
PG: Silence. "Did you see how low the DOW was today?"
On a different matter, I love talking to venture capitalists. They are the only ones that aren't afraid to say they are going to "change the world." I grin like a giddy school boy when they say it and I can never figure out why. Maybe it's because, subconsciously, I know some have actually already done it. Venture capitalists are behind some of the biggest game changing technologies like, Apple, Google, Yahoo, eBay, Amazon, Skype, Twitter, Cisco, MySpace, and Facebook. That's not even including the VC's who are working on advanced biotechnology and Life Science projects that will synthetically replicate human organs without the chance of rejection. I suppose I like talking to them because they're not depressed like the rest of us--they still dream. Here's one of the premier VC's in the world, Steve Jurvetson, of Draper, Fisher, Jurvetson, talking about his love of rockets. Incidentally, my son loves this clip.
http://www.ted.com/index.php/talks/steve_jurvetson_on_model_rocketry.html
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