Black Monday Exploring Current Financial Crisis Bellevance Honors Program Mind Sharpnel & Cookies Lecture Series Salisbury University Tuesday, September 23, 2008 by Arvi Arunachalam
Warning Signs Ann Lee, 2006, " Wall St House of Cards" "It warned of the danger to the nation from the sale of trillions of dollars of complex financial products called "structured credit derivatives. 2006 value of derivatives, $ 26 Trillion, twice US GDP Regulatory black hole, complexity beyond regulation CFTC has no control, regulates only commodities Today, nominal value of derivatives $ 100 Trillion, twice global GDP Risk bearer is unknown due to complexity Warren Buffett, Financial weapons of mass destruction Credit Rating Agencies indiscriminate ratings of risky CDOs (mortgage backed securities,..) as low risk
Began 13 months ago Indicators Collapse of two Bear Stearns hedge funds Credit Default Swaps premiums increase Credit Rating Agencies earlier errors, agency problems, lack of oversight on ratings, sudden downgrades Financial Institutions write down of bad assets, need huge capital infusion Capital flight from stocks to commodities to Treasuries, Gold Countrywide, largest mortgage lender fails 2007 Mortgage insurers, MBIA, Ambac,.. near death
Sunday, Sept 7: Time Line of Crisis US govt takes over Fannie Mae, Freddie Mac $5.5 T in MBS Monday, Sept 15: Lehman Bros files for bankruptcy, refused bailout market plummets, 6th largest one day drop in history Merrill Lynch bought by Bank of America Tuesday, Sept 16: Govt gives AIG short term bridge loan of $85 B to orderly unwind assets (sell) (Fed Govt owns 80% of AIG) Reports of banks' interest in WaMu (has $200 B in FDIC insured deposits from investors)
Wed, Sept 17 Time Line of Crisis $121 B was borrowed from Fed by financial institutions (short term lending facility) Treasury sells $ 40 B of 35 day T-bills, DJ falls 4.1%, MS 24 % Housing new starts falls 6.2%, lowest in 17 years Thur, Sept 18 Virtual run on money market funds - $180 B withdrawal by institutions, unprecedented in history since Depression (usually long term investors) MM funds worth $ 4 T market. Resolution Trust Corp - to orderly unwind mortgages worth $ 5 T Fri, Sept 20 Fed government guaranty for $4 T Sat, Sept 21 Congress legislate $700 B to buy bad debt - largest since Great Depression (proposal 3 pages long), increases
DIA ETF movement Sept 10 23, 2008
Short Positions on Financial Firms
Victors Key Players Vanquished Ken Lewis Bank of America Benjamin Bernanke Fed Reserve Chairman Robert Willumstad AIG John Thain Merrill Lynch Henry Paulson Treasury Secretary Richard Fuld Lehman Brothers
AIG ML Firms & Numbers Biggest issuer of CDS, $ 240 B exposure, default on $ 24 B Wrote down $ 41.4 B is assets, raised $ 21 B in equity Total write downs by financial firms $ 408 B in 2007 of distressed assets (Jon Haskins, Economist Goldman Sachs) Raised $ 367 B in new capital Value of sub-prime loans issued in the last 5 years $ 2.1T this is an estimate Value of Freddie, Fannie Mac exposure $ 5.5 T of US mortgages 2008 1Q commercial borrowing Down to 5.1% half from 2002 Value of CDS - $ 62 Trillion from $ 144 Billion in 10 yrs
Global Contagion UK government steps in to rescue Northern Rock run on the bank, 1st in 150 yrs, cost $100 B HBOS loses 30% value in 2 days UK's largest mortgage lender, acquired by Lloyds for 12.5 B pounds Markets in Asia, Australia, Europe drop dramatically
Lack of Confidence Soverign Wealth Funds invested $ 43 B to Citi, ML, MS from Kuwait, UAE, China, Singapore China Investment Corporation lost more than 75% of investment in Blackrock ($ 8B) & Morgan Stanley Singapore Government Investment Corp invested $4.4 B in ML, lost a big chunk - reluctant to recapitalize US assets again Waiting to stabilize, positive impact of AIG bailout (AIG $1T balance sheet, $110 B revenues, 110K employees 130 countries)
Why is this crisis severe? Slowing economy Recession: from fast growing to inflation filled slowing down Deleveraging economy highly leveraged to less leverage, lack of credit, more collateral, 02-06 household debt 11% Shrinking economy US economy after WW II from 50% of global GDP to current 25 % ( Source: David Rubenstein, Chairman Carlyle Group) Economy slowdown previous crisis current crisis Financial Markets
Credit Default Swaps Bets on whether a borrower will default write down distressed assets bonds rated lower stock price falls bonds price declines need to raise capital borrow money to pay off debt Financial accelerator Ben Bernanke
U.S. Govt Bailouts Source: Reuters / Christian Science Monitor
Crisis Comparison S & L crisis (1989-92) $100 B losses (Market value of insolvent banks) 21% prime rate High inflation 3,000 banks, thrifts failed, merged Economy, agricultural sector deep in recession Initial bailout request $ 25 B Final cost of bailout to taxpayers $150 B Current financial crisis (2007-??) $1,200 B of sub-prime mortgage securities ($200-300 B held by US banks) 5.25 2 % prime rate (Sep 07 Apr 08) Low inflation 3 of 5 top investment banks failed, no independent investment banks remain Economy in recession, not severe yet Initial bailout request $700 B might reach $ 1 T (guess by Trea Sec) Final cost??????
Reasons Regulatory Complacency Fair Value Accounting (SEC, FASB) Mark to market: assign market value to assets illiquidity, opacity, what value to assign? Short selling Naked short selling: shorting stock without owning irrationally forced asset price decrease Removal of uptick rule: traders could short a stock only after it had moved up Hedge funds short positions on Credit Default Swaps Hedge funds No reporting requirements nor oversight
Availability of credit : Effect of Crisis student loans, credit card rates, mortgages, auto loans becomes expensive Lending to institutions restricts credit to local business - car dealers, construction etc AIG break up ILFC largest aircraft leasing firm, sell off foreign insurance businesses 70% of all spending in US by consumers cut back on spending, more recession, later recovery - little savings and are deep in debt through credit cards, car loans, home-equity loans Increasing unemployment
Fed Government Deficit Pre-crisis national debt $ 10.3 Trillion Bailout amounts Freddie, Fannie $ 100.0 Billion Bear Stearns $ 29.0 Billion AIG $ 85.0 Billion Paulson s plan $ 700.0 Billion Post-crisis national debt $ 11.6 Trillion + Trade deficit Unfunded obligations (SS,..) $ 9.0 Trillion $ 54.0 Trillion
What can be done? Unified regulator, FINRA Tougher oversight, ensure compliance Reinstate uptick rule for short sellers Hedge funds make it more transparent Independent agency to dispose bad debt Ensure transparency, no party affiliation, smooth transition Taxpayer stake in firms rescued No free lunch for Wall St firms
Source: NBC Nightly news, Sept 22, 2008
Sept 24: Updates NY Insurance Regulator to regulate $ 12 T out of $ 62 T CDS market Berkshire invests $ 5 B in Goldman Sachs