Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.
As the federal government continues to grapple with a runaway financial liquidity crisis, the structure of Wall Street is being remade helter-skelter.
In prior articles, we have discussed:
- The federal rescue of Bear Stearns (announced March 16th), including the extension of a $30 billion line of credit by the Federal Reserve Bank, and an explicit credit guarantee regarding a sub-portfolio of toxic assets, leading to acquisition by Chase JP Morgan at a price of $2 per share, later increased to $10 per share.
- What amounts to the nationalization of Fannie Mae and Freddie Mac, formerly independent federal agencies; the Congressional Budget Office (but not the Treasury Department) now believes all of their liabilities must be consolidated onto the federal balance sheet. The plans were revealed to Fannie Mae and Freddie Mac on September 5th.
- The frantic effort to find a buyer for all or part of Lehman Brothers, which failed, leading the Lehman Brothers holding company to seek protection under federal bankruptcy law.
- The shotgun marriage of Merrill Lynch to Bank of America, for approximately $50 billion in stock, announced on Sunday September 14th, sealed the same weekend that Lehman Brothers fell.
In the most recent developments:
- On Tuesday, September 16th, the Federal Reserve Board announced that it had extended an emergency $85 billion two year loan facility to insurance giant American International Group (AIG), which was suffering a severe loss of confidence with investors. The Fed facility is intended to allow an orderly liquidation of AIG assets and offset of its huge book of liabilities in swap markets (including credit default swap notional exposure estimated at $400 billion). Pegged at the rate of 3 month LIBOR plus 8.5% (about 11.30% currently), the loan was granted with additional consideration to the federal government of a 79.9% stock position. CEO Robert Willumstad, who had replaced Martin Sullivan on June 15th, stepped down; the Board will stay in place. Ultimately, though, longtime CEO (1968-2005) Hank Greenberg made the big policy decisions that led to AIG’s demise.
- On Friday, September 19th, the SEC listed 799 financial stocks on which it instituted a temporary ban on short-selling. The New York Stock Exchange added about seventy stocks to the list, and Nasdaq 60 more, as the SEC decided on September 21st to allow the exchanges to add other stocks to the banned list. (Apparently, many additional companies wanted this protection, arguing, hey, we’re financials too! And why not join the party: does not every firm have financial operations and a chief financial officer?) The short-selling ban lasts until October 2nd but can be extended up to a maximum of 30 days.
- Also on the 19th, Treasury Secretary Paulson proposed a $700 billion (estimated) rescue plan that would establish effectively a federal clearing house for distressed mortgage assets. These would apparently include residential and commercial whole loans, mortgage backed securities and collateralized mortgage obligations (CMO's). There is some notion of the use of reverse auctions, possibly to be orchestrated by financial intermediaries. The federal government would thus seek to liquefy numerous financial institutions, moving away from ad hoc attempts to address these institutions’ problems one by one. Needless to say, as the government will be involved, that there is an opportunity for well-connected financial intermediaries and principals to make a killing on this scheme, as happened also with the disposition of assets of the Resolution Trust Corporation(RTC) in the 1990s.
- Also on September 19th, President Bush authorized the Treasury Department to use an existing $50 billion emergency pool to support money market funds, some of which were “breaking the buck” and trading at less than par (100% of nominal value). Further, the Federal Reserve announced it would expand its emergency lending program to allow financing of illiquid asset of such funds.
- On Sunday, September 21st, the Federal Reserve Board announced that Goldman Sachs and Morgan Stanley, the last two large independent investment banks on Wall Street, have agreed to change themselves into bank holding companies, thereby making them subject to far tighter regulation, lesser ability to leverage, but potentially also the ability for bank subsidiaries to receive FDIC insured deposits. Thus, the investment banks--which had to fought for many years to prevent the commercial banks from encroaching on the investment banking sphere (under the provisions of the Glass-Steagall Act of 1933, finally repealed in 1999)--are set to become regulated as commercial banks themselves.
One might well ask, is there any consistent logic to the federal actions? Why would Bear Stearns, Fannie Mae and Freddie Mac and AIG be rescued, while Lehman was left to fail? A first factor is perceived centrality. Regarding Fannie Mae and Freddie Mac, quasi-public agencies, the federal government’s own credit was at stake, and these could not be allowed to fail. As to the others, federal officials apparently determined that a failure at Bear or AIG risked more systemic damage to the financial system than at Lehman. Very important at Bear was the position of that firm as a “prime broker” and financing counter-party to hundreds of hedge funds. At AIG, its huge role as a credit guarantor in credit default swaps (AIG had been a triple A rated credit counterparty!) may have made it “too big to fail.” A second factor is timing. It has only gradually become apparent to Fed officials that real estate problems and the subprime lending fiasco, once viewed as “contained,” would spread so menacingly, threatening utter meltdown.
It is unclear whether the proposed measures will work as intended. As to the distressed mortgage clearing house concept, after an initial warm reception on Friday (the S&P 500 Index rose 4.0%), the U.S. stock market fell sharply Monday (S&P down 3.8%), partly on fears that the plan will stall out in Congress. The exact auction mechanism and extent of the program remain completely unclear, but the proposal will certainly become an unprecedented political hot potato, as the facility will be directly tied to the issue of which homeowners in mortgage foreclosure proceedings actually will lose their homes. The short-selling ban is pernicious and ultimately futile, as free markets will find other means to express negative views on particular stocks, for example through options. Commercial banks rightly complain that the Fed action backing money market funds effectively compromises their position as the only entities offering federally secured deposits. Any of the traditional rhetoric with which the United States lectured other countries about free market capitalism—wagging our finger at other members the World Trade Organization, for example—will now be hooted. It is certainly ironic that a Republican Administration, backed into a corner by a financial crisis in an election year, and haunted by its own lax regulation and somnambulence, has now been forced to propose the most sweeping government intervention into the US economy and financial markets since the Great Depression and New Deal.
Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.
Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com).
