September 11 – 19, 2008

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September 11, 2008

Bad sentiment just keeps building for Lehman and it’s not clear that they are going to survive the upcoming weekend.  Moody’s hosted a conference call today to give their perspective of Lehman’s announced reorganization plan.  They said the plan will result in a ratings downgrade from the current rating of ‘A2’ to somewhere in the ‘BAA’ range.  Further, Moody’s thinks that Lehman needs to find a “strategic buyer with deep pockets” to maintain their ratings and they need to find one soon.  For better or worse, this announcement pressures Lehman’s stock further – the downward cycle is in full swing.

September 12, 2008

I attended a meeting with several PhD’s from FRBNY’s Research Department where we discussed the pro’s and con’s of bailing out Lehman.  There was no clear consensus, but the argument which I preferred, no bail-out, seemed to be winning.  Someone, not me, was going to de-brief Tim Geithner on what was discussed.  The reason to bail out Lehman is to minimize the resulting collateral damage / contagion.  The reasons not to bail them out are mostly based on not promoting morale hazard noting the lack of surprise in Lehman’s current difficult state as this situation was a long time in the making. Market participants had plenty of time to prepare and the Fed can’t hold everyone’s hand all the time.  Sometimes the free-market economy has to be just that, a free market.

Although I favor the “no bail-out” option, I’m concerned about contagion risk in these three areas:

  1. The tri-party repo platform may “melt down” with repo investors getting possession of underlying collateral instead of their cash back.  This would almost undoubtedly cause a “fire sale” of all assets that were not Treasury securities.  Anxious selling will push prices lower, which will cause more margin calls and more selling, a true negative feedback loop.
  2. The OTC derivative market may also implode.  If Lehman defaults, they make take others with them with the derivative market as a vector.  For example, bank X thinks it has effectively hedged its risk by putting on derivative trades with Lehman but suddenly this hypothetical bank can lose billions of dollars if Lehman defaults.  This may cause Bank X to default to Bank Y, and so on.
  3. Lehman has a lot of commercial real estate. If there is forced selling into this market, prices may revert back to the 1970’s.  Of course, if Lehman does go into bankruptcy, those assets would have to clear substantial legal hurdles before being sold.

September 13 – 14, 2008 (over the weekend)

            So much happened over the weekend – just unbelievable!  My boss and my subordinate both came to work at FRBNY’s main building over the weekend, but not me.   I would have been happy to come, if asked, but I wasn’t going to just show up.  I think my subordinate served as an usher and he was probably quite busy as the place was a beehive of activity.  Although the Fed did not offer to “bail out” Lehman, they did arrange a last-ditch meeting at 33 Liberty Street, the same building that holds more gold than Fort Knox.  Anyone who was anyone in the U.S. financial community, that is to say, anyone with credit exposure to Lehman Brothers, came to the New York Fed over-the-weekend, including Richard Feld, Lehman Brothers’ CEO; Tim Geithner, FRBNY President and Henry Paulson, U.S. Treasury Secretary.  From what I understand, Paulson and /or Geithner basically said that Lehman has become illiquid and very well may be insolvent too.  The Fed and the Treasury went on say that while the government will try to help with any deal that the private sector is willing to support, don’t count on the government to “bail out” Lehman.  When its creditors couldn’t reach agreement over the weekend, Lehman’s management had no choice but to file for bankruptcy.   Here’s a summary of this weekend’s notable events:

  1. The parent of Lehman Brothers’ broker / dealer filed for Chapter 11 bankruptcy protection in court.
  2. Bank of America and Merrill Lynch agreed to merge, but the merger looked a lot like Bank of America buying Merrill Lynch.  It was an all-stock transaction which valued Merrill Lynch at $29.00 per share.  The sale price seemed incredibly inflated to me as Merrill Lynch had many of the same problems that led to Lehman’s demise.
  3. The Fed expanded the scope of the lending facilities it offers dealers.  The size of the Term Secured Lending Facility (TSLF) auctions will increase and this facility will start accepting fairly low quality assets as that are eligible collateral to be exchanged for US Treasury securities.  The Primary Dealer Credit Facility (also known as the PDCF, which functions like a Discount Window for dealers) will also expand its pool of eligible collateral and will now accept all securities that are pledged in tri-party repo, including some dodgy stuff such as Whole Loans, High Yield bonds, A2/P2 Commercial Paper, etc., and for the first time will accept equity (stocks) as collateral.
  4. The Fed will relax, at least temporarily, some of the 23A restrictions which limit how banks are able to lend to their non-bank affiliates.  This will allow some “stressed out” non-bank entities to rely more on their bank affiliates for support.

September 15, 2008

Needless to say, I head to work with more than a little trepidation this Monday morning.  How will the funding markets react?   Well, the fed funds target rate is currently 2.00% and fed funds were trading around 4.00 % in the morning.  The Fed’s money desk saw this striking level of firmness and conducted a very large Temporary Open Market Operation to provide liquidity.  The market saw the Fed’s $20 billion repo and …yawned. Rates started trading even higher after the repo operation.  The Desk was a bit taken aback at the reaction.  There is an old saying, “don’t fight the Fed”, and when rates started rising, the Desk called an unusual supplementary repo operation, this time for $50 billion!  The high rate on the day was 7.00%, the low rate was 0.01%, one basis point.  Apparently the second ($50 billion!) operation was enough to lower rates as the market was just a little on edge.  !:-0 .

All the markets were down today and there was a lot of talk that Lehman’s trustee would not be able to unwind their trades, or even process them, in a timely manner. Notable equity moves included a 55% decline in the price of AIG stock – it opened trading at $11.50 and closed at $4.75.  Ouch!  Also in trouble is Washington Mutual, a bank with $300 billion in assets.  They were just downgraded to below investment grade and their stock price dropped about 20% on the day to around $2.00 a share. Bank of America’s stock price was down 20% on the day, while Citibank dropped (only) 15%.  Of note, while Bank of America’s stock was down, Merrill Lynch’s was flat.  The market expressed some skepticism of over whether or not the BoA / Merrill deal will get done, as Merrill’s stock should have rallied to $22.50 (90 % of B of A’s share price), instead it remained around $17.00. I suspect that without the announced merger, Merrill’s stock price might have behaved more like AIG’s.

September 16, 2008

            Despite losing 55 % of their value yesterday, AIG’s stock price fell precipitously today.  It appears that they are on the verge of being downgraded by a major ratings agency.  This downgrade will then likely trigger collateral margin calls, to the tune of $15 billion or so.  This doesn’t sound like that big a deal, after all AIG has total assets of about $1 trillion, but as the old story goes, AIG may have trouble coming up with the money.   This is apparently the case, because after the market close, AIG agrees to a deal that you would only sign on your death bed.  Treasury agrees to lend AIG $85 billion, in exchange for 79.9% of AIG’s stock, AND the $85 billion loan bears interest at the rate of 3-month LIBOR + 8.50%!!  Good luck paying that back.

I thought financial markets would be choppy after the Lehman / AIG news, turns out I had no idea!  Fed funds trading was very firm both on Monday and Tuesday, so the Fed’s money desk added a ridiculous amount of liquidity on both days, $70 billion on Monday and $50 billion on Tuesday.  When you add that amount of money, the banking system will meet its technical need for electronic money, also known as banking reserves, on the first day of a 14-day reserve maintenance period.  While the system doesn’t need that much money, it doesn’t mean that individual banks won’t have trouble raising money, especially if many banks are hoarding / refusing to lend.  Staying with the overnight, unsecured lending markets (fed funds), the main culprit for the persistent morning firmness seems to be the European banks.  An example of this is overnight LIBOR, which fixed at 6.30% on Tuesday, an incredible 4.30% above the Fed’s target rate.  In response to the firmness, the Fed has been adding tons of money to the market via Temporary Open Market Operations (e.g. $70 billion on Monday) which means that rates basically have to crash at the end of each day. 

This brings us to Wednesday morning when the Fed’s money desk decides that there’s plenty of liquidity in the system and they let a $50 billion overnight repo mature without a replacement, thereby withdrawing $50 billion of banking reserves / liquidity from the market.  They did this to prevent another late-day crash in money rates.  Even though there was plenty of liquidity in the system, the Desk’s withdrawal of this liquidity literally freezes the repo market: trading stops.  Although very unusual, this just means that the repo market has joined the Commercial Paper market which is already frozen, primarily because the money market mutual fund (MMF) industry is completely freaking out. This paralysis started when a fairly large MMF, the Reserve Fund, notified shareholders that it lost about $800 million in investments with Lehman and can no longer sustain $1.00 net asset value accounting.  Hence it has to “break the buck” and its shareholders will realize some, presumably modest, credit losses.  Panic ensues.   !:-0 .

The stock market trades down a full 5.0% on Wednesday; looks like a full-fledged “run” is occurring with Morgan Stanley and Goldman Sachs may not be far behind.  Morgan Stanley’s market capitalization falls from about $40 billion two weeks ago to about $20 billion by the day’s end.  To illustrate the downward momentum, ½ of the $20 billion loss of Morgan Stanley’s market capitalization occurred today!

September 19, 2008

I was hoping / expecting to hear that Morgan Stanley had found a deep pocket partner when I turned the financial news on at 6 am today, but they had no such luck.  There was report that a Chinese bank, CITIC, was interested but they encountered political problems with the approval of any potential purchase – maybe they insisted on a controlling interest?  There was no shortage of news at 6:00 am, however.  Fed Chairman Bernanke and Treasury Secretary Paulsen had a meeting with members of Congress to explain the need to set up some type of government owned program to buy illiquid assets (Resolution Trust Company II ?) and the market started rallying like crazy on the news; a broad index of financial shares quickly increased by something like 20%.  Meanwhile, the Treasury announced that it would use its Exchange Stabilization Fund, which is intended to stabilize the value of the US dollar relative to foreign currencies, to “insure” the value of MMF shares to keep more money funds from “breaking the buck”. 

Just like an infomercial –  “but wait, there’s more!” –  the Fed also announced that it would allow “back-to-back” lending from the Discount Window to banks who purchase Asset-backed Commercial Paper (ABCP) from MMFs.  This effectively allows banks to provide liquidity to MMFs by purchasing ABCP from the MMFs with the intent of immediately re-selling the ABCP to the Fed. Let’s give the Fed some credit here, this looks like an effective way to provide a “bid” in the Commercial Paper market. 

“But wait, there’s more!” – the Fed also announced that it would start buying short term agency debt (Fannie, Freddie, FHLBs) for its portfolio, also known as the System Open Market Account, or SOMA. This technical change makes a lot of sense, given that Treasury has already promised to support agency debt through at least December 2009, effectively making short-term agency debt the equivalent of Treasury bills.  Despite this, when all hell broke loose this week in the aftermath of the Lehman bankruptcy and the AIG bailout, Treasury bills were trading in a wide range of yields between 2 and 30 basis points, while agency discount notes were trading with yields around 200 basis points.  In announcing its intention to buy agency discount notes (known as “disco’s” for those who buy and sell them), the Fed is acting like a savvy relative value investor, buying cheap securities (“disco’s” with a ~200 basis point yield) and shunning the expensive securities (Treasury bills with a yield of ~ 15 basis points).  Of course, the Fed’s motive isn’t to make more money, it’s to promote market functioning in a market that is just obsessed with liquidity and the credit quality of issuers.  For those readers with some familiarity with the study of economics, this action was like Adam Smith’s (the so called father of Economics) “invisible hand” of the free market leading the way, except this time the “hand” is the Fed’s.

Meanwhile for people working at securities dealers, this week has been a “tale of two cities”.  Morgan Stanley, which always seemed like a very well-run firm, remains in the midst of a classic “run on the bank”.  Meanwhile, Merrill Lynch, which seemed just clueless as to what was going on, is enjoying the benefits of having a new partner with deep pockets.  Bank of America has the largest deposit base of any bank in the U.S.  Hard to believe, but on the week, Merrill Lynch’s stock price is up ~75%, while Morgan Stanley’s stock price is down 25 to 30%.  Even Goldman Sachs, the darling of Wall Street, endured a down week for its stock to the tune of about 15%.

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