Tools to Help Business Owners Understand and Survive the Financial Crisis

We’re Seven Months into the Great Mess. What’s Going to Happen Next?

Posted on April 14, 2009

Seven months ago (Monday September 15, 2008) we learned of the failure of Lehman Brothers and soon thereafter the sale of Merrill Lynch and the bailout of AIG.  These events were the culmination of a series of market shocks that had started with the demise of the sub-prime loan market, had accelerated with the collapse of the leveraged loan market starting in August 2007 and had included the takeover of Bear Stearns in March 2008.  But September 15, 2008 is the current era’s equivalent of 1929’s Black Monday.

Since September we have witnessed dramatic governmental actions designed to prevent the current crisis from descending into a downward spiral reminiscent of the 1930s.  For the moment, the stock market seems to be giving these actions (as well as our charismatic new President) a vote of confidence.  We’re also hearing from some of our clients that their operations improved in March and that they are more optimistic about their businesses looking toward the summer.  Another “green shoot” is the middle market M&A market, where I spend much of my time.  The M&A market has definitely improved since the first of the year and indications are that it will remain reasonably strong for a while, at least for profitable companies in favored industries such as government contracting, IT services and health care.

So what is the economic scorecard to date and what can we expect to see going forward?

1)    The World economy is in the midst of the first major global recession of the postwar era.  Global trade has been collapsed for many of the major exporters, particularly China, Japan and Germany.

china-exports1

While there have been some recent hints that the rate of decline is slowing (the second derivative of negative growth) or even bouncing a little, world trade is still an area of significant concern.  Additionally, there remain a number of weaker economies (the Baltics, Spain, Ireland and Hungary among others) which could precipitate a currency and/or banking crisis at any moment.

2)    U. S. government commitments to the financial system bailout now total around $10 Trillion and perhaps more.  At this point we appear to have a two tiered banking industry, with most smaller banks reasonably well capitalized, though closures of the worst continue on a weekly basis, and a number of larger banks in the intensive care ward.  Both Chairman Bernanke and Secretary Geithner have said that these larger banks will not be allowed to fail, though additional capital may be required at some point.  The Treasury has committed to bet $1 Trillion of the FDIC’s credit on a public private investment plan (PPIP) designed to fix the balance sheets of the large wholesale banks.  Secretary Geithner has indicated that a primary focus of this plan is to restore the function of the securitization markets.  As we indicated last fall, the loss of these markets has had a far greater impact on credit contraction in the U. S. than credit tightening by the banks.  In fact, politics aside, indications are that the banks have been lending more to consumers, not less, since the crisis began.

consumer-loans

The primary unresolved issue with the big banks is whether there has been an impairment of their capital large enough to wipe out shareholders and potentially some of their unsecured creditors as well.  The PPIP is predicated on the belief that mark to market accounting has forced the banks to write down mortgage assets to levels below their ultimate realizable values and that, by stabilizing these values through injection of federal guarantees; the major banks will be able to fix their balance sheets and return to their normal businesses (primarily wholesale lending, trade finance, securitization of consumer loans, mortgages and other assets, and trading of derivative contracts).

A lively debate has developed over this point, with many observers convinced that the PPIP plan (combined with the earlier AIG bailout) is an outright subsidy to the banks, without compensation to the taxpayers.  As a result, a real question exists as to whether Congress will be willing to commit additional budget dollars when the fast dwindling TARP funds run out.  To prepare for this eventuality, Treasury and the Fed have asked for new authority to place major financial holding companies into receivership in the event of insolvency.  Additionally, trial balloons are being floated to test the possibility of a forced debt for equity conversion at some of the big banks similar to that now being push for GM’s bondholders.

Our view is that the wheel is still in spin with regard to the financial solvency of some of the larger banks.  With residential mortgage defaults still working their way through the system, there are at least three major categories of bank loans at risk:

a.    Credit card receivables.  Delinquency rates are at historic highs and expectations are for further deterioration through 2009.

b.    Commercial mortgages.  Leon Black, one of the most successful distressed asset investors, recently projected it will cost the banking industry $2 Trillion to clean up losses from commercial real estate problems.

c.    Leveraged loans.  Leveraged lending peaked in 2006-2007 at the zenith of the buyout boom.  Many of these loans were made on relatively short terms and will be coming due or moving into a period of rapid amortization over the next two years.  While some of the larger loans have most likely already been haircut under mark to market rules, many others are being treated as level three assets held to maturity and have likely not yet sustained any impairment.  Many of these will eventually default, particularly if the recession drags on into 2010 or worsens further.

Countering these negatives is the strongly positive yield curve being maintained by the Fed.  This is the perfect environment for bank profitability, leading some bankers such as Jamie Dimon of J. P. Morgan Chase to argue that they will be able to earn their way out of these issues, given a reasonable amount of time.

3)    The U.S. economy is far from healed.  Consumer confidence may have bounced at the bottom, but remains at historical lows

consumer-confidence

U. S. consumer spending was in free fall at the end of January and, based on today’s surprise report to the downside, has likely not improved much since.

retail-sales

The decline in U. S. manufacturing at the end of February was even more dramatic:

manufacturing

We previously predicted that yearend financial statements would cause significant stress in companies’ relationships with their banks.  This chart below, produced by Randy Schwimmer of Churchill Financial in their On the Left newsletter, shows Q4 results for selected firms financed with leveraged loans, as well as the dramatic impact in terms or renegotiated covenants and likely interest rate increases as well.

leveraged-loans

There is nothing in this picture that supports the cheer seen in the stock market in recent weeks.  As we have written previously, the real issue that must be addressed if the economy is to recover and resume its growth is the dramatic overleveraging that has occurred since the 1990’s.  Far from addressing this issue, the Administration’s bailout plans are calculated to maintain this high level of borrowing, which hit a new record of 3.7 times GDP in Q4 of 2008.

credit-market-debt

Notwithstanding all these negatives, an enormous amount of financial stimulus have been injected into the U. S. economy over the past four to five months.  Additionally the Obama administration’s fiscal stimulus package is just now beginning to flow into the economy.   With normal lags, this is likely to begin to have an impact on the economy in the next few months.  We expect to see some near term improvement in economic activity in some sectors.  This should not be confused with the end of the economic malaise; that will only come with the deleveraging of overstressed consumer balance sheets, which will likely take several years.  In the meantime, a better tone in the financial markets may present a short window of opportunity for companies to clean up their balance sheets through refinancing, loan restructures and asset sales.

How Much Risk is the Treasury Really Assuming from the Financial Institutions?

Posted on April 7, 2009

What does it really mean to talk about saving “the banks”?  The Treasury would like us to have a mental picture of Jimmy Stewart in It’s a Wonderful Life, protecting the savings and mortgages of the good citizens of Bedford Falls.  In truth, for all material purposes, the current Public Private Investment Plan (PPIP) is about saving four mammoth financial institutions considered too big to fail, BankAmerica, Citicorp, J. P. Morgan Chase, and Wells Fargo.

These financial behemoths, each as large as a significant number of the world’s national economies, bear as much relationship to the Bedford Falls Building and Loan as a rowboat does to the Titanic.  For public consumption, however, it is convenient for the Treasury to continue to describe its efforts as a rescue of “the banks”;   rescuing hydra-headed financial giants just doesn’t have quite the same ring.  Additionally by lumping these institutions under the category of “banks” the Treasury can continue the fiction that the bailout is about “getting the banks lending again.”

Notwithstanding this fiction, as we showed last week, even Secretary Geithner has abandoned the pretense that the PPIP program is about encouraging direct bank lending in the traditional sense of taking deposits and making loans, admitting that the primary purpose of PPIP is to restore the strength of these wholesale institutions so that they can restart the private securitization markets that fueled the credit bubble earlier in the decade.  So here’s the plan.  Just remove the toxic assets from the books of the financial giants and the system will be restored to its former picture of robust health.  Hopefully the PPIP will be sufficient to fund the fix.  If not the Treasury can use its proposed new liquidation authority, invest few hundred billion dollars more to fill the gaps and sell the freshly minted “clean” institutions to the capital markets for a premium.

On its face this appears to many to be a rational bet.  With the survival of the financial system at stake, risking a few hundred billion more to clean up the banks would indeed be far less costly than another liquidity crisis like that surrounding the Lehman collapse.  Unfortunately this calculation omits one major element of risk that has the potential to increase the cost of the bailout beyond even the capacity of the Treasury to fund: i.e. the derivatives portfolios of the major banks.

Last week the Comptroller of the Currency – Administrator of National Banks issued its quarterly report on Bank Trading and Derivatives Activities – Fourth Quarter 2008.  In reviewing the report, several things become quickly apparent.

1.    Derivatives Trading is a really big business; the notional amount of all derivatives positions at all U. S. commercial banks and trust companies that participate in this business was slightly more than $200 Trillion on December 31, 2008.  That’s more than three times Gross World Product which the CIA estimates to have been a little over $62 Trillion in 2008.

2.    Over 93.7% ($188 Trillion) of this gross exposure was held by only four bank s, J. P. Morgan Chase, Bank of America, Citibank and Goldman Sachs.  One institution, J. P. Morgan Chase, accounted for $87 Trillion of the total exposure or approximately 140% of Gross World Product.

3.    While the bulk of the exposure ($181 Trillion) was in the “traditional” derivatives markets, interest rate and FOREX swaps, almost $16 Trillion was in Credit Default Swaps, up from $1 Trillion in such transactions five years earlier.

4.    What had once been a very profitable business for the major banks, turned decidedly sour in 2008, with net reported trading losses of $836 million for the year as compared with profits of $5.5 Billion in 2007 and $18.8 Billion in 2006.  Drilling down to the details, Credit Default Swaps generated losses for the banks in 2008 of $12.6 Billion, more than offsetting gains for the year in Interest Rate and Foreign Exchange trading.

The OCC report provides a lengthy explanation as to why the notional amounts dramatically overstate the risk posed to the system by these contracts.  First, the real credit exposure is not the notional amount of the contract, but the amount that the market has moved from the strike price of the swap: i.e. the net amount the counterparty would be obligated to pay to true up the contract based on current market conditions.  This is referred to as the Gross Positive Value (GPV) of the contracts.  Since this GPV is in effect an unsecured claim against another financial institution, it represents a credit risk to the holder of the claims.  At yearend total GPV held by U. S. commercial banks was $7.1 Trillion.  Actual credit exposure was much lower, however, as the holders have the legal right to set off this exposure against certain of their counter exposures to the obligor institutions (Gross Negative Fair Values).

The netted credit exposure was estimated to be only $800 billion.  Added to this was Potential Future Exposure of $782 Billion based upon the amount by which the contracts could move in favor of the obligee banks to generate a Total Credit Exposure of $1.58 Trillion.  For the top five derivatives trading banks (the four above plus the U. S. operations of HSBC) total credit exposure averaged 489% of the institutions’ Risk Based Capital at the end of the fourth quarter.  At one bank, Goldman Sachs, credit exposure was more than 1000% of Risk Based Capital.  To be fair this calculation does not take into account pledged collateral backing a portion of the credit risks, which the OCC estimates as typical averaging 30-40% of the exposure amounts, so actual credit exposure was presumably somewhat lower.

By now your head may be swimming a little.  Mine certainly was as I worked to puzzle this out.  These are very large numbers.  Notwithstanding the OCC’s implication that all of this exposure is well managed and under control, I am reminded that we heard similar assurances with regard to subprime loans and CDOs, not to mention AIG’s Credit Default Swap portfolio.  The closest analog we can observe (AIG Financial Products) does not provide much comfort.  Apparently AIG FP had Credit Default Swap exposure of $440 Billion out of total derivatives exposure of $1.6 Trillion.  To date the AIG mess has cost the Treasury/Fed approximately $170 Billion to clean up.  With bank Credit Default Swap exposure in the aggregate reported at 36 times AIG’s CDS exposure, how much risk are the Treasury/Fed/FDIC actually assuming if they take on the unsecured debts of the big banks as they seem increasingly committed to do?  While I draw some comfort from the OCC’s explanation of netting and other factors limiting bank exposure on these volatile instruments, I am left with the nagging concern that there may ultimately be more risk here than meets the eye.   Absent more facts to the contrary, I’m reminded of the immortal words of Judy Garland as Dorothy Gale, “Toto, I’ve a feeling we’re not in Kansas anymore.”

Geithner Told it Straight (But you really had to listen)

Posted on March 29, 2009

This morning (March 29) Treasury Secretary Geithner appeared on Meet the Press to explain his plan for rescue of the financial system.  He described a series of actions to not only fix the banks, but to get the securitization markets working as well.  For perhaps the first time we heard a (relatively) clear rationale explaining how the Treasury expects the toxic asset rescue plan to lead to the restoration of credit for consumers and entrepreneurial business.

The interview started with an explanation of the difference between bank lending and securitization.  Per Geithner, “Typically somewhat less than half of lending for business and consumers comes from the securitization markets.”  As I have written previously the current financial crisis was created by an explosion of debt to unsustainable levels in great part through the mechanisms of the shadow banking system, which includes the securitization markets.  This created a massive amount of liquidity, much of which was not captured in traditional measures of the Money Supply.  The collapse of these mechanisms beginning in August 2007 created the credit crunch.  Sec. Geithner believes that, until these non-bank markets are restored, the financial system can’t be fixed.

There’s been much loose talk in the media claiming that lending to small business entrepreneurs can’t be restored until the toxic assets come off the balance sheets of the banks.  Here is what Geithner said on the subject of the toxic asset bailout:

“This is a better way to get these markets working again.  Let me just      step back for one second.  What we’re trying to do is get the entire financial system – our complicated financial system - working again so that we get credit where it needs to go in the economy.  And that requires strengthening our banking system.  It requires making sure there is enough capital in the financial system to withstand a wider and deeper recession.  And we’re going to make sure that capital comes with conditions to make sure that banks restructure; that there’s accountability for boards and management; that the firms emerge stronger, not weaker; and that there are tough conditions to protect the taxpayer.  That is a critical part of what we’re going to do.  But our system is much more complex, depends on more than just banks.  So we have to do things to get these markets working again by providing financing directly to those markets that small business, consumers depend on.”  (emphasis added)

So what does this really mean?  The last sentence above clearly states that the toxic asset rescue will do nothing directly to encourage small business and consumer lending.  That’s a job for TALF.  The bottom line is this.  The Treasury believes that a restoration of the securitization markets is critical to restore lending by non-bank lenders.  Securitization is the province of a few big banks in New York.  Two of these, Goldman Sachs and Morgan Stanley, have said they don’t need further help from the government.  So basically the task at hand is to save the other major players (primarily the four biggest banks) on which the securitization markets depend so that they can restart the merry-go-round.

Underlying all of this is a bit of sordid history.  Securitization is essentially an agency function.  Prior to the repeal of Glass-Steagall, securitization was conducted by investment banks, which were limited by their (relatively) small capital bases from taking on significant principal risk.  They bought loans for short holding periods during which the bankers and lawyers packaged the loans and quickly sold them off to investors.  If they got caught short and couldn’t unload the paper, they were soon out of business or merged into a larger player.

By the late 1990’s Wall Street had found these limitations to be too constraining.  As the instruments became more and more complex, it became more and more difficult to market the riskiest portions of the loan packages (the “toxic waste”).  If the toxic waste couldn’t be sold, there would be no deal.  No deal meant no commissions.  And no commissions meant no bonuses.  The repeal of Glass-Steagall enabled an ingenious solution.  Where the investment banks had no choice but to unload the toxic waste because there was no place to hide on their balance sheets, the major money center banks had much larger and deeper balance sheets and complex corporate structures with multiple regulators.  Aided and abetted by the invention of credit default swaps, which enabled the pooling of toxic waste into “investment grade” securities which could be sold to third parties or into off balance sheet conduits created and managed by the banks, the major players in these markets dramatically ramped up the securitization engine between 2003 and 2007, fostering the housing bubble.

While much of this activity was not conducted directly by the banks, the bulk of it was ultimately for the account of bank lenders, which in effect supported proxy institutions in the securitization market through lines of credit and asset purchases.  This appears, for example, to have been the case with Bank of America’s support for Countrywide mortgage.  When the music stopped, the biggest non-bank participants were quickly rolled up into the major banks (Countrywide and Merrill into Bank of America and Bear Stearns into J. P. Morgan).  The toxic assets the Treasury is now proposing to deal with through its bailout plan are the detritus of the securitization collapse that these banks could not unload on third party investors when the music stopped in the fall of 2008.  This was confirmed by Lloyd Blankfein of Goldman Sachs following last week’s meeting between the big bank heads and Pres. Obama, when he was asked whether Goldman would be selling assets into the new program.  His response was that with its business model Goldman didn’t have much exposure to that type of consumer assets and what they did have had already been marked to market.  I. E. Goldman (and likely Morgan Stanley as well) stuck to their knitting as investment bankers, quickly moving the paper they had created off their balance sheets and did not retain the types of principal risk taken on by the big banks.

More than half of U. S. banking assets are held by four banks that are also major players in the securitization markets: Bank of America, Citigroup, J. P. Morgan, and Wells Fargo.  Almost certainly a far larger percentage of the securities and loans that will be purchased from U. S. based banks under the toxic asset plan will be from the balance sheets of these four institutions.  If you believe that these new multibillion dollar conduits created by Treasury are going to be purchasing bad subdivision loans to clean up the balance sheet of Podunk Thrift Bank for Savings to enable it to make loans to local businesses, then I’ve got a bridge in Brooklyn I need to sell you.

So why, you might ask, should we be willing to put the U. S. Treasury on the line for $1 to $2 Trillion to bail out these banking behemoths?  Sec. Geithner’s answer today is that we must save the banks to restart the securitization engine.  What he doesn’t say, but which is likely far closer to the truth, is that the government is deathly afraid not to.  An outsized percentage of outstanding corporate debt was issued by the major bank holding companies.  When the government allowed a comparatively smaller player (Lehman  Brothers) to fail, the world’s financial markets ground to a halt.  Geithner’s unspoken answer:  we’ve got to bail out the bondholders of the big banks because their failure will crater the system.  Since it’s politically impossible to do so directly, we’ll do so by allowing these banks to unload their underwater assets on the Treasury.  We’ll dress it up by getting a few friendly institutions (many of which will likely be big holders of corporate debt) to take a small slice of the risk so we can put the pricing decision on them rather than the Treasury.  Once the big banks are cleaned up, they can again raise money in the capital markets and we can depend on them to again create a vibrant private securitization market so that the merry-go-round can again turn.

All of this makes me profoundly uneasy, but I am not sure that there is a good alternative to bailing out the creditors of the big banks.  There may well be no other way to avoid the chasm of economic collapse than to bail out the debt holders of the big banks.  To not do so could irreparably damage the U. S. standing in the world capital markets.  I do object to selling this plan as being necessary to “get the banks lending again” or to provide liquidity to entrepreneurs.  That’s not what this plan is about.

The powers that be hope to sell this plan without an honest public debate over its real implications for our economy and society.  Inherent in the Geithner plan are a number of assumptions, which are presented as givens not open for discussion.  At a minimum the following questions need airing and extensive public debate:

1.    Is a banking system in which more than 50% of the assets are controlled by four institutions good for the economy, the political system or the social fabric of America?

2.    Should the taxpayers ever be called on to preserve the equity value of the shareholders of insolvent private entities?

3.    Should the Treasury be committed permanently to an implied guaranty of the debt (as opposed to consumer deposits) of “systemic” financial institutions and, if so, is there a regulatory structure that can be created that is adequate to protect the Treasury from the need to conduct similar bailouts in the future?

4.    Is a system in which 50% of credit is created through securitization healthy for the long run stability of the economy?  Do we have regulatory and monetary tools in place that can deal with the impact on the larger economy of the market swings inherent in such financing?

5.    Is our focus on the big banks preventing the allocation of capital to those institutions (community and regional banks) that have traditionally provided most of the financing for entrepreneurial businesses?

Let’s do what it takes to save the economy, but not at the cost of an open democracy.  It’s time to demand a debate over the real issues at stake, rather than blindly accepting the PR smokescreens of those with trillion dollar vested interests in the outcome.

We’re The Marks

Posted on March 17, 2009

From Dictionary.com

Def. Mark - noun

15. b.   Slang.  the intended victim of a swindler, hustler, or the like: e.g. “The cardsharps picked their marks from among the tourists on the cruise ship.”

It’s midnight in Vegas.  A somewhat paunchy fiftyish guy from the Midwest has just sauntered over to the poker table.  With a bourbon in his right hand and a party girl on his left arm, he stumbles slightly before announcing “mind if I join you guys?”  The player with the dark glasses looks up briefly, mumbles something unintelligible and looks back at his cards.  The one in the cowboy hat says “howdy partner, glad to have you”.  Our hero throws his chips on the table and takes his seat.  “Boy I’m feeling lucky tonight.”

Guess who’s flying back to river city tomorrow with a lot fewer chips than he came with?

Uncle Sam stumbled into the world’s highest stakes casino last fall.  He didn’t know how to play the game, but he certainly knew how to raise the table stakes.  Nothing that has happened since then increases my confidence that the U. S. of A. will be leaving this game as a winner.

This morning Andrew Ross Sorkin of the New York Times was on Morning Joe making the case for payment of the AIG bonuses.  His core argument in an article in Tuesday’s Times is that we can’t ignore contractual rights just because they’re not politically popular.  To do so would cause untold damage to the American economy.  On Morning Joe Andrew was brave enough to take the even more unpopular position that the partially nationalized financial institutions must pay up to hire good people or the smart guys at Goldman, et. al. will clean their (and our) clocks.

That this has suddenly become a major political issue should come as no surprise to anyone.  As I said in this posting published February 15:

The big banks have tens of trillions of dollars of credit default swaps and other risk positions on their books. It’s not hard to picture recruiting calls going out from hedge funds and other trading firms not subject to the new law offering the best and brightest traders highly incentivized deals to move from the big banks to begin trading for these non-regulated firms. These traders will come armed with extensive knowledge of their former employers’ investment positions and will have every incentive to take advantage of that knowledge at the expense of their former employers and ultimately at the expense of the taxpayers who will likely soon own the big banks. And they’ll be trading against bank employees happy to take a comfortable salary and a 50% stock option bonus.

The stakes in this game aren’t millions, but trillions of dollars of taxpayer money. Odds are we just bet on the wrong champions.

An old saw on Wall Street goes like this.  “What’s the best way to end up with a $1 million account?  Start with a $10 million account.”  The Treasury and the Fed are starting with a $10 Trillion account, which they have placed on the line at the great Wall Street casino.  They clearly don’t have enough talent in house that knows how to play the game.  Even worse a political consensus is building that will block them (and their proxies at AIG, Citigroup, Bank of America, et. al.) from hiring people competent enough to play in the big leagues against the world’s best and brightest.

It is naïve indeed to think that the political and media demagogues will be any more forgiving of a government controlled bank that pays a star derivatives trader a salary of $20 million, than they are to see her earn that as a bonus.  Yet that’s what top traders earn in what is likely the most complex market ever invented by the mind of man.  If we’re not willing to pay these stars what it takes to attract them to the government owned banks, then they will most certainly be working for the competition and the competition will win.

There’s a lot of anger building over AIG handing $7-12 billion to Goldman to settle derivatives contracts.  Imagine how much anger there will be when the public learns in a couple of years that the government’s mismanagement of the major financial institutions has caused not billions, but trillions, of dollars of new losses from naïve and ill timed trades, made, not on the watch of “former management”, but under the noses of their new Treasury overlords.

There’s no way that we the people are going to win this game.  Continuing to use public funds to trade these treacherous markets is a course guaranteed to lead to a disaster on a scale that makes everything we have seen to date pale by comparison.  It’s time for the Treasury and the Fed to run, not walk, for the exit and demand that the institutions under their control cease these dangerous trading activities immediately.