Summary:
Article exploring the cause of the prolonged duration of the current financial crisis. Due to the mechanics of leverage. Intoxicating on the way up, devastating on the way down. Banks deleveraging. Develeraged state could go on for a long time. Banks will shrinks, and even if banks were able to rush back into heavy leverage soon, investors likely wouldn't stand for it. Regulators could add fuel to the deleveraging machine with tougher rules. More bank failures and seizures are likely. Like to see fewer investment banks in the future, which opens door for hedge funds and private equity to provide capital to the companies seeking it. This landgrab by big hedge funds and private equity firms might create new problems: hedge funds are largely unregulated and aren't bound to make any disclosures to anyone but their investors. Would mean even less transparency than exists on Wall Street now. Swing from one problem to another? (Published: 16/07/08)
Notes:
- Why hasn't the healing begun?
- answer lies in the mechanics of leverage, i.e. borrowed money
- Leverage is a powerful but dangerous tool
- intoxicating on the way up and devastating on the way down.
- Banks live on the stuff:
- When they post profits, they borrow more money to make more loans and book still more profits.
- During the boom, bigger mortgage loans pumped up home prices until people couldn't handle the debt and the bubble burst.
- Then the banks, poorer from the losses, had to cut back their own borrowing, too.
- Now the damage is spreading.
- Simplified, for every dollar of bank wealth lost, government-regulated commercial banks must eliminate some $10 of lending
- for investment banks, the figure can be $30.
- extent of the credit contraction to come will depend on the banks' initial losses
- elusive figure, to be sure, and one that keeps growing
- $400bn across the credit markets so far
- IMF says total could swell to $1 trillion
- Slap on a leverage multiplier of 10 or 15, and the math turns grim
- Robert Greifeld, CEO of Nasdaq:
- "I believe we will live in a deleveraged state until the next generation of management gets in place and doesn't remember what we went through here"
- "The harder question is about the lack of leverage in the broader economy: How does it ripple through?"
- tempting to view the July swoon as a sign that a bottom is near
- but: in protracted downturns the first several waves of bottom-fishers are usually wiped out
- e.g. the pain suffered by many of the professional investors who have bet on beaten-down financials in the past year
- more important: the stock market and the credit markets are rarely in perfect sync
- credit markets may remain weak after the stock market began a sharp recovery
- recent study projected that losses resulting just from mortgage-related lending would sap $1 trillion of credit from the U.S. economy
- even if banks were able to rush back into heavy leverage soon, investors likely wouldn't stand for it.
- "On the way up, banks get penalized [by stock investors] for not being aggressive enough. On the way down, the pressure is on to show how conservative you are. If lenders are fearful of losses, they are going to contract."
- Regulators could add fuel to the deleveraging machine with tougher rules
- Swiss bank regulators want to tighten standards following big losses at UBS
- Federal Reserve likely to limit the amount of leverage those banks can use
- in return for opening its discount window to investment banks
- But: regulators are in a bind.
- don't want to see more bad lending, but they also don't want to cut off credit for an economy that needs it
- government takeovers of banks pose another not-so-obvious threat to lending
- can save money in the long run and are almost always necessary to prevent widespread panic
- constrain lending, too, because
- when banks are taken over by the government, their shareholders usually register losses
- bank capital is erased from the financial system, and with it, the ability to make new loans
- lending practices are certain to be more conservative under FDIC management than in the past
- More bank failures and seizures are likely
- FDIC says its list of problem banks is up to 90 now, nearly twice as many as two years ago
- Treasury has its own list of 100 banks in danger
- lists haven't been made public
- but investors on Wall Street are making their own judgments
- how long it will take for wounds to heal?
- some convinced the worst is over
- interest rate cutting and other Fed actions that started last September should give the economy a boost soon
- another credit not in the offing, though
- some say country is in the early days of the worst "capital strike" by banks since the one that raged from the Great Depression to the 1950s
- some see parallels with the last big credit crisis in the U.S., which started in 1989 with the collapse of the junk bond market
- tighter credit weighed on the economy for at least three years
- by 1994 normalcy had been restored to the credit market
- but it took until the late 1990s for boom psychology to return
- cause for concern: "Many historical financial crises, a year later, were pretty much over. There's nothing about this one that looks like it is really over yet."
- may be entering an era in which there are fewer investment banks and those that exist aren't as important
- will open the door to competition from hedge funds and private equity firms
- deleveraging hangover means they won't be able to shower companies with loans anytime soon
- But: some private investment pools are beginning to connect companies seeking capital with investors providing it—just as investment banks do
- hedge funds and private equity
- growing market for private placements is already enabling more corporations to sidestep Wall Street stock underwriters
- instead go directly to hedge funds, pension funds, and other big investors to raise cash
- hedge funds and private equity firms also have become big providers of so-called mezzanine financing
- a type of loan that can be converted into an equity stake in a company
- But: a landgrab by big hedge funds and private equity firms might create new problems
- SEC and the Finance Industry Regulatory Authority oversee investment banks to some degree, and the Federal Reserve is moving in that direction
- hedge funds are largely unregulated and aren't bound to make any disclosures to anyone but their investors
- even that information is often incomplete
- move by hedge funds into traditional corporate finance would mean even less transparency than exists on Wall Street now.
- "It's just a swing from one problem to another"
- Lehman
- investors have abandoned the firm in droves on fears of a sudden collapse and the expectation that it will be swallowed up by a larger rival at a bargain price
- shares trading around $16, down 74% for the year
- market value of just under $12 billion
- has been in full deleveraging mode of late
- leverage ratio now stands at 24 (through May), down from 31 two quarters earlier
- mortgage business dried up
- over the six months ended in May, the firm originated just $2 billion in residential mortgages, compared with $32 billion during the same period in 2007, and $4 billion in commercial mortgages, down from $32 billion.
- "They bought risky securities and they levered up, but the bet didn't pay off"
- "There's no difference between Lehman and a subprime borrower who bought more house than he could afford."
