Debt Crisis?
Posted by Jody Eisenman | Filed under Uncategorized
Much of the financial news this past week concerns the sovereign debt situations of several European countries, as well as the United States. As pretty much everyone knows, too much debt, whether it be by individuals, companies, municipalities or countries, can be devastating. The past 30 years has shown us several examples of this. Back in 1982, Mexico faced default on enormous debts to several US commercial banks. In the end, the IMF (International Monetary Fund) bailed out Mexico, thus saving the banks from potential devastating losses. In 1994, the crisis re-emerged, and they were again bailed out. In the late 1990s, many emerging nations such as Thailand, Indonesia, Brazil and Argentina faced a similar situation. Once again, the IMF stepped in to bail out most the countries. In 1998, Long Term Capital Management, a %6 billion hedge fund headed by John Meriwether, faced severe margin calls due to excessive leverage. In a controversial move, the Federal Reserve arranged a bailout, due to the belief that the unwinding of their positions in a less then orderly fashion could be harmful to the financial markets. Finally, in 2008-9, we saw the government bail out several whole industries, including the autos, the banks, and Fannie Mae and Freddie Mac.
Today, we are faced with a situation eerily familiar to the past. The difference is, the crisis is now with countries, and the countries include the largest industrial nations of the world. Early this week, President Obama introduced a new budget that will show a record deficit. Although the United States is considered one of the wealthiest nations on the planet, with a standard of living that can only be envied by most of the worlds’ population, we are in debt up to our eyeballs. In the last 30 years, the US debt has gone from $380 billion and 26% of GDP (Gross Domestic Product) to a projected $14.5 trillion in 2010 and 67% of GDP. These numbers are staggering, but what is more amazing is the fact that in any normal situation, the interest rate on our debt should be rising. In other words, lenders who buy our treasury bonds should be demanding higher yields to offset the risk of lending to a country with huge debt. In fact, this has not happened. Six month treasuries are yielding 17 basis points, or .17 per cent. One year paper is around 30 basis points. That means that an investor who buys a one million dollar one year treasury will get roughly $3000 in interest for the year, or $250 per month. Hardly seems worth it, does it? Why are rates so low? Lenders believe that the US represents low risk as we have not missed a payment in 200 years. Eventually, all debt must be repaid. Should lenders such as the Chinese ever get nervous enough to cut back on treasuries, it could spark a painful rise in rates. Tomorrow, I will analyze the European debt situation and the effect on the Wall Street.
The Backdoor Bailout
Posted by Jody Eisenman | Filed under Uncategorized
Back in 1835, the city of New York experienced a tremendous fire which destroyed almost 700 buildings in the area now known as the financial district. The total damage was estimated to be around $20 million, which would obviously translate to a large multiple of that in 2010 dollars. By and large, the companies were covered by a variety of insurance policies offered by 29 different companies. Unfortunately, 23 out of the 26 insurance companies could not meet their requirements and went bankrupt. The financial devastation to the businesses involved was severe, and thousands of New Yorkers were out of work. Lets flash forward to 2008. Over the decade, AIG discovered a new very profitable business, that of bond insurance. Lets say an institution bought a $100 million bond from General Motors. The institution becomes nervous over the prospect of GM possibly declaring bankruptcy and defaulting. For a few pennies on the dollar. They could go a company like AIG and buy an insurance policy on the bond. Should GM default (which ultimately happened), the institution would get paid the full face amount of the bond. AIG later expanded this coverage to real estate as well. These insurance policies were known as credit default swaps or CDS. At the time, AIG was only required to put up a very minute amount of the face value of the policy in escrow as collateral. As such, AIG’s earnings exploded, as the default levels were almost non-existent. However, as the financial crisis grew, it suddenly became apparent that the likelihood of default on some of these companies had increased dramatically. In addition, as the prices of these CDS shot up in value (CDS are actually traded in the open markets; thus one could actually own a policy on a bond without actually owning the bond at all!), AIG was now forced by the insurance regulators to put up much more collateral. These collateral payments were in the tens of billions of dollars. There was no possible way for AIG to either put this money up or raise it quickly. By the summer of 2008, AIG, one of the high flyers of Wall Street, was facing bankruptcy!
What did AIG do? They went running hat in hand to the government. Without much fanfare or debate, the US gave AIG an $85 billion dollar line of credit on September 16. In less than one month, AIG drew down over $70 billion on this credit line. In return, AIG gave up 80% of their company. Ultimately, these credit facilities were expanded to $123 billion. On November 10, AIG reported a third quarter loss of twenty four and a half billion dollars. This brought the total loss over the previous four quarters to $42.5 billion. Amazingly, this was just the appetizer. On March 2, 2009, AIG reported the largest quarterly loss in US history, a staggering $61.7 billion.
Now comes the fun part. As many questioned even then, why did the government rush to pump in such incredible sums of money into AIG? The answer, it seems, lies in the counter parties, or the institutions that bought the CDS from AIG. As revealed last March, these institutions included some of the biggest names in the financial world, including Goldman Sachs, Merrill Lynch, Societe Generale, Deutsche Bank and UBS. According to a fascinating report by Ranking Member Darrell Issa of California of the Committee on Oversight and Government Reform, the Federal Reserve Bank of New York (FRBNY) was asked by AIG to negotiate with the counter parties in November of 2008. This report can be found on www.scribd.com At this point, these institutions were about to go over Niagra Falls without a paddle. Therefore, they were not exactly in a favorable negotiating position. Negotiations lasted barely two days. The institutions were adamant on receiving 100 cents on the dollar, a posture that seems outrageous in the face of the maelstrom swirling around them. Amazingly, the FRBNY agreed. In the words of Tom Baxter, FRBNYs’ general counsel, “I don’t know why even bothered to ask”. They way I imagine the negotiations went were that the large banks told the FRBNY that if AIG was not bailed out pronto, there was a great likelihood that they (the banks) were going to go under as well. In which case, you could kiss our financial system goodbye.
Now, during this crisis, current Federal Reserve head Geithner was head of the FRBNY. He didn’t give up his post until he was confirmed in January 2009. Geithner admitted that he approved these 100% payments, but he denied that he agreed to bail out AIG because of the precarious position of the banks. On Wednesday, Geithner (and former Fed head Paulson) were grilled by congress. It seems that the FRBNY basically demanded that the 100% payout be left out of AIGs’ mandatory SEC filings. Geithner denied having a part in the cover up, which many believe strains the limits of credibility. In any case, more and more information is starting to leak out of this fascinating situation. Could this be the beginning of the end for Geithner? I will keep you updated.
Obama Versus the Banks
Posted by Jody Eisenman | Filed under Uncategorized
I do not envy the President. One year into office, Obama is facing a double digit unemployment rate and a rising tide of dissatisfaction among much of his traditional support. Meanwhile, housing prices have barely recovered off their steep drop. Foreclosures remain high, and many homes that have been repossessed by the banks remain unsold, as banks are unwilling to dump them on an already fragile market. Although Obamas’ dramatic spending has apparently rescued the banks and Wall Street, it has not had a tangible effect on much else. If the government continues its’ massive spending, there are fears of inflation. On the other hand, there is no real tangible plan afoot to create new jobs. Instead, there is a lot of pent up frustration by unemployed and underemployed people against the “fat cats” of Wall Street, who are supposedly making fortunes. http://online.wsj.com/article/SB20001424052748704281204575003351773983136.html
As such, Obama has now proposed a banking regulation overhaul. These proposals will seek to limit risk, which greatly contributed to the financial meltdown we experienced. Along with this proposal, Senators McCain and Cantwell have proposed restoring the Glass-Steagall Act. This act, which instituted separation of banks and investment companies (as well as creating the FDIC in 1933), was repealed in 1999. This repeal directly led to the creation of financial “supermarkets” like JP Morgan Chase and Bank of America. Former Federal Reserve head Paul Volcker has come out in favor of the McCain/Cantwell bill. In addition to the banking overhaul, Obama has proposed a fee to be imposed on any bank with more than $50 billion in assets in order to recoup all the lost TARP money, which is believed to be in the area of $120 billion. The administration believes that the tax, if passed, will recoup all the money in a dozen years.
Berkshire Hathaway head Warren Buffet, who was holdings in Goldman Sachs and Wells Fargo, is, not surprisingly, opposed to this tax.“Look at the damage Fannie and Freddie caused, and they were run by the Congress,” Buffett said. “Should they have a special tax on congressmen because they let this thing happen to Freddie and Fannie? I don’t think so.”
As a result of this uncertainty, the stock market retreated this week. The Dow fell 436 points this week, with most of it coming the last two days. Not surprisingly, the banks led the decline, with JP Morgan and Morgan Stanley losing more than 8 per cent. This coming week should be very interesting.
