Financial Meltdown
Oct 5, 2008
Posted by Jody Eisenman | Filed under crisis
Last week, the Chairman and CEO of AT&T made a curious announcement. He stated that his company was unable to sell any commercial paper last week for terms longer than overnight.
This is not some fly by night company. This is a company that is a household name, one that earned 13 billion dollars last year on sales of over 120 billion. Yet no one will lend them money for any terms other than one day!
Two days later, Mike Jackson was on CNBC. Jackson is the head of Autonation, a conglomerate that is the largest auto dealership in the country. They not only sell cars and trucks, but also arranges financing to purchase these vehicles through third parties. Most people who purchase cars tend to finance them, rather than pay cash. Jackson stated that Tier one customers (people with the best credit ratings) were getting 90-95% approval rating on their auto loans until about a month ago. Today, that number is down to about 60%. People with weaker credit histories saw their acceptance rates drop from 50 to around 10%. He thought that as many as 3000 dealerships could go bankrupt in the next 24 months.
Recently, the Prime Minister of France stated that “the world is at the edge of the abyss”.
In recent months, we have seen the demise of Bear Stearns and Lehman Brothers, a government bailout of AIG to avoid bankruptcy, and the effective takeover of Fannie Mae and Freddie Mac. This past Friday, President Bush signed into law an unprecedented 700 billion bailout for the financial industry. Despite this, the US stock market continues to drop dramatically. Unemployment is over 6%, and will almost certainly go much higher. Even worse, the credit markets are in complete turmoil. The economic situation here, as well as worldwide, is dire, and I’m not mincing words. I believe that we could be on the verge of the worst financial disaster this country has ever seen.
What the heck is going on?
Lets go back to 1929. Although there are many opinions as to why exactly we went into a depression after the market crashed, there can be little doubt that too much debt going into an economic downturn led to massive foreclosures. In other words, with unemployment rates hitting as high as 25%, people simply could not repay their debts. In addition, mortgage practices at the time were to give homeowners 5 year interest only loans with a balloon payment. Banks would generally issue another 5 year note at the time the balloon was due. However, due to the contraction of the economy, the banks were a lot less willing to lend money. They wanted to hang on to their capital (very similar to today). Instead, they refused to re-loan the money and demanded full payment on the mortgages. As very few people could come up with the entire price of their home, the banks simply foreclosed. By 1933, one of every ten homes became bank owned.
In order to try to prevent this from happening again, the US government prevailed upon the banks to issue 20 and 30 year conventional mortgages, such as what is typical today. However, the banks felt these were too risky, so they balked. In order to induce the banks to lend in this fashion, President Roosevelt created the Federal National Mortgage Association, or Fannie Mae, in 1938. Essentially, assuming the home buyer met certain guidelines (such as a minimum of 20% down and sufficient income), Fannie (FNMA) would be willing to buy the mortgage from the bank, effectively guaranteeing the interest and principal if the home owner defaulted. FNMA (and later Freddie Mac, another similar government agency) would pay for the mortgages by issuing short term bonds. These mortgages would generally be sold to investors (generally institutions like pension and mutual funds) in large blocks. The institutions didn’t have to worry about defaults, as the government agency were backing them up.
This situation continued for over 50 years, until two major events changed the game forever. The first event happened the Clinton administration. Due to various special interest group pressures, as well as the desire to allow more people to purchase their own homes, mortgage standards began to relax. In addition, Fannie and Freddie began to purchase a lot more risky loans (known as subprime). In the last few years, it became worrisome to many that these agencies (collectively known as GSEs) were taking more risks than their balance sheets could handle. Unfortunately, the situation deteriorated as mortgage lenders relaxed their standards even more. In addition, in order to make loans at almost any cost, financial institutions began offering many exotic products (such as the old 5 year interest only mortgages!). This allowed a lot of borrowers to get in at low rates, but also put them in a position where their payments would almost certainly rise, sometimes dramatically, over time. However, even this could have been withstood by the financial industry except for event number two.
In 1999, congress repealed the Glass-Steagall act. This law, passed in 1933, created FDIC. However, more importantly, it created a separation between banks and investment companies. Thanks to over $200MM in lobbying, the new Gramm-Leach-Bliley act passed which effectively allowed banks to underwrite securities and led to large financial “supermarkets” like Citicorp and JP Morgan Chase. However, it also allowed these institutions to underwrite and trade these mortgage backed securities, also known as Collateralized Debt Obligations (CDOs). In addition, the Federal Reserve gradually relaxed it’s margin procedures, effectively allowing these financial institutions to leverage their balance sheets as high as 40 to 1. Effectively, firms like Lehman, Bear Stearns and Merrill Lynch began to borrow huge sums of money at low rates, and looked to reinvest it at higher rates. Obviously, this is a very risky proposition. For years, these firms made handsome profits, and paid their top executives accordingly. From 2004-2008, Dick Fuld, the head of Lehman, earned over 250 million dollars in total compensation! Henry Paulson. The current Treasury Secretary, achieved a personal net worth of over 500 million, mostly from Goldman Sachs. One of the items these firms decided to get involved with was sub prime mortgages. Frequently, they would buy huge blocks of this paper and then create a new security to sell to investors. To understand this, think of these mortgages like a pie cut into several slices ( also known as tranches). The top slice, or tranche, would be guaranteed to be paid off first in case of default. The investment banks packaged these products, added their fees, and sold them to institutional investors all over the world. Somehow, the rating agencies managed to give these tranches relatively high ratings. The bottom tranche, which would only be paid off after all the others, clearly the most risky. The banks kept these tranches on their books (sometimes off shore) and simply borrowed against them. Now, there was no way these risky low rated tranches were worth full face value, or 100 cents on the dollar. However, the regulators never seemed to figure this out. So, essentially, these banks were playing a risky game of chicken. Then the roof caved in.
First of all, housing prices started to drop. Borrowers were defaulting. It became obvious that these banks had a problem. However, when you are borrowing against your capital at 20 or 30 to 1, this is not a small issue. This could imperil your entire existence. While these banks kept up the charade that these assets were still “money good”, Citi and Merrill began scouring the world to try to get capital to shore up their rapidly deteriorating balance sheets. It was at this point (late in 2007) that I began to get concerned about the US stock market. Now, a new accounting rule came into play. The Financial Accounting and Standards Board (FASB) passed a rule that stated that banks could no longer put on this charade about how much (or little) their assets were worth. They had to “mark to market” their assets, essentially now revealing to everyone what these sub prime mortgages were really worth. All that was needed was a catalyst. This happened on July 28, when Merrill Lynch sold about 30 Billion dollars worth of the CDOs for 6.7 billion. This was about 22 cents on the dollar. It got worse. In order to get this sale done, Merrill financed 75% of the purchase, Since in the case of default, Merrill’s only recourse was to claim the toxic loans back, the actually price worked out to be around 5 cents on the dollar! Too bad for Merrill. However, now that this sale was consummated, the other banks, which held similar paper, were going to be forced to take huge write downs as well. Effectively, as amazing as this sounds, many of them were now essentially bankrupt.
Next: Why Bear Stearns Lehman and AIG essentially went under.
