FYI | Sep 22 2008
By Greg Peel
“Nobody understands who owes what to whom – or whether they have the ability to pay. Counterparties have become afraid to trade with each other. Sovereign wealth funds are no longer willing to supply badly needed capital because they no longer know what they are investing in. The crisis continues because nobody knows what anything is worth. You simply cannot have a functioning market under such circumstances.”
This neat summation, provided by Joe Nocera of the New York Times, defines the situation the US, and the world, has found itself in some 14 months or so after the global credit crunch began. This is the big picture view. It was, however, a small picture view that prompted extraordinary action from the US Treasury late last week.
On Thursday morning in the US, the Treasury acted quickly to inject US$105bn into the financial system. This was not the Federal Reserve acting in its role of system manager, it was the government. It has since been suggested that had the Treasury not made such an injection, the system would have collapsed, reverberating into the stock market and sending the Dow down over 20% in one hit.
What specifically prompted the injection was a sudden and massive increase in money market fund withdrawals. Whereas to date the focus has been on share prices of financial institutions being hammered down, and credit spreads being blown out, the withdrawal of funds from the money market was effectively one step away from a traditional “run” on a bank. Except it was a run on all banks, all financial institutions, and all corporations who borrow money. In essence, the run on money market funds was a run on the US economy.
Investors – particularly small, “mum and dad” investors – have come to equate a money market fund as being not unlike a bank deposit except that it pays a slightly better rate of interest. But this is a misconception, for while a portion of all bank deposits are protected by the government (up to US$100,000 in the US) there is no protection for money market accounts. They are simply a risk investment like all others.
But money market funds are to a great extent what keep the daily wheels of the economy turning. Money market funds buy short term loans from banks and corporations – what is known as “commercial paper”. It is this paper which the banks use to finance credit cards, which finance companies use to provide car loans, and which companies use to fund their day-to-day operations, for example. Imagine what might happen were that market to suddenly shut down. The economy would stop.
There is little agreement among reports as to just how much money was withdrawn from US money market deposits on the week ending last Wednesday. I’ve read everything from US$58bn to US$144bn. But what all reports agree on is that in the week preceding, only US$7.1bn was withdrawn. From this one can gauge the element of “run”. Banks operating money market accounts usually keep an average of US$2bn aside in cash to cover any account withdrawals. On Wednesday last they had to pump that up to an average US$90bn, and by Thursday US$100bn, according to the Wall Street Journal.
Money market accounts are an essential part of the “cash” portion of any balanced pension fund. There was suddenly an extraordinary level of withdrawals out of accounts not from mums and dads but from pension funds and sovereign wealth funds. While money market funds have never been explicitly capital guaranteed, there has always been a perception that capital invested is implicitly “safe”. However, it was late on Tuesday when one large money market fund – the Reserve Primary Fund – announced it had “broken the buck”. What this means was the value of all funds held in its accounts had fallen to only 97 cents of the investor’s dollar.
With the real threat being that all money market funds would “break the buck” and the entire system would collapse, the Treasury acted quickly on Thursday to make its US$105bn injection. The reason Reserve Primary had hit such a level is because it was heavily invested in the bonds of a company known as Lehman Bros. When Lehman filed for bankruptcy last week those bonds defaulted.
In allowing Lehman Bros to fail, the Fed and the Treasury thought they were doing the right thing. Neither had the capacity to run around and save every financial institution which had found itself in strife through its own poor decisions. They had “saved” Bear Stearns to prevent a sudden collapse of the system, but had also opened the emergency lending facility to investment banks. If Lehman was to go under with the facility available to it, then what was the point of trying to “save” Lehman as well? The system was never going to repair itself unless “weak hands” were allowed to fail. The Treasury had also just forked out to acquire Fannie and Freddie. The difference there was an overt move to be seen to be saving US mortgages, rather than Wall Street bankers.
The warning had gone out that were Lehman to fail, no one could quite predict the effect this would have on the large and largely unaccounted for credit default swap market. Positions on the wrong side of a Lehman’s default were spread right across the system, and nobody knew how many there were. What we did suddenly realise, however, was that when the world’s largest insurer – AIG – went to the Fed looking for a quick US$20bn loan to help it deal with defaulted bonds it had insured, it was not mucking around. But having said no to Lehman, the Treasury said no to AIG.
This was to prove a grave error, and it was only when the authorities were hustled in to take a look at AIG’s books did reality hit. The blood would have drained from Paulson and Bernanke’s faces. Having said no to US$20bn, suddenly they offered US$85bn. AIG was saved, and the authorities lost all credibility. They had saved Bear but not Lehman, they had said no to AIG, then saved it, but it was all too late for Lehman. What next?
By Thursday, and despite a US$105bn injection from the Treasury, the US financial system had frozen. It had reached the ultimate point as described by the opening paragraph to this article. Credit spreads blew out to ridiculous levels because no one was willing to lend. With no money in the system, suddenly the last two investment banks on Wall Street, which had so far weathered the storm pretty well, were seeing their share prices shot to oblivion too. If investment banks can’t borrow, they can’t function, and very quickly it looked like Morgan Stanley would not see out the week. Goldman Sachs was also in trouble, and that investment bank had famously not bought any of the mortgage-backed CDOs which had precipitated the whole disaster. Goldman would have gone down merely as collateral damage.
The problem of financial sector shares being sold down rapidly was exacerbated by the authorities’ acceptance of “naked” shot selling – selling stock you have not yet borrowed. Ironically the SEC had imposed a brief ban on naked short selling back in July, but after Fannie and Freddie were saved the ban was lifted again. The SEC was still dithering about the problem on Thursday when, mid-session, the UK authorities announced a total ban on all short selling in the financial sector. Goaded into action, the SEC, after the closing bell, announced it might impose the same ban.
The SEC made good on Friday, but not before the Australian Securities and Exchange Commission had also decided to impose a ban on Friday local time, at least on “naked” short selling. Over the weekend ASIC has gone one better and banned all short selling as of Monday. The only exemptions are for market makers who use covered short selling to hedge their options, warrants and other derivative services.
On Friday the US Treasury also made another decisive move. It tapped into its facility known as the Exchange Stabilization Fund – a facility put in place in 1934 – and put up US$50bn to save the money market funds. For twelve months the Treasury will insure all the holdings of eligible money market mutual funds.
The significance of this move alone cannot be underestimated. Earlier in the year, panic spread across Middle America when the country’s largest regional bank – IndyMac – went under. For many Americans this was the first time they learnt that the lender of the last resort facility only meant the first US$100,000 of any deposit was guaranteed by the government. A bank deposit is meant to be as safe as any investment can be. That’s why it pays a low rate of interest. Money market accounts pay higher rates of interest because there is an inherent risk, albeit a small one (until last week). But now all money market accounts are protected, regardless of how much.
By late last week the market had begun to lose all faith in the US Treasury. The decision to allow Lehman to fail and then to back-flip on AIG suggested to the world that neither Hank Paulson, nor Ben Bernanke, nor anyone else for that matter, had any real idea what to do. The writing was on the wall. Paulson – a politician – had previously applied the requisite spin to current financial difficulties, suggesting times were tough but we’d all pull through. But it was a sleep-deprived and candid Paulson who greeted journalists late last week. The situation was dire, he told them. A new and comprehensive plan was needed.
News of an impending “plan” was first broken on CNBC late in Thursday’s trading session on Wall Street. At that point it was expected such a plan would likely mirror that of the Resolution Trust Corporation which stepped in during the Savings & Loan crisis of the early nineties and took control of all the real estate that had been lost in the collapse of so many small S&Ls. In so doing, the US government had been able to stabilise the market and implement an orderly disposal of assets over time. At the end of the day, the US taxpayer lost no money.
Paulson’s plan for 2008 will supposedly involve giving the government the broad power to buy all the bad debt of any US financial institution for the next two years. This debt represents all the toxic asset-backed securities and other credit derivatives that have brought the US and world financial systems to their knees. The amount of funds required has been variously touted as US$700bn, or US$850bn, while others have suggested that realistically US$1 trillion will be needed, or even US$1.3 trillion. Taking the first figure of US$700bn, the requirement would be Congressional approval to raise the government’s statutory limit on the national debt from US$10.6 trillion to US$11.3 trillion.
The details are still not set in stone, and given this legislation will need to be rushed through Congress there is every chance it will be tweaked before finally passed. There is supposedly bipartisan support for its passage, but a few dissenters may yet force the changing of some details. It is hoped the bill will be seen through in a week.
This plan differs from the RTC of the nineties because the US government will actually be buying the toxic debt from financial institutions which are still in operation. In the S&L crisis the RTC simply took control of the assets of already bankrupt institutions, most of which were plain old houses, not complex financial derivatives which few even understand. The question thus is: what price will be paid?
The plan so far is to hold a form of “reverse auction” of the various assets. This means the US Treasury puts in a high bid and then opens up the floor for any institution to decide just how little they are prepared to accept for those assets. With the threat of bankruptcy now hanging over many an institution it may be that those bids will be low. The institutions know that they will never be able to raise the sort of capital they need to survive if they still have unpricable toxic securities on their balance sheets. Thus they may be willing to accept, say, 20 cents in the dollar just to get rid of the stuff, just as Merrill Lynch had done months before. If that happens, the US government will be “buying” the assets at very low prices and over time should be able to manage them and sell them back out at a profit.
One has to remember that within all these toxic instruments lie actual “good” loans.
But what if the institutions hold out? What if they are still marking their assets at 50 cents in the dollar and can’t afford another write-down? This is where it is all still unclear.
It would be safe to assume that most in the market accept such a plan as a necessary and inevitable evil. To not act in such a comprehensive fashion would be to allow the world’s financial markets to fail, wreaking havoc on the global economy. On the other side of the fence are those who invoke the “moral hazard” argument – the argument that suggests Main Street has been forced to bail out greedy Wall Street.
Whatever the argument, it is going to happen anyway. The real question is as to whether or not such a plan is going to actually work.
We have seen markets across the globe rebound spectacularly over Thursday and Friday, and the same will be true in Australia today. These rebounds lend themselves to two sources. One is the faith in the US Treasury’s plan to stabilise the financial system and stop more institutions going to oblivion on the slippery slope, thereby also stabilising the global economy and preventing a Great Depression which may have made the 1930s look like a curtain raiser. The other is the universal ban on short selling, which forces hedge funds in particular to scramble to cover their short positions, thus pushing up the market hard.
The victims of the short selling bans will be hedge funds across the globe, including in Australia. Many will go down.
This will clearly not upset too many smaller investors. But what smaller investors would like to know is as to whether these solid rallies mean it is all over – the credit crunch has ended and a new bull run has begun.
No, that is not the case. The fiercest stock market rallies occur not in a bull market, but in a bear market. This rally will be a short covering scramble, accompanied by bargain-hunting buying, but the root problem has not gone away. Those toxic assets in the US will not be annulled, they will just belong to the public sector instead of the private sector. If the Treasury does manage to pick up the securities at a nice cheap 20 cents in the dollar or thereabouts, there will be another big round of write-downs. Finally a price will be set and that price will not be a pretty one, one assumes. This will still impede the raising of capital needed to return any business back to normalcy.
And the rest of the world will not be feeling so inclined to rush in either. The US dollar has become a spurious reserve currency, controlled by a government which has been seen to not really know what to do.
On a local level in Australia, consider that last week the cost of wholesale bank funds blew out to levels not seen since the Bear Stearns turmoil – levels which prompted the banks to independently raise their lending rates. Now the ball is firmly in the RBA’s court. Will it make an emergency cut? It may need to drop the cash rate by 50 basis points just to prevent banks having to actually raise their lending rates once more.
And where does that leave all the highly-geared companies in Australia who are trying to reduce their debt levels, and/or borrow money to survive? The stability that the US Treasury’s plan may bring is not in itself a solution, it is only a “time out”.
There is a very good chance that world and Australian stock markets will continue to rally fiercely this week. There is every chance that rally will peak and selling will return again soon. There is still a chance we may see new lows.
