Fall Street

Even though it has not yet been compared to infamous financial crises in the past, the recent credit crunch fuelled by the US subprime housing crisis certainly shows no signs of slowing down. Many on Wall Street are of the opinion that far from being over and averted, the subprime crisis is still largely ahead of us. Though there are numerous factors that have contributed to the current situation, it is imperative that we set a strong foundation of understanding the role of investment banks in order to better comprehend the magnitude of the risks that lie ahead for the global economy.
It is well known that investment banking and other financial services firms have a large number of highly compensated individuals. Their primary role however, is to perform a variety of services which include underwriting, acting as an intermediary between an issuer of securities and the investing public, facilitating mergers and other corporate reorganizations and also acting as a broker for institutional clients.
Historically speaking, investment banks have always been a source of debate to many and have been the sole contributor to the lure of Wall Street. In the modern global economy, in spite of strict government regulation in many countries, numerous investment banks have branched out across the six continents, constantly looking to expand their practices and involvement in the economic business cycles . Perhaps the most well known investment bank, The Goldman Sachs Group, Inc has its regional headquarters or offices in New York, Sao Paulo, Melbourne, Mumbai, London and Singapore to name a few.
Even to a layman, it is evident that although the margin for error is little, the profit margins of all established investment banks are most often unusually high. Why is this? What exactly are the qualities of the services offered that lead to such high rates of return? Over the last twenty years, there has been an increase in the amount of money allocated by institutional investors and wealthy individuals to alternative assets. Of these alternative assets, the most pertinent ones are hedge funds, venture capital funds and private equity or leveraged buyout funds. The fees typically paid to any of these funds consist of a management fee that is based of a percentage of total or committed capital and a share of profit or the interests of the fund profits. Today, the typical compensation of a hedge fund is 2/20, which is 2% management fee and 20% of the profits on the total capital.
However, this should only serve as a statistical example to shed some light on specific practices undertaken by investment banks. As far as profit margins are concerned, there is clearly a cut-off line for all banks. For the year ended 2007, Goldman Sachs reported a 25.2% profit margin. Deutsche Bank reported an increase to 21.7% for the year ending 2006. Though investment banking services such as underwriting and corporate advisory do play a large role in these high values, a significant cause can also be attributed to other asset and securities management services that are now proving to be their undoing. Furthermore, an overall expansion in the fixed income market as well as an overall rise in trading revenues also adds to these high profits.
In fact, a thorough analysis of the financial statements of a sample bank (Goldman Sachs) informs us of the three main sources of revenue: Investment Banking, Trading and Principal Investments and Asset management and securities services. In addition, an analysis of their cash flow informs us of the key factors that contribute to the final net income. These are components such as proceeds from sales of property, investments, available-for-sale securities and earnings from various unsecured short term and long term borrowings. Also, the fair value statements of certain instruments are a key indication to the amount invested and the risk that they find themselves in. Of these, the maximum are equities and convertible debentures together with derivative contracts.
Nevertheless, the primary source of income and networking occurs in the Mergers and Acquisition department, where banks are hired to provide advice on a deal while also acting as the underwriter for the entire transaction. Although the fees might seem nominally insignificant, they are immediately inflated when we consider the bigger picture. For example, considering that the total number of deals in 2006 was $3,900 billion, a simple half of a percentage as the ‘average’ fee would yield a colossal $18.8 billion as profit.
Even in the wake of the housing crisis and immense pressure on numerous securities backed and invested in by financial services firms in America, the general consensus on the list of top investment banks, whether they are classified by revenues, volume or simply reputation has more or less remained the same.
In the US, the Goldman Sachs group continues to occupy a slightly elevated place with their higher profit margins, greater liquidity and more recently, risk control qualities in the wake of the credit crunch. Before the housing crisis, Morgan Stanley (which handles the maximum assets), Merrill Lynch, JP Morgan and Lehman Brothers were equally competent and able in securing the handling of major underwritings and security issuances in the capital markets. Globally, apart from the aforementioned banks, UBS AG (Union Bank of Switzerland), Credit Suisse First Boston and Deutsche Bank are some of the names that immediately come to mind for their specialized reputations.
Now that we have briefly been familiarized with descriptions of a few various facets of investment banking, we must analyze the role of macroeconomic factors in determining the state of an economy. In addition, certain definitions must be clearly explained so that we better comprehend the meaning of terms such as recessions, slowdowns and a mortgage crisis.
In numerous magazines, newspapers, websites and news channels, we often hear politicians and economists debating the possibility of a recession. Currently, amidst reiterative statements made by the Federal Reserve and the Treasury, the possibility of a recession has not been ruled out in the near future. However, since it is also claimed that we are already in the midst of a minor recession, it is imperative to clarify the causes and effects of a modern economic recession experienced by a nation.
In the early Greenspan era of the Federal Reserve, fluctuations and risky speculation contributed to a crunch in the economy. In hindsight, many blamed it on the failure of monetary policy since nothing was done to prevent it. Thus, as time wore on, the economy was gradually overwhelmed with repetitively poor management decisions and price rises due to increases in pay. The consequences proved to be moderate but similar to what we are witnessing today.
During the course of a recession, there are normally major financial losses in the banking, insurance and property sectors. Ensuing bankruptcies and liquidity problems tend to affect a part of the basic money supply. The economy can be forced to contract and insufficient purchasing power can make it difficult to maintain the de facto standard of living. As a direct result of this, inflation becomes more susceptible and unemployment simultaneously rises causing many to blame the high interest rates which are thought to bring inflation down. Even conservative economists point to three main groups that always stand a chance of contributing to the prevention of a recession.
(1) Employers: Firstly, during the course of a recession, surplus employees are sometimes released to the labor market. Instead of cutting remuneration and keeping savings up through costs in their prices, the lay-off rate tends to rise and employees are normally not given a chance to save their jobs at all.
(2) Banks: Inflation has a weakness in that it has to be financed in a free market economy. Consequently, most pay increases are necessitated by bank borrowing. However, sensible banks with cautious risk management procedures normally provide additional finance for businesses but not for increases in pay. If banks do not finance it, employers automatically have an answer to an inflationary pay claim before them.
(3) Government: It is theoretically always possible to eliminate inflation. This can be done by legally ensuring that employers be obliged to cut all forms of remuneration and take the savings in costs from prices. Since inflation can be cured, albeit other fluctuations in key macroeconomic factors, it cannot be wholly viewed as a monetary problem or phenomenon to some economists.
Unarguably, a recession is an extremely strong economic term that implies dire consequences and an immediate need to act. This is precisely why the current term that economists prefer to use is an economic slowdown. Although a slowdown does have negative implications, the definitive difference between the two is exposed when the semantics of each are considered. Essentially, a slowdown is characterized by slow economic growth.
The important aspect is that there can be growth nonetheless but obviously at a slower rate than expected. A recession contrastingly is sometimes specifically defined as two fiscal quarters (six months) of negative growth. For further comparison, a depression is often characterized as a severe recession, either in terms of highly negative growth or perhaps negative growth sustained over a considerable period of time.
All definitions considered, where does this help us place the current situation in economic terms? A depression is definitely too strong primarily because apart from the infamous 1930’s Wall Street ‘crash, the US economy has not witnessed a clear cut depression. Through careful analyses of statements made by the Treasury Secretary and various members of the Federal Reserve including the Chairman himself, one would be inclined to think that both Main Street and Wall Street are definitely witnessing a slowdown along with the possibility of a recession in the near future if proper measures are not taken.
Clearly, it is evident that when a crisis looms or has passed, the most important things to consider are the factors that are causing or have caused it. We do this in order to prevent it from further happening and on this note, it would be wise to analyze in detail, some of the factors that contributed not only to the subprime housing crisis, but also to the enormous losses that many top investment banks faced on their balance sheets.
Preceding a look at the causes, we must clarify why it is logically equivalent that a subprime crisis is what is fuelling a slowdown. A subprime loan, to a layman, is simply a loan made at a rate higher than the prevailing interest rate. It is done so because the borrower is a ‘subprime’ customer, which means that he/she is not credit worthy and is generally considered to be risky in terms of bankability. Thus, some estimates claim that people with credit ratings of less than 620 or 600 would tend to fall in this category. It is not an ambiguous fact that a process with maximum risk compared to the alternative would be responsible for creating structural problems in the economy. In any case, it is still surprising that there are so many factors behind the mortgage problems.
For starters, nothing was helped by poor underwriting and in some cases; fraudulent and abusive practices as far as investment and advisory services were concerned. Though not a direct trigger, this partially contributed to the high rates of delinquency that we observe in the adjustable rate mortgages (ARM) market for subprime loans.
Yet, this reason, according to Ben Bernanke’s early January testimony was altogether based on a flawed premise, which was to presume that house prices would continue to rise rapidly in the bubble that had been created for them. In fact, during the time when house prices were witnessing double digit rates, subprime borrowers in the ARM market quickly built equity in their homes where they had paid a low introductory mortgage rate. With sufficient accumulated equity, refinancing proved viable in order to avoid incremental payments on the reset of the rate on the mortgage itself. Though this proved to be a comfortable situation, it all changed when people were no longer able to afford mortgage payments and the demand for homes and hence house prices, suffered.
No longer able to bank on appreciating home values for an increase in equity, refinancing failed where it had previously succeeded and subprime borrowers found themselves locked in their ARM contracts with no place to go. Consequently, not able to pay the introductory rates much rather the post adjustment rates, delinquencies and foreclosures slowly began to rise and have now reached a state of heightened worry.
The impact of the housing crash and apparent economic slump is far from uniform. Based on various studies, Western States have seen the sharpest decline in sales and prices of existing homes as well as the most repossession. The Mid-West has also been suffering from pockets of high unemployment. A careful breakup of the study reveals that among metro areas, the highest unemployment rate for January turned out to be 8.2% witnessed in Detroit. However, based on regional dissection, we clearly observe that in the West, sales have decreased down -29% and -13% in prices.
An important development has also occurred on the macroeconomic front. Increasing oil prices have had nothing but a negative influence on growth by lifting consumer prices and contributing to core inflation. In 2007, food prices also increased rapidly by the standard contributing to further consumer price inflation. Related to all this is the crucial and underestimated depreciation of the dollar which affects the import-export balance and relevant prices. With an increase in inflation, unemployment is naturally affected and consequently, all these factors come into play as the Federal Reserve plans its next rate cut.
Worrisome inflationary problems creates additional hesitancy to alter interest rates because quite simply, lowering the interest rates implies that money can be borrowed more cheaply than before and this improves the liquidity situation in the market. However, a direct result of this if not done carefully is that it causes inflation and other necessary prices to rise.
However, another crucial reason in which it is relatively easy to point fingers is the process of rating risky securities. In retrospect, it is far easier to sit back and fault the overestimated predictions of rating agencies, but criticism has continued to be strong in particular towards the underwriters and rating agencies of volatile packages such as collateralized debt obligations (CDO’s). The argument is that rating agencies should have partially foreseen the high default rates for subprime borrowers and should have rated these far lower than the AAA ratings provided to the higher quality tranches. Perhaps if the ratings had been more accurate, these securities would have lured fewer investors and hence, the losses on them would have been automatically cut down.
A good reason for this turns out to be a possible conflict of interest between rating agencies primarily due to the fact that they receive fees from the original creator of a security. Logically, this might affect their ability to calculate the risk with an unbiased opinion, but the results clearly do not affect the premise.
Since structured products are highly complex, the values of most of these related underlying assets proves difficult to analyze. Thus, investors are inclined to use rating agencies as a means of determining whether to invest or not. Even as subprime mortgage losses rose to levels that threatened highly rated tranches, investors hesitated to question the reliability of credit ratings before they finally became unwilling to hold these products.
Evidently, in order to continue receiving fees, some rating agencies might have been tempted to maintain their high rating standard or else face the risk of their underwriter turning to a different agency. Regardless of this theory, the fact of the matter remains that throughout 2007, underwriters and rating agencies together brought questionable bonds to the market simply based on market demand and without carefully analyzing their worth.
Related to the aforementioned factor was also the underestimated role of asset backed commercial paper (ABCP). When various institutions use special purpose vehicles to help fund different assets (private mortgage backed securities, structured credit products and other long maturity assets), they are enticing primarily because commercial paper is far more liquid than other securities. In addition, commercial paper is also viewed to be ‘safe’.
Unfortunately, concerns about these credit products and mortgage-backed securities by investors made them reluctant to roll over their commercial paper holdings especially at maturities of a few days. This in turn, left the investment vehicle sponsors scrambling for liquidity and hence, they were gradually forced into selling their assets in a highly illiquid and unreceptive market.
Before we move on to the crucial role of banks and other financial intermediaries, a quick note should be made on the role of hedge funds. In 2005, Fitch Ratings claimed that, “Hedge funds have quickly become important sources of capital to the credit market,” but “there are legitimate concerns that these funds may end up inadvertently exacerbating risks.” Looking back now, there is no doubt that the collapse of some reputable and well established hedge funds triggered further weaknesses in the overall financial structure of the US economy.
The cause of this becomes apparent when we consider the characteristics of hedge funds. Investing in largely high-risk ventures, the most important aspect is that a hedge fund is not a transparent entity. This means that their assets, liabilities and other trading activities are not publicly disclosed and they are often highly leveraged, using derivatives or large borrowed amounts of money. Furthermore, as a result of this quality, investors and regulators possess limited knowledge of their activities and because of their leverage, their “impact in the global credit markets is greater than their assets under management would indicate.”
Although hedge funds can deeply cripple a bank through its excessive losses, it is the imbalances on the balance sheet of a bank that are crucial to further credit weakening in the market. In short, most large banks underwrote numerous loans and actually created the structured credit products that were sold onto the market. Additionally, they supported various investment vehicles in more ways than one, by serving as advisers and providing liquidity and credit enhancement facilities.
As their problems compounded, the onus of rescuing the vehicles that had been backed fell on the banks themselves. This was done by either providing liquidity or more popularly, taking the assets of the off-balance-sheet onto their own balance sheets. Also, their own balance sheets welled up further by non-conforming mortgages, leveraged loans and other securities that the banks had extended but for which the secondary markets no longer existed.
However, this expansion of balance sheets had adverse affects on their financial stability. Banks began to report large losses while simultaneously reporting sharp declines in the values of mortgages and other assets. By doing so, they ended up subjecting themselves to valuation uncertainty and sharp drops in their share prices coupled with unsatisfactory quotes on credit swaps painted a bleak picture of things to come in the future. Key indicators such as stock quotes and capital ratios floundered, forcing several institutions to raise capital as an alternative response to combat liquidity.
In doing so however, banks overall have become extremely protective of their liquidity and balance sheet capacity resulting in an unwillingness to fund other participants in the market. With additional pressure on overnight funding rates, the spreads have gradually increased. Lending to firms and households has considerably reduced and this has created a strain in the market.
While the role of banks is still being discussed, a prime component of the subprime mess (Collateralized Debt Obligations) should be discussed briefly. Popular views claim that CDO’s are a major part of the mortgage crisis. However, what exactly is a CDO? When subprime mortgages sense impending debt, the key to a safe passage through the market is found by logically dividing up the risk, creating low-risk investment grade segments and higher-risk (lower rated) segments from the relevant pool of mortgages. The method to do this is by creating a Collateralized Debt Obligation, first done in 1987 for the purpose of financing junk bonds of leveraged buyouts. When mortgages are pooled accordingly, the securitized claims on the overall payment are classified according to the risk that they possess. These risks are referred to as “tranches”. Technically, they are no different from their predecessors in that they also pay the basic principal and interest.
An example of this can be discussed by considering three tranches from a mortgage pool. The highest tranche (the least risky), has the highest credit rating (sometimes AAA) and thus has the first claim on the payments. For this purpose, the interest rate is also lower than the others. Next, the middle or ‘mezzanine’ tranche receives its payments. These represent a far greater risk and usually receive below investment-grade ratings and a high rate of return. The lower most tranche, known as the equity trance, can only receive payments if the other two tranches are paid in full. In doing so, it suffers the first losses of the overall pool. It is highly risky and usually unrated, offering the highest rate of return. All these securities are sold separately so that they can be traded in the secondary market enabling their prices to be discovered in accordance with their level of risk.
In a CDO, approximately eighty percent of the debt on the subprime loan can be resold to institutional investors as senior tranche and investment grade assets. Lower tranches are deemed attractive by some investors in search of high yielding instruments. These can include, but are not limited to hedge funds. Looking back to our brief analysis of hedge funds, it is of significant importance that some press reports have indicated that typical hedge fund leverage while purchasing high yield tranches was 500 percent!
Loosely speaking, this translates to a real world example of stating that if $100 million is present as capital, it would be as an addition to $500 million in borrowed funds to a $600 million investment in equity or mezzanine tranches of a subprime CDO. If these tranches were even 10% (a low percentage) of the total debt obligation, then the other 90% would be sold as investment grade debt to the institutional investors and that $100 million in hedge fund capital would allow private mortgage backed security firms to move $3 billion through the secondary subprime market, $2.7 billion as investment grade securities and $300 million as high-yield junk!
In theory, the outlook for financial intermediaries does not look extremely promising and the effects are being witnessed as 2008 moves along. Now that we have briefly looked at some of the factors considered responsible for the subprime crisis, it is necessary that we look at their effects, keeping in mind the effects they have had on investment banks. After providing a general picture of less than favorable situations across the country, I will consider individual case studies to elucidate my point further.
As far as investment banks are concerned, only a couple so far, have avoided unfavorable media attention by cutting their losses. Not among these is foremost the case of Bear Stearns. As of 2007, the company, one of the largest global securities firms, reported a decrease of over 40% in their net profit margin (for the last quarter) and almost 70% on their operating margin. Their net income fell by almost a billion dollars for the quarter amidst an unfavorable period where they were forced to pledge a few billion to bail out a couple of their bankrupt hedge funds.
Citigroup experienced annual losses of almost eighteen billion dollars. To compound the turmoil that the bank went through, (being the largest bank in the world by revenue), their CEO Charles Prince stepped down in a move that saw Vikram Pandit take his place (December 11th, 2007) , vowing to cut costs and reduce the company’s exposure to subprime risk. Perhaps it is ironic that Mr. Pandit had earlier founded a hedge fund which he sold to Citigroup after thirteen months for $800 million.
For a while, Merrill Lynch was also in the news for all the wrong reasons. Since June 2007, the company saw a 36% drop in its share price, from $84 to $54. Initially announcing that they would write down approximately $4.5 billion in subprime losses (for the third quarter of 2007), Merrill shocked investors and analysts just three weeks later by announcing an eight billion dollar deficit! In June itself, their exposure to subprime loans was $41 billion and an eight billion dollar write down translates into a 19% loss on the bonds that they had been dealing in. By the end of the year, the company had ousted its CEO, Stanley O’Neal in the wake of reporting a loss of over $14 billion.
Perhaps the most recent of all Wall Street shakeups, UBS AG (Union Bank of Switzerland), though not based in the US, announced the resignation of their chairman Marc Ospel while simultaneously reporting a first quarter loss of $12 billion and expecting further write downs upto a possible $19 billion. For the past nine months, the bank’s write downs have totaled $37.4 billion, the largest of any financial services firm so far. Deutsche Bank AG, another of the world’s top financial services firms, accompanied UBS AG to a far lesser extent, announcing write downs of upto four billion dollars for the first quarter of 2008.
To summarize the write downs of the banking industry and put statistics into comparative perspective, a look at the 2007 write downs of the country’s top investment banks yields staggering results. Led by Merrill Lynch with $22 billion, the write down list is completed by Citigroup, UBS, Morgan Stanley and Bank of America with respective write downs of $20.4, $13.7 (fourth quarter), $7.8 and $4 billion.
In contrast to the majority of their counterparts or rivals, Goldman Sachs (and to a lesser extent Lehman Brothers), appear to have minimized damages through their tight oversight and shrewd hedging practices. Still, analysts are of the opinion that the traders at Goldman Sachs especially must have taken huge gambles to raise profits for the third quarter of 2007. Despite a $1.5 billion write down, experts claim that their skill is probably accompanied by an equivalent amount of luck. Their share price is up by 24% this year but still trades at only ten times their earnings, conservative standards by Wall Street expectations.
In an individual case study of Bear Stearns, perhaps the only positive that can be drawn is from the dire consequences of reiterative exposed risk to unsafe markets. It took only a week for everything to vanish. Its decade’s old reputation, corporate culture and identity along with the savings of 14,000 of its employees traumatically vanished at a rate faster than most can imagine. To further put it in perspective, the company was worth twenty billion dollars hardly a year ago. However, on March 14th, it was worth just $3.6 billion (18% of its original valuation) and desperately fighting for survival. Two days later, on March 16th, JP Morgan Chase, headed by Jamie Dimon, put forward a $236 million offer to purchase the 85 year old investment bank for $2 a share. Since this was viewed by most as blatant opportunism, the offer was quintupled to $10 a share making the overall value $1.2 billion.
To most, it didn’t really matter whether the purchase price was two dollars or ten dollars. In one instance, newspapers reported that the morning after the announcement of the deal, a real estate broker stood outside the headquarters of the company and offered his services to those needing to sell their homes quickly! For the most part of its existence, Bear Stearns has always been considered an outlier although it is the country’s fifth largest investment bank. Regardless, its sudden demise has made it impossible to pinpoint the responsibility of an event of this magnitude.
Over the course of the next month, lay offs are expected to occur with JP Morgan already in the process of providing details of retention bonuses and severance payments. In fact, the company’s woes led to further scrutiny of the Securities and Exchange Commission’s role in the collapse. On March 11th, the chairman of the commission, Christopher Cox claimed that he was “comfortable” with the amount of capital held by five of the largest investment banks, including Bear Stearns. Only two days later, Bear sought emergency funding in an incident that would transpire to results of a much greater magnitude as the month would wear on.
Facing even greater scrutiny is the role of the Federal Reserve in the Bear Stearns saga. Many claim that JP Morgan Chase was “egged” on by the Fed. This was further compounded by a statement made by Treasury Secretary Henry Paulson claiming that, “At this time, the Federal Reserve’s recent action should be viewed as a precedent on for unusual periods of turmoil.” The Fed effectively calls it a $29 billion loan, issued in order to finance JP Morgan Chase’s purchase of Bear Stearns. To some, it looks more like a $29 billion investment in securities owned by Bear.
The upside is the opinion that by intervening in March to bail out the investment bank, the Fed may well have prevented an impending series of cascading failures that could have had a severe effect on the financial system and economy. On March 26th, Senator Chris Dodd (D-Conn) announced an April 3rd hearing to explore this “unprecedented arrangement”. Top executives in all three entities are likely to be grilled about the deal. To further shed light on the deal, we must consider what the Fed is actually getting in exchange for supplying $29 billion to JP Morgan Chase. In essence, this deal is far from a standard loan. This is because strangely enough, even though the money goes to JP Morgan, the firm is not the borrower. It means that if Bear Stearns assets turn out to hold less than their calculated or estimated value, then the Fed cannot theoretically demand repayment from JP Morgan. Astonishingly, in the event that there is excess money after the loans are paid off, the Fed gets to keep the residual value for itself.
Essentially, the timeline went like this. When JP Morgan refused the two dollar per share offer(largely because the majority of Bear’s assets were worth almost zero), the Fed set up an irresistible arrangement to provide JP Morgan with the full appraised value for some of Bear’s assets upon their acquisition of the company. The process for this would be as follows. Using a Delaware based Limited Liability Company, the Fed would hand them Bear holdings worth $30 billion. In turn, they would pass on that amount to JP Morgan, the new owner who would lend a billion dollars back to that company. Upon paying back the loans by liquidating the Bear assets that they held, the company would act as a middle man to seal the deal.
The Merrill Lynch study yields similar causes, yet effects that are starkly different from those of Bear Stearns. Presently, Merrill’s balance sheet still has about $90 billion of dicey loans along with other derivatives. This would surely guarantee further write downs as the year progresses. Analysts claim that if it weren’t for the subprime disaster, the company would have raked in over seven billion dollars in pretax earnings.
Their back to back quarterly losses in 2007 (which exceeded their previous two years’ net income) were clearly forced by their subprime dealings. Although their 2006 10-K report hardly mentions the word ‘subprime’, the fact is that the firm was probably heavily reliant on them, treating it as raw material for CDO’s that it could package and sell for rich commissions. To feed this spurt, Merrill purchased subprime originator First Franklin for $1.3 billion at the height of the bear run. It shut down the unit in March, incurring rough $200 million in charges and cutting 650 jobs instantaneously.
However, with the ousting of their CEO Stanley O’Neal, insiders are far more optimistic of the crisis in the coming months. Most still hold him responsible for taking the dive into the subprime market in an effort to shore up the balance sheet and raise profits. Recently, on the heels of their eight billion dollar write down, new CEO John Thain has proceeded to cut the value of Merrill’s securities and related hedges by another $14 billion.
Last December, in an effort to strengthen the bank’s damaged balance sheet, Merrill agreed to a $6.2 billion cash infusion from Singapore’s Temasek Holdings and Davis Selected Advisors. This additional and much needed raising of capital was expected by around mid January and has gone some distance in calming investor fears that the bank would collapse under liquidity pressures. Although Merrill is trading at one and half times its book value and at half the levels it hit at the turn of the century, its investors remain optimistic in the new leadership and impending recovery of the markets.
Citigroup, the most diversified of all banks that generates more than half its revenue from its consumer banking services should theoretically have been hit less than its rivals. Since October 2007, its write downs have mounted gradually to colossal proportions. From its 52 week high of $57, Citi shares are currently being traded at approximately $24 a share, far greater than half a drop in stock value. Its fourth quarter profit has been wiped out by their bad subprime mortgage investments and some analysts project that in spite of the change at the top, another few billion in write downs could be in the offing.
Having also announced a capital raising move to sell 4.9% equity stake to the Abu Dhabi investment authority, Citigroup exemplifies the fact that in the current hour, liquidity is the safest bet. However, the company’s recent struggles have done nothing to allay fears that their diversified business model and risk management practices are actually a recipe for success. In reality, there have been bad bets at its investment bank, souring mortgage and credit card loans in its highly touted consumer division and bloated costs across the company.
Now that we have individually considered the cases of some of the top investment banks in the country, it would be wise to turn our attention to the global economy keeping in mind the monetary policies of the US government. By doing so, we will better understand how such a small segment of the economy (the subprime market) can trigger global panic repeatedly. Of prime importance, simply because it affects almost every commodity globally, is the status of the US dollar.
Against the Euro, the dollar has slipped up 5% this year touching record lows in the process. Since the beginning of 2005, there has been a 23% dip. Simultaneously, the dollar also touched its weakest level against the Japanese yen in eight years. This predictable dip can easily be traced back to flagging US economic growth and reduced global demand for US dollars. As a result of the repeated rate cuts by the Federal Reserve, investors automatically earn less on US bonds than on foreign debts because other Central Banks have not followed suit. Joseph Brusuelas, Chief Economist for Singapore-based IDEAglobal, believes that, “The Fed has cut rates repeatedly and we think they’ll cut another percentage point before it’s all done. That is profoundly dollar negative.”
The negative impacts however, are also long term. The U.S trade deficit currently stands at $712 billion which means that American dollars outside America have increased. A falling dollar can negatively affect inflation by increasing import prices as investors may snap up commodities to bet against the dollar. On the other side, a weaker dollar makes American products cheaper overseas thus boosting U.S exports. To some analysts, the turning point in this six year old bearish dollar market could occur with a change in the relationship between U.S and European interest rates. However, many strategists suggest that the dollar will act as a direct function of the state of the housing market. Therefore, until the economic slowdown shows signs of bottoming, the dollar will remain under pressure.
The subprime crisis unfortunately, is not limited to the U.S alone. The reverberations from this crisis have basically left no region of the world untouched. From Germany to Japan and India to Iceland, stock markets around the globe have repeatedly fallen and experienced their worst quarter in years. In fact, the two fastest growing economies in the world of India and China have seen this year’s worst falls with shares in both countries down more than 20%. The Nikkei, Japan’s stock index, feel equally deep into the mire down 18%. Europe has not missed the gloom either and benchmark indices in the UK, France, and Germany have each fallen more than 10%. If anything at all, such incidents only illustrate the fact that far-flung markets have become highly correlated as time progresses.
With extended ranges of global investors, connections between various markets have deepened. Thus, when markets get more volatile, they all tend to move in the same direction. However, this broad dip in global markets is contrary to the state of expectation for global economic expansion outside the U.S. Still, one factor that has remained constant to the start of 2008 has been the slide of the US dollar, as mentioned earlier. While shares rose across the world, the weakening of the dollar provided an impetus to investors while simultaneously increasing their rate of returns. The constraint is that there are mounting fears that the super charged Euro, on the other hand, will make life difficult for companies that export services and goods overseas.
So is it over? A terse analysis of the first quarter is perhaps the key for future predictions. The Dow Jones Industrial Average finished March 7.6% down from where it started the year. This has been its worst quarter since the dotcom bust at the turn of the century. Shares have been driven to all time lows and the bond markets have witnessed turmoil that climaxed with the collapse of Bear Stearns Co. Over the past three months, the Dow has lost over a thousand points, the largest first quarter point decline ever. The five month consecutive losses on the Standard & Poor’s 500-stock index are its longest loosing streak since the 1990 crisis.
Apart from all these startling figures, the general outlook is that things will turnaround sooner than later. The Federal Reserve has been aggressive in its policies and they, in turn, have been reflected in the Fed’s actions. The reduction of short term interest rates is believed to be a right step in easing the liquidity strains on the economy and help stabilize the financial system. The pessimistic side contends that the job losses have barely begun and declines in home prices appear to be accelerating. The cost of raw materials remains high and this will lead to a dip in consumer spending while also crimping corporate profits.
Renowned economist Paul Krugman has a distinct set of beliefs regarding the status of the economy as a whole. He treats the current situation as a combination of the 1990 and 2001 slowdowns, albeit a little more threatening. He maintains that there is financial disruption which is greater than the Savings and Loan crisis and when compounded with the wealth erosion from the housing bust (greater than the dotcom bust), the current situation is not one to be treated lightly. Furthermore, supporting the rate cutes of the Fed, he maintains that Japan’s zero-rate interest policy could be a reality should the situation demand it of the Fed. Keeping in mind the $200 billion bailout by the Fed, Krugman warns that though it may seem like an aggressive action, the amount is still relatively small in comparison to the securities market that is currently at risk.
In conclusion, we have two options to determine our opinions. The first is to further consider statistics related to the current state of the housing economy. The two crucial barometers of the nation’s housing market have worsened considerably. Towards the end of 2007 (fourth quarter results), the number of American homes entering foreclosure rose to the highest level of record. Contrastingly, homeowners’ share of the equity on their homes fell to an all time low since World War II. It is this contrast that also indicates how the drop in home prices is weighing on consumers directly and indirectly. Rising mortgage debt (faster than home prices) has ensured that equity as a percentage of home values have been falling from its high back when World War II ended.
The second option is to consider the broader outlook. For months, economists have debated whether the United States is headed towards a recession. Introducing a $150 billion stimulus plan and cutting short term interest rates may not be the solution to the entire problem that keeps the economy from sliding. Severe liquidity problems remain and the subprime mortgages have produced a serious credit crunch to consumers across the nation. Oil is still hovering around the $100 mark and unemployment, as evidenced by Mr. Bernanke does not paint a promising picture. To further clarify, it is worth noting that American consumers spend about $9 trillion a year; while China’s and India’s combined spend well under $2 trillion. Even in wealthy European households, global insecurity and low income growth have caused households to save more than usual. Since countries such as China rely on their exports to sustain their economic growth, the pinch to the US consumer could have a telling effect on the trade balance between the two countries.
It is not hard to see why an American financial crisis could increase global worry financially. After all, America accounts for approximately 25% of the world’s Gross Domestic Product. Thus, apart from China, other countries such as Canada, Mexico, South Korea and the rest of South-East Asia may be at risk since they are reliant on their exports to the United States. Other factors of concern include the weakening US dollar, falling commodity prices faltering financial confidence worldwide and speculative opinions that the US isn’t the only nation that has witnessed a housing bubble.
In hindsight, it is far too early to deem the current situation as a recession. However, the status of the economy is precarious and only the coming two or three years will let us know whether the hit can be negated or softened as much as possible.