Fear and Greed Blog

Lehman Brothers announced that they will file a petition under Chapter 11 on Monday morning.

It's a sad, and apparent end, to a 158 year old firm.

Together with the news of Merrill being purchased by Bank of America, and AIG in a search for capital to avoid a downgrade, the markets on Monday will be highly volatile (obviously).

We will learn more in the morning.

There has been a tremendous amount written about the credit crisis; its origins; who's to blame; potential solutions, etc. Some of this has been excellent; some, not so much.

I am still trying to catch up and provide, perhaps, my own observations.

In the mean time, Gillian Tett and Paul J. Davies of the FT wrote a particularly good article in December that's worth a look. That paper continues to provide insightful information and analyses.

Bill Gross and Paul McCulley, of PIMCO, are also providing good insights that are available here and here.

One thing that I continue to find troubling is that so many of the holders of effected securities (ABCP, CDOs, etc.) seem surprised that it was possible for them to incur losses on their investments. The perception of increased risk for increased return seems to have eluded them.

Perhaps their surprising losses were due to fraud on the part of those who sold the securities to them. I'm sure we'll learn more about this in time.

The entire structured world and the banking system will likely be examined, to various degrees, as the situation in the markets becomes clearer.

It was well known in the financial world that risk was being priced at unusually low cost. Spreads on lower grade securities were squeezed as demand for higher returns apparently outweighed the fear of associated risk.

Given that the positions of many SIVs and conduits have been taken onto the balance sheets of the financial institutions associated with them (CitiGroup being the largest example), there will (appropriately, in my opinion) be a reexamination of what types of entities should be subject to regulation and how their assets and liabilities should be presented on financial statements.

On the other side, however, is the question of what constitutes an "accredited investor" and/or who should be allowed to make the decisions to purchase specific investments.

Personally, except for cases of fraud, I am offended by investors that claim to be sophisticated (the definition of "accredited investor" is an attempt to clearly state who is sophisticated), until they incur a loss.

It's understandable that people/institutions don't want to lose money, but I think it's childish to claim ignorance when investments generate losses.

These parties want to have access to all of the wizardry the financial houses can devise, but not the ones that lose money (I'd like that too, if only the world worked that way).

Perhaps the SEC and other regulators should consider a licensing exam to purchase unregulated investment products instead of assuming that having assets/income makes investors qualified to understand what they are buying.

Agents have to be licensed, why not their customers? It should generate a more sophisticated group of investors, whether or not they pass the test.

I, at least, think it's an intriguing idea.

People and institutions that were defrauded should be protected, but I have a problem with rewarding laziness and/or stupidity. Sophisticated Investors are supposed to be able to understand the risks involved in what they purchase and to be able to bear the burden of any related losses (which is why the Securities Act has an asset/income definition).

The ratings agencies, who are being picked on as the implied regulators, made their own mistakes. They always stated that investors should not rely on their ratings; and almost everyone knows that they are compensated by the issuers.

More later.

Mark:

Two things, with very long explanations:

1. In my opinion you are WAY oversimplifying the Federal Reserve, its role in general, and its culpability in this instance.
   
   The Federal Reserve is, in fact, a regulator. As I noted in my follow up comment, I exaggerated the relatively free markets we enjoy by referring to "unregulated."
   
   You said "The board of governors of the federal reserve system determines monetary policy and how to implement it."
   
   That is partially true. The Federal Reserve determines monetary policy, but they have only specific tools with which to implement it. Specifically, according to page 27 of The Federal Reserve System: Purposes & Functions:
   
   

   By conducting open market operations, imposing reserve requirements, permitting depository institutions to hold contractual clearing balances, and extending credit through its discount window facility, the Federal Reserve exercises considerable control over the demand for and supply of Federal Reserve balances and the federal funds rate. Through its control of the federal funds rate, the Federal Reserve is able to foster financial and monetary conditions consistent with its monetary policy objectives.

   
   Other than using the Discount Rate and open market operations to manage the Federal Funds Rate, the Fed's other main tool is to change reserve requirements, but that is very tricky to do without major market disruptions.
   
   I'm not sure how to specifically address the other related comments. The division of supervision over certain financial institutions (which does NOT include all of the players in the markets), from page 60 of The Federal Reserve System: Purposes & Functions is:
   
   

   The primary supervisor of a domestic banking institution is generally determined by the type of institution that it is and the governmental authority that granted it permission to commence business (commonly referred to as a charter). Banks that are chartered by a state government are referred to as state banks; banks that are chartered by the OCC, which is a bureau of the Department of the Treasury, are referred to as national banks.
   
   The Federal Reserve has primary supervisory authority for state banks that elect to become members of the Federal Reserve System (state member banks). State banks that are not members of the Federal Reserve System (state nonmember banks) are supervised by the FDIC. In addition to being supervised by the Federal Reserve or FDIC, all state banks are supervised by their chartering state. The OCC supervises national banks. All national banks must become members of the Federal Reserve System.
   

   
   There are no governmental bodies that regulate the Ratings Agencies (although Congress is looking into that - scary thought). The users of their products, however, are accredited investors. Accredited investors ARE expected to be able to understand the meaning of the reports from the ratings agencies. That's not to say that there won't be litigation against the agencies (I'm sure there will), it's just not a slam dunk (forgetting George Tenet for a minute).
   
   You also seem to be stating that it's the Fed's job to determine whether assets are becoming overpriced. In fact, that is NOT THE FED's ROLE! In fact, the Federal Reserve Act states:
   
   

   The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates (emphasis added).

   You seem to expect too much of the Fed and other regulators.
   
   Keep in mind that the reason the Federal Reserve cut rates to the level that they did was in response to a recession and the economic effects of 9/11.
   
   Another important thing to keep in mind is that the Federal Reserve only can act on short term interest rates. When the Fed started to raise rates in June 2004, the long term interest rates fell, first to the point where we had a flat yield curve, and then the yield curve inverted in July 2006.
   
   The liquidity (at least in my opinion) was coming from overseas. Exporters, such as China, kept their dollar revenues in the US and invested them in liquid securities (primarily long term Treasuries), pushing down yields (if they hadn't, they would have imported inflation since their currency is, arguably, overvalued and there are not enough productive opportunities to invest the cash locally).
   
   The desire by other investors for higher yields drove them to compress the spreads on all other investments, effectively pricing risk at zero. It was that environment that created the bubble.
   
   In order to counteract this effect, the Federal Reserve would have to had increased short term rates to a level that would have created a terrible recession, if not a depression - EXACTLY THE OPPOSITE OF THEIR MANDATE!
   
   I guess the short way of expressing it is that we had a choice, we could lower the cost of capital, risking excessive asset investment, but keeping the economy running and people employed (without inflation); or we could increase the value of the dollar at the expense of increased unemployment and possible deflation (which would be deadly to the economy - it means that you wait until the last minute to consume because prices will be lower tomorrow).
   
   There are no easy answers.
   
   Also, I think you misused "moral hazard."
   
   Moral hazard is the belief that, if you make a bad investment, somebody else will reimburse you (effectively) for the loss.



2. The Citibank / CitiGroup issue is a little simpler. Their explanation of "maximum exposure" is incredibly misleading. Their explanation is:
   

   "For this purpose, maximum exposure is considered to be the notional amounts of credit lines, guarantees, other credit support, and liquidity facilities, the notional amounts of credit default swaps and certain total return swaps, and the amount invested where Citigroup has an ownership interest in the VIEs."

   
   They don't really explain the meaning of "Notional Value".
   
   If you read the definition (and you can find others using Google), what they are saying is that if they own an option to buy something for $50 and hold an option to sell it for $50, they have $100 dollars of exposure (despite the fact that the position is perfectly hedged). Furthermore, if they own a Call to purchase a security at $50 that cost them $1, they can only lose $1.
   
   Notional values are a common term in the finance/derivatives world, but the meaning is not obvious to people outside of that world.
   
   If Citi said that they had $20 trillion of notional positions, that wouldn't tell you what they could lose, if anything. It is fully possible that they could have $20 trillion of notional valued positions and have nothing at risk.
   
   Of course, there may still be counter-party risk, but that's a story for another day.

While M-LEC may take some of the pressure off of credit markets, the overhang of leveraged loans and high-yield securities still looms.

According to Fitch Ratings, there are $577 billion in leveraged loans and high yield securities maturing between 2008 and 2010. There is an additional $283 billion coming due in 2011, and more after that.

Typically, companies try to roll over these loans. The existing loans, however, were issued in an unusually loose credit environment. Credit spreads were compressed in the market place (risk was priced at an unusually low level), Treasury securities were still at low yields, and then there were the covenant lite loans.

It is highly unlikely that these loans will be refinanced on terms similar to those of the original loans/bonds.

The question then becomes, how are the companies performing? Unlike structured securities, this will be relatively straightforward.

In all likelihood, unless the Fed drives rates down significantly below 4 percent, there will be a large number of defaults.

This situation only relates to the structured security mess in that losses in those markets could lead to distress sales of existing loans/bonds, and a lack of appetite for new loans.

Personally, I'm brushing up on my distressed securities skills. I'm reviewing notes from my bankruptcy class with Professor Ed Altman, looking over my notes from the bankruptcy seminars I took at NYU Law, reviewing the changes to the bankruptcy law, and studying current techniques for the valuation of distressed securities.

I was very involved in the restructuring market in the early 1990s (I was a founding member of the New Jersey Chapter of the Turnaround Management Association and the East Coast representative to the Deloitte & Touche Valuation Group Restructuring Committee).

Interestingly, the skill sets employed in understanding a distressed company are not terribly different to understanding early stage companies. In both cases it is imperative to monitor cash, assess existing operations and make changes, and position the business for the future. The major differences are that early stage companies tend to not have the legacy issues associated with bankrupt companies, and their capital structures tend to be more straightforward (although I have seen some very strange structuring of early stage financing).

With these experiences (and some other related work), I feel that I can add significant value to this process as it progresses.

Bottom line, I personally expect a reversion to the mean. By this, I mean that default rates cannot continue at such low levels, particularly given the excesses of the last few years.

I have heard conflicting reports about how active the distressed market is at this point, but I do expect a significant increase in activity.

Here is an article from The Lawyer discussing the current situation from a legal professional's point of view:

From The Lawyer, 1 October (Vol 21, Issue 38)

Credit crunch casts NY shadow

Forget corporate - it's so last season. In New York, the field to be in if you want to get hired is bankruptcy. Now you won't sense this from walking around Manhattan. The US may be on the brink of financial meltdown, but there's no sign of that in the streets below Central Park.

Although the fallout from the credit crisis continues to make headlines - along with the indictment of Milberg Weiss class action stalwart Melvyn Weiss, the big legal market news in the city this month - around town the usual New York business of making as much money as possible continued non-stop.

In Bryant Park, the site of one of New York Fashion Week's big shows last week, the construction of the $1bn (£496.13m) Bank of America Tower slowed not one jot because of the summer's hysteria in the debt markets. When the building is completed in 2009, expect some of the city's leading law firms to move in.

For now, however, all there is to see by the freshly laid turf squeezed between the
towers is ranks of men and women bashing their laptops and barking into phones. Slowdown? Not here.

But first impressions can be misleading. None of New York's top lawyers are going to admit it, of course, but there's a nervousness here. Major M&A is on hold. The promised restructuring wave hasn't arrived.

What happens next is, according to Weil Gotshal & Manges restructuring partner Harvey Miller, "the sixty million-dollar question".

"Three months ago, if you asked someone what the effect of the sub-prime crisis would be, they'd probably say, very contained and limited, no leakage," says Miller. "The fact that it spread so international, that BNP closed two funds in Paris, and the problems at Northern Rock, was a shock. The ability to contain the credit crunch wasn't as strong as those so-called knowledgeable people thought."

So New York's law firms, like everybody else, are waiting to see whether the events of the summer will hit the real economy. Will there be a deeper recession that hits at the bricks and mortar underpinning the confidence not just of the markets, but of the consumer? And if so, shouldn't they be hiring to reflect the market change?And as Miller says: "It seems to me the situation is less under control than anyone thought."

But in New York the firms with the big litigation and bankruptcy groups, firms such as Milbank Tweed Hadley & McCloy, Paul Weiss Rifkind Wharton & Garrison, O'Melveny & Myers and Weil, are gearing up already. That could be via lateral hires (such as Vinson & Elkins' hire of New York bankruptcy boutique Cronin & Vris last month), or it could be at the bottom. The September crop of associates may just have discovered that their services are more in demand in restructuring than in corporate.

Lawyers might not move the market, but the canny ones will be ready to jump when their clients ask them.

As I said last night, I don't believe cutting the Fed Funds rate was a good idea. That was, and is, my opinion. It is, however, only an opinion. I could be wrong.

The Fed cut 50 basis points in both the Fed Funds and the Discount Rate. As anticipated, initial stock market reaction was very positive and the Dollar is falling against major currencies (but not by very much). The yield curve steepened, which is a good thing.

As I pointed out last night, the problems that have roiled the credit markets were less about return issues and more about risk concerns.

The cut may help financial institutions that have borrowed short and lent long (like the SIVs that were having difficulty replacing their ABCP on a cost effective basis). There will modest benefits elsewhere.

The report that I referenced last night, however, reported that teaser rate mortgages (issued at less than 2%), in particular, will be likely to default. A 50 bp reduction in the absolute rate will not do much to help those borrowers having to deal with resets.

It was concerns in the mortgage-backed securities market that initiated the market correction, and that problem still exists.

The Fed clearly is concerned about growth, and feels that inflationary pressures will not be significantly increased by this cut. I hope that they are right.

The effect on market psychology may be greater than I imagined, and THAT could make the cut worthwhile.

My only criticism of today's move is that they didn't bring the Discount Rate down to the level of the Fed Funds target. The policy of managing monetary policy through open market operations was enacted at the start of 2003. Prior to that, the Discount Rate was the primary mechanism employed by the Fed.

In my opinion, concerns about counter-party risk are unusually high in the inter-bank markets; higher than they have been since the implementation of the new policy. I believe that the Fed should have, temporarily, resumed using the Discount window as the primary mechanism so that funds would be more readily available at minimal cost.

On Wednesday we'll see the CPI numbers for August, which will give us a clearer picture of the past. Today's PPI numbers were relatively benign (2.2% increase in PPI excluding food and energy).

Bottom line, the same opportunities that were available before the cut have been unaffected.

It's been said that pictures say a thousand words. I believe that these pictures give a fairly accurate assessment of what has been happening in the markets.

I have included graphs of the Credit Default Index spreads (CDX) from Markit and the yield spreads from Merrill Lynch for Emerging Market, High Yield, and Investment Grade bonds, respectively.

This information is available at: http://www.markit.com/information/affiliations/cdx/history
and http://www.mlindex.ml.com/GISPublic/Default.asp (free registration required).

Fear permeates this market. On Thursday it spread to Emerging Markets, seemingly because holders of those securities needed to meet margin calls, investor redemptions, or genuinely fear risk - of any kind!

These graphs only go back over relatively short periods of time, so the levels that we are now experiencing appear to be unprecedented. The Markit data shows less than four months, and Merrill's data goes back only two years. If more data were available (to me), it would be clear that we are seeing a return to normalcy in the pricing of risk.

Another measure of the price of risk is the VIX index ( http://finance.yahoo.com/printchart.html#symbol=^vix;range=my;
indicator=volume;charttype=candlestick;crosshair=on;logscale=on). Yahoo has seventeen years of data on the VIX, giving a better perspective. This data, as presented in the graph, shows that this measure of risk is getting into the range that was experienced around the first Persian Gulf War, the Asian problems in '97, LTCM, the days of the day traders, and 9/11. This risk measure, therefore, seems to support the idea that we are returning to normalcy.

Whether the repricing of risk will stop within "normal" bounds is unclear. It is possible, as some in the media have speculated, that we've hit a bottom in the stock market. Personally, I doubt it.
I will write more about these issues in the near future, but there are definitely buying opportunities out there. All corporate securities are being thrown out as investors run for the exits (and government securities). It is particularly interesting that investment grade corporate spreads have increased by approximately 30% since June (a significant increase over the experience of the last few years).

More later.