A Global Banking... 911

October 2008 Salvatore Ruscitti & Dr. Hans Black

ince July we have seen an unprecedented and historic reshaping of the U.S. financial landscape. These events, of course, accelerated during September and will surely be referred to in all future financial history books. As the mortgage crisis continued its romp through credit markets, the foundations of Wall Street have been shaken hard. These shockwaves have now permanently altered the investment banking business model in North America with the forced merger of Bear Stearns with J.P. Morgan in the springtime, followed by the bankruptcy of Lehman Brothers and the shotgun wedding of Merrill Lynch into Bank of America. The last two standing members of the investment banking fraternity, Morgan Stanley and Goldman Sachs, will become commercial banks and significantly de-leverage. American International Group (A.I.G.), the world’s largest insurance company, was threatened with its survival, and thanks to the U.S. government, now functions as a crippled entity trying to regain its footing. Having severely miscalculated the effects of the Lehman Brothers bankruptcy and its effect on money market mutual funds, within 48 hours this contagion effect caused a virtual seizing up and rising mistrust of many money market mutual funds. These difficulties prompted the U.S. Treasury to take the unprecedented step of back stopping most of the money market mutual funds available domestically. In rapid succession, due to the continued outflow of deposits, Washington Mutual with assets totaling $307 billion became the largest bank casualty in American history. Wachovia Corp., another large regional bank, faced a potentially debilitating credit downgrade, and thus sold most of its operations to Citigroup for a mere $2 billion. Not to be forgotten, all of these events immediately followed the truly remarkable seizure of both Fannie Mae and Freddie Mac by the U.S. government, effectively declaring them insolvent.

The momentous days of last month exposed the scale and scope of the bad debt problem overhanging the global economy following nearly two decades of brazen expansion in leverage, a topic which has been discussed in this publication over many years. The latest financial panic was triggered when a troubled Lehman Brothers opened its books to would-be acquirers. The exercise revealed what a number of sharp-eyed market participants already had suspected; mainly that Lehman was still carrying sub-prime paper on its books at substantially inflated values.

When the potential buyers of Lehman balked at an acquisition, the markets quickly discovered the concept of collateral damage as it applied to a different type of weapon of mass destruction, financial derivatives. The reality check at Lehman almost immediately reverberated back to insurance giant, A.I.G. As a major player in the credit default swaps (C.D.S.) market, A.I.G. had underwritten a whopping amount of derivative contracts, many of which were under-capitalized given the rapidly deteriorating credit environment. After A.I.G.’s credit was downgraded, it could not put up the additional collateral needed to back its vast pool of credit default swaps (C.D.S.). Thus, it faced bankruptcy, a frightening prospect for a firm with a global asset base of over $1 trillion.

Due to its expansive nexus of counter-party risk, A.I.G. was determined to be too big to fail. Consequently, the U.S. Treasury stepped in to extend an $85 billion bridge loan facility to the company. Lehman, by contrast, was left to fold. The dichotomy in the handling of Lehman and A.I.G. revealed the stark set of choices facing policymakers. Although Lehman’s bankruptcy was thought to be less of a threat to the global financial system, it nonetheless spawned its own set of unanticipated problems. One of the largest money market funds saw its net asset value fall below $1 when the Lehman paper it owned went to zero. What ensued was a run on U.S. money market mutual funds resulting in the withdrawal of nearly $200 billion in one week. Lehman’s bankruptcy also froze the prime brokerage collateral that a number of hedge funds had deposited in the company. As a result, hedge funds started pulling money out of Goldman Sachs and Morgan Stanley, fearful that these relatively stronger investment dealers were having their own funding issues.

Both Goldman Sachs and Morgan Stanley eventually had to seek outside investors and convert to bank holding companies in an effort to acquire more stable sources of capital. Merrill Lynch managed to avoid Lehman’s fate by running into the arms of Bank of America in a shotgun wedding reminiscent of the hasty nuptials between Bear Stearns and J.P.MorganChase back in March. These adhoc solutions, while necessary, are far from elegant, and they may in fact be laying the groundwork for a larger reckoning down the road. The financial industry may be shrinking in terms of firms and jobs, but its liabilities are being consolidated into ever-larger entities, whose balance sheets are further weakening. The current wave of mergers is not exactly bringing together strong firms. Press reports suggest that Jamie Dimon, C.E.O. of J.P.MorganChase, is already expressing regret over his bank’s acquisition of Bear Stearns; this despite paying a rock-bottom price and receiving nearly $30 billion in government guarantees as part of the deal. Of even more concern is the fact that the new larger institutions are themselves now becoming too big to fail. Consider that J.P.MorganChase has total liabilities of $1.6 trillion. With the purchase of Merrill Lynch, Bank of America will see its liabilities balloon to $2.5 trillion, an 88% increase from year-end 2006. Citigroup is up to nearly $2 trillion in liabilities after several years of fashioning itself into a financial supermarket. If A.I.G., with its $972 billion of liabilities, was deemed too big to fail, then the aforementioned institutions certainly have the balance sheet heft to pose an equally large, if not larger systemic risk.

In recent days these problems have exploded onto the headlines of European financial newspapers. Quickly following the collapse of Washington Mutual and Wachovia, a large British mortgage bank, two Belgian banks, as well as several German banks have had to be rescued. The largest of these, Fortis (based in Belgium), was successful in acquiring ABN Amro approximately eighteen months ago, unfortunately leveraging its balance sheet too much in the process. As this is being written, there is considerable speculation regarding the fortunes of Spanish banks that also are faced with many of the difficulties, including a complete disaster in their Spanish domestic real estate market.

As risk becomes more concentrated in fewer hands the potential for more global government intervention increases. The undeniable reality of de-risking balance sheets is that for every entity that de-leverages some other entity must necessarily leverage up. The burden of absorbing the financial system’s toxic debt is falling upon the U.S Treasury, as the government is the only institution that currently has the ability to expand leverage. The U.S. Congress is busy trying to work out the details of a $700 billion package to purchase distressed mortgage paper. This initiative comes on the heels of the U.S. Treasury’s commitment to stand behind $5.4 trillion of combined mortgages belonging to Fannie Mae and Freddie Mac as well as a further backstopping of $3.4 trillion in money market fund assets. As this is being written, the situation is extremely fluid with the added dimension that contagion is now spreading throughout Europe and also into Asia.

The U.S. government is underwriting a large amount of risk at a time when tax revenues will decline as the economy slows and the long-term funding challenges of social security move closer. Federal funding needs could easily top $1 trillion next year. Meanwhile, the Federal Reserve’s balance sheet has become stretched to the tune of over $1 trillion in credit. The numbers involved are truly staggering. We used to deal in billions of dollars; now it is trillions!

When Drexel Burnham Lambert collapsed in 1989, the investment dealer had what many considered a large sum of $3.5 billion in assets. Before last month’s shakeout, the five largest U.S. brokerage firms had a combined $4 trillion in assets. Clearly credit has been allowed to grow out of control.

While we can only speculate on how all of this will play out, our suspicion is that the G7 finance ministers’ meeting, which will be held within the next ten days, will likely come together with a global central bank policy toward containing this latest series of problems. This will likely lead to stabilization of credit markets and for the time being some stability in equity markets. Unfortunately, we doubt that the problems are over as we are now facing a global slowdown in growth which is involving not only the developed world but also the developing world. As the memory of the events of September 2008 remain in the consciousness of global consumers, it will also likely lead to a severely diminished appetite for consumption of all kinds. European and North American consumers will need to become considerably more frugal in the next few years. This will likely result in far reaching changes to the business models of many enterprises currently operating globally.