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Big Freeze part 2: Banking

By John Gapper

Published: August 4 2008 19:46 | Last updated: August 4 2008 19:46

On Friday August 3 last year, as US financial
markets were approaching the summer doldrums and bankers began to head off for
holidays on Long Island or Cape Cod, Bear Stearns held a conference call for investors.

Shares in the investment bank, the fifth largest in the world, had fallen as
investors worried about the collapse of two hedge funds that it managed and its
exposure to the troubled housing market. But few were prepared for the candour
of Sam Molinaro, its chief financial officer. Instead of reassuring them about
Bear Stearns’ financial condition, he scared them even more: “I’ve been at this
for 22 years. It’s about as bad as I have seen it in the fixed income market
during that period . . . [what] we have been seeing over the last eight weeks
has been pretty extreme.”

Later that afternoon, Jim Cramer, the former hedge fund manager, whose show,
Mad Money, on the CNBC financial cable channel had become a cult among US
retail investors, took to the air to sound his own alarm. Mr Cramer chided Bear
Stearns for admitting publicly that it was struggling to cope but then launched
into an angry tirade. He lambasted Ben Bernanke, chairman of the Federal
Reserve, for
not cutting interest rates aggressively, and said bank executives were
calling him in distress. “We have Armageddon. In the fixed income markets, we
have Armageddon,” he shouted, as Erin Burnett, his co-host, tried to calm him
down.

If all of this sounded bizarrely alarmist at the time, a year later it reads
like a fair assessment of the havoc that was breaking out in financial markets
as the liquidity that had washed through the US economy and the rest of the
world abruptly froze.

As Americans defaulted on subprime mortgages in increasing numbers, bond
markets became chaotic. Most of these mortgages had been securitised by banks
and sold to investors in complex collateralised debt obligations, which were
rated by credit agencies led by Moody’s and Standard & Poor’s. Investors
knew that the lower-rated tranches would be at risk in any downturn, but few
predicted the damage to investment grade securities (see below).

The chaos in the US housing market and structured finance rippled into the
wholesale markets in which banks raise short-term finance. Trust evaporated as
financial institutions hoarded cash and withdrew credit from others. The London
interbank offered rate, the main measure of interbank lending rates, rose
sharply.

The effect was devastating. Six weeks later, Northern Rock, the mortgage lender that relied on
interbank funding, was rescued by the UK government after other institutions
refused to lend to it. Seven months after Mr Molinaro’s warning, Bear
Stearns itself succumbed to the market crisis. It was given emergency funding by
the Federal Reserve and forced to sell itself to JPMorgan Chase for $2.1bn
(€1.3bn, £1.1bn), paying the ultimate price for the market’s loss of
confidence.

Financial institutions are still fighting to restore stability. Banks such as
Citigroup, UBS and Merrill Lynch have
made billions of dollars worth of asset writedowns, forced out chief
executives and repeatedly raised new capital. Lehman Brothers has fought to
persuade investors that it is more stable than Bear Stearns.

It is impossible yet to know the full damage from the credit crisis. Bank
writedowns are estimated at $476bn by the International Institute of Finance.
This is still less than the $600bn of US bank failures in the savings and loans
crisis of the early 1990s but $1,600bn has been cut from the global market
capitalisation of banks.

Many bankers think the eventual bill will top the S&L crisis, although it
may cause less financial harm than the Scandinavian and Japanese banking crises
of the 1990s. But, whatever the ultimate bill, the impact on investment banking
and financial regulation will be profound. “This has been a very deep and
unusual crisis that involves the unwinding of a decade of excess. The impact on
the financial sector has been seven on the Richter scale [a “major” earthquake],
as dramatic as anything for 25 years,” says Bill Winters, co-head of the
investment bank at JPMorgan Chase, which has navigated the crisis better than
most.

The crisis has called into question the existence of independent investment
banks, the institutions that have been among the biggest winners of the past
three decades of financial and trade liberalisation. Investment banks led by
Goldman Sachs have grown rapidly and rewarded their employees lavishly: Wall
Street banks paid bonuses of $33bn last year.

But many analysts think that the crisis has shifted power in the direction of
“universal” banks – those with retail as well as investment banking arms – and
away from broker-dealers such as Goldman and Morgan Stanley. The latter may find
it hard to keep on operating with small, highly leveraged balance sheets,
relying on wholesale markets for funding. “It is pretty clear that retail
deposit-taking institutions are in a stronger position . . . I think the
business model will change significantly and there will be fewer independent
investment banks,” says James Wiener, a partner in Oliver Wyman, the financial
consultancy.

Not surprisingly, the universal banks that have expanded into investment
banking in the past decade – many by investing heavily in bond operations –
agree with this. They think the crisis will give them an opportunity to grab
business from the independents, or acquire them. “Stand-alone investment banks
will struggle to operate in anything like the way they were before the crisis,”
says the head of investment banking at one commercial bank. “They are not going
to be able to operate with the same degree of flexibility and leverage.”

Investment banks have two challenges. One is to reassure investors that they
are financially stable. Bear Stearns collapsed while it was making money and
had, theoretically at least, a sound balance sheet. Its former leaders still
complain that short-selling hedge funds spread false rumours to bring their
institution down.

While they argue this point, however, the four remaining big investment banks
have rushed to reduce their leverage and raise their capital reserves. Goldman
Sachs, the strongest of them, now holds $90bn in cash and liquid assets and its
balance sheet debt has an average maturity of eight years. This makes them safer
but it adds to their second challenge of making enough money to satisfy
shareholders and keep their most highly valued employees from joining hedge
funds or private equity groups.

Banks enjoyed a run from 1998 onwards (with a brief interruption after the
September 11 2001 attacks) of rising profits and high ratings. They had been
valued at one to 1.5 times their book value because of their earnings volatility
but their share prices rose as they persuaded investors that they had learnt how
to manage risk.

Few people believe that now and banks’ share prices have fallen abruptly. Not
only are their earnings back to being rated as they were before, but the banks
have to find ways to replace the huge revenues from bond financing over the past
decade.

The optimists point to the industry’s history
of migrating from one business to another. The chief executive of one bank says
that investment banks often lose 70 per cent of their revenues in financial
crises and replace them with new ones. “Investment banks have shown an amazing
ability to reinvent themselves,” says Mr Wiener.

Indeed, Scott Sprinzen, an S&P analyst, says investment bank revenues
have held up well so far, although results have been hurt by writedowns. Their
troubles have even brought them some business – they have earned fees raising
capital for each other.

But their longer-term outlook is clouded. The credit crisis has brought home
once again the need for investment banks to have diverse earnings streams so
that mishaps in one area can be offset elsewhere. In practice, only Goldman Sachs has had sufficient depth and breadth to
ride out this crisis reasonably unscathed.

Before the crisis, others were trying to mimic Goldman’s expertise in hedge
funds and trading. Bear Stearns was trying to build its fund management arm,
Merrill was continuing a long push to transcend its roots as a retail broker and
Lehman was expanding outside fixed income. But Bear has gone and others have
been set back.

Their capacity to bounce back is constrained by new limits on their balance
sheets and freedom of manoeuvre. The market is imposing its own disciplines and
regulators are likely to impose others. Bear Stearns’ near-collapse prompted the
biggest government intervention in the financial system since the splitting of
banks and investment banks and the setting up of the Securities and Exchange
Commission in the wake of the Great Depression.

The Federal Reserve has long provided a funding back-stop to banks that took
retail deposits through its discount window, but investment banks were not given
the same explicit backing. That policy changed during Bear’s rescue, when the
Treasury and the Fed judged that it was too central to the US financial system
to be allowed to fail.

The Fed gave investment banks temporary access to the discount window and has
since extended the guarantee. Even if it eventually closes off access, the
precedent has been clearly established: in times of financial distress, the Fed
will give financial backing to investment banks.

In return, the Fed will demand much closer oversight. Reforms to the
regulatory system await the next president and Congress but the Fed is very
likely to gain some oversight of investment banks as well as large retail
banks.

Indeed, officials hope that the Bear rescue, which was carried out on terms
that involved the bank’s shareholders and executives suffering heavy losses,
will serve as a warning. “Investment banks should have a deep interest in making
the Fed comfortable. They will not want it to escalate late [launch emergency
action in response to a funding crisis],” says one banker.

Fed oversight of investment banks, instead of them being supervised mostly by
the SEC, would come at a cost. “A government back-stop would reduce the risks of
the business but it could also take away some of the profit potential,” says Mr
Sprinzen of S&P.

When there was no implicit government guarantee, investment banks could run
highly leveraged balance sheets, carry out a lot of proprietary trading and lend
to hedge funds and private equity groups. Now they face scrutiny of, and perhaps
curbs on, their most profitable activities.

Some investment bankers remain sanguine, arguing that the past few years was
an era of super-profitability that is not likely to return in a hurry. They say
that investment banks will be able to adapt after a year or two and resume as
normal, albeit with lower revenues and share prices.

But the fear is that investment banks’ advantages over their universal bank
rivals have been eroded by this crisis. There are not many independents in any
case. The disappearance of Bear leaves only Goldman, Morgan Stanley, Merrill Lynch and Lehman Brothers as big
broker-dealers.

It may be that merchant banks such as Lazard, private equity groups such as
Kohlberg Kravis Roberts, or hedge funds such as Citadel or Fortress will expand
to fill the gap left by Bear. Consolidation in financial services has often
prompted the rise of new players.

But there is another possibility: that investment banks such as Lehman and
Merrill will give up the unequal struggle to match Goldman and be swallowed up
into universal banks. Partners at Goldman, who have traditionally worried about
being outsmarted by Morgan Stanley and others, now have another concern.

If their rivals cannot bounce back from the credit crisis of 2007, Goldman
could end up as an industry of one.

Sources for charts: Thomson Datastream; Office of the New York State
Comptroller; Sifma

How risk refused to be sliced and diced

Last week, after a year of continuous, shocking writedowns of banking balance
sheets, Merrill Lynch sold a $30bn portfolio of structured securities based on
US mortgages for 22 cents on the dollar.

The portfolio was made up of collateralised debt obligations, the structured
finance vehicles that lay at the heart of the credit crisis that broke out a
year ago. It was described by William Tanona, a Goldman Sachs analyst, as a
“capitulation trade” that was painful but necessary.

John Thain (below), Merrill’s chief executive, clearly wanted to draw a line
on the past year and move on. But the irony is that CDOs were designed to
relieve banks of the necessity to hold loan risks on their balance sheets at
all.

The Merrill trade is a sad epitaph for a period in which banks thought they
had transformed themselves from lenders to intermediaries in credit markets, and
investment banks believed they could lend money as effectively as commercial
banks.

In practice, it did not work out that way. When the credit markets froze in
August last year, many banks had not yet passed on the risk to others. Many were
holding asset-backed securities in “warehouses” and were working on splicing
them up into CDOs, getting them rated by a credit agency such as Moody’s or
Standard & Poor’s.

This version of banking had developed over two decades with the evolution of
credit derivatives and structured finance. Instead of a bank making loans and
then either holding them on its balance sheet or syndicating them to others, it
structured them into new securities.

This opened up the market for credit to all kinds of investors. The cashflow
from a portfolio of mortgages could be spliced into a variety of securities with
different interest rates, appealing to a wide range of buyers. Hedge funds and
insurance companies became the holders of mortgage loans.

The collapse of the CDO market and recriminations among bankers, credit
agencies, investors and regulators has called all of this into question. If the
CDO market was riddled with such flawed assumptions and lax calculations, what
does that say about the theory behind it?

Few believe the CDO debacle will cause a return to old ways. “We are not
going back to the days when banks made loans and kept them all on their books.
We have seen that movie and we know what happens in the end,” says one senior
banker.

Indeed, the reason why banks moved first to loan syndication and then to
securitisation was that they suffered so badly in past banking crises when the
borrowers defaulted. Although CDOs failed to protect them, that was not entirely
the fault of structured finance techniques.

For one thing, several banks were caught out not only because it took time to
structure the securities but because they deliberately held on to what they
regarded as “safe” tranches of loans. UBS was badly damaged by retaining
“super-senior” CDO debt.

But banks will be a lot warier about treating structured finance as the
cure-all for lending risk in future. They are unlikely to be given much choice:
investors in such securities will demand more transparency and may well require
an originating bank to keep some exposure.

The ultimate lesson of the CDO collapse is that technology does not obviate
the need to assess a borrower carefully. Neither banks nor credit agencies did
this well enough on behalf of investors and it proved a painful experience for
everyone.

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