Merry Christmas

Merry Christmas to everyone out there. I hope everyone finds something or someone to be merry about on this day.

However you plan to spend the day, remember: Do everything in moderation — including moderation.

My quick understanding of what has been happening in the markets so far (Part 3)

Before I jump into the final part of this three part series, I want to make yet another quick apology to the readers out there. While it might appear that I make at least one apology every few months nowadays, please take note that I make these apologies only when even I am disappointed with the quality of my work. As to the cause for the apology, I noticed upon re-reading the second part of the series that I am guilty of the reductive fallacy – that is, I oversimplified complex human emotion, reasoning and action into simple themes of collective ignorance, greed and sheer stupidity to explain the causes of the credit crisis. I would not doubt that these simplifications were among the complex elements but I would be distorting the truth if I did not make the reader aware that the situation was more complicated than I let on. It would be impossible to have a discussion as to all the underlying factors that led to the mispricing of the risk of the CDOs without delving into a bit of behavior economics and risk/return analysis. So in the interest of practicality, we will have to agree that some simplification is required even though it does lead towards reductive fallacy. One other minor item that I noticed as I re-read the post is that I quickly glossed over crucial concepts and acronyms without explanation of the terms. After my finals are completed, I will go over the series and link those concepts to external sites for further clarification. 

Before AIG had to be rescued though, Bear Stearns had been in a similar state whereas two of its hedge fund that held CDOs found that the assets on their book had devalued and Bear Stearns did not have enough cash reserves to answer the margin calls. The Federal Reserve had arranged a fire sale of Bear Stearns to JP Morgan at $2 a share (the price was later raised to $10 a share so as to win the approval for the buyout from Bear’s shareholder). When Lehman Brothers was in a similar situation, the Fed, perhaps choosing not to create the impression that they would rescue any failing institutions (moral hazard), decided not to intervene and force a buyout of Lehman. Presumably when John Thain, CEO of Merrill Lynch, saw the inevitable demise of Lehman, he negotiated the sale of his firm to Bank of America to prevent a similar fate. When Lehman filed for Chapter 11 bankruptcy protection, it sent a ripple through the financial industry. Reserve Primary Fund, a money market fund that had invested in Lehman debt, was forced to write off the loss of the debt it acquired forcing the fund to break the buck; falling to 97 cents a share. AIG had also issued many of Lehman’s credit default swaps and with Lehman’s bankruptcy, AIG had to settle its accounts and the company soon found itself insolvent and requiring federal assistance. The Fed quickly learned that it could not afford to let a run of the bank compromise the financial industry.

Since no one was quite sure which of the CDOs that were available contained subprime loans, the market for CDOs dried up for fear of a few toxic CDOs. Those institutions that still held on to CDOs tried to keep the value of these CDOs at the value they traded before the market disappeared and the assets became illiquid but due to an accounting rule, FA 157 also known as mark to market accounting, the institutions were forced to mark down the value of the assets – to market value. Since no market existed, the CDOs were marked to fire sale value and this drop in the financial institution’s assets triggered margin calls. Many of the institution were highly leveraged and were required to keep a certain percentage of assets for every liability on their book. Once forced to mark down the value of their assets (in the billions of dollars) fire sale prices, these institutions were either forced to raise their asset values or lower their liabilities. Many institutions went scrounging for cash, and those that received cash infusions were able to survive for another day. The unlucky ones became insolvent and either went bankrupt or were sold to other institutions. The financial institutions that did receive cash now held on to their cash to prepare for another rainy day. As the financial industry hoarded cash, the economy came to a standstill; other institutions and main street were unable to receive loans that were needed to continue operating once the financial institutions ceased lending.

To attempt to relieve the problem that these toxic CDOs were causing on the economy, the Fed and the Treasury came up with a plan to purchase the toxic CDOs from the institutions and allow the financial institutions to clean up their balance sheets and resume lending thereby easing the credit crisis. This plan was named the Troubled Assets Relief Program (TARP). After the bill was finally passed, a foreseeable problem started becoming more evident. In order to purchase the assets, the Treasury would have to price the value of assets for which a market does not currently exist. If the Treasury purchased the assets at the current fire sale prices, banks may refuse to sell the assets hoping to hold on until a market return or they are offered a better price. If Treasury purchased the assets at the price before the crash of the asset market, then the Treasury would purchase over-valued assets at miscalculated valuation at the taxpayer’s expenses. Rather than resolving the conflict, the Treasury, a few week later, announced that it would no longer use the TARP funds to purchase these toxic assets. Instead, it would instead inject equity into financial institutions by purchasing preferred share of these institutions. The upside to this is that the Treasury would not have to value the toxic assets and buy them, but will give the institutions enough cash equity to continue their operation without the risk of being insolvent. The Fed hoped that with sufficient cash reserve, the institutions would start lending again and relieve the credit crisis. This plan also had the upside that the Treasury (and hopefully the taxpayers) would be able to profit from the recovery of the institution through the appreciation of their shares. The banks that initially agreed to receive equity investments were Morgan Stanley, JP Morgan Chase, Bank of America (including Merrill Lynch), Wells Fargo, Goldman Sachs Co, Bank of New York Mellon, Wells Fargo and Citigroup (the big 9) with potentially thousands of other smaller banks eligible to receive funds.

That brings us to today. The credit crisis has not yet been abated, and the federal government is still using the TARP to rescue new institutions – now the auto industry. The National Bureau of Economic Research (NBER) had now declared (and I believe incorrectly) that the US has been in a recession since December 2007. Job-loss numbers have been the worst since 2003 fueling thought of recession. The Fed has cut the federal funds rate to 1% a floating rate between 0 and 0.25% and the government is attempting to protect consumers by subsidizing other consumer loans.

Déjà vu…

 

 

If you see any errors, please feel free to let me know. No one is perfect after all, least of all me.