Whatever you do, do not nationalize the banks*.

I was sitting in Spanish class learning the use of the conditional tense: the tense used to express what you would have done in place of another. The prompt was how we would have fixed the financial markets when a girl chimes in, “If I were the President, I would nationalize the banks.” Normally I am very receptive to the opinions of others, but today was a black swan day. Without hesitation, I replied, “And what would that solve? Have we not learnt enough from historical precedent set in the Soviet Union and other cases of failed and still failing practices of government overtaking and planning of private capital to finally throw this solution by the wayside.” No matter the amount of bs coverage and garbage opinions the press can conjure up, nationalizing the banks can never be the answer.

It is rather difficult, at least to me, not to see the apparent conflict of interest inherent in the nationalization of a banking institution by the federal government. Imagine a situation wherein the nationalized bank is completing an M&A deal but the deal is currently facing FTC antitrust approval, does the FTC consider the trickle down benefits of the completed deal on the national economy or does it stay wholly focused on antitrust regulation? Who is the FTC ultimately responsible to in this scenario, the government, the people, or the economy? Can these goals even be separated in this event? Even another scenario is quite apparent. Imagine that the nationalized bank had been overstaffed, does the bank, which needs to trim headcount, continue with the mass firing? Will there be any chance of retribution when election season rolls around? It’s imperative to ask if the federal government is comfortable with a profit motive or will the motive of maximizing the happiness of their constituents get in the way? Whose constituents would a nationalized bank try to appease anyway?

Even if it is at all possible for the government to navigate these conflicts of interest (and I assign a very minuscule probability to that event), it is still possible that by nationalizing a bank, the federal government will have to do everything to prevent that bank from failing, even when it clearly deserves to fail. With a governmental backstop, private monetary capital would flow from other institutions and markets into this nationalized bank due to the relative safety of the governmental guarantee (it is safe to assume for the time being that the US will not default on its debt obligation). At the same time, it is fair to assume that there will be a flight of human capital away from nationalized bank. Apart from the stringent rules that the federal government imposes on banks receiving capital injections at the current moment (for which I agree with and think it should be more stringent), I can only assume the number of rules and governmental red tape that will exist at these new institutions will grow exponential. This would cause most people to either switch firms, or to create new ones. So as there is an inflow of monetary capital into a nationalized bank, there is also an outflow of human capital. Soon the bank would lack the personnel to function properly but it now cannot fail because of the governmental backstop. The very banks that the government is trying to assist will become weaker compared to their competitors due to internal maladies.

Then again, how does the federal government go about deciding which banks it would nationalize? Some banks are staying afloat, even in this economy (or at least the banks are giving us the impression that they are) and others are not. Does the federal government nationalize the ones with exposure to CDOs or the ones unable to raise capital in the private market? The solution to this question is a bit difficult because once a list is created of which banks the government believes to be insolvent, the bank is instantaneously blacklisted. Basically, designating the banks as insolvents instantly makes so^‡ and wipes out the last remaining equity that is still being traded on the exchange and sends their trading partners (or potential partners) into hiding. For some banks, this probably is not a huge problem as the government already owns the majority of shares (albeit preferred shares), but not every firm that could be insolvent currently has a high federal ownership stake. So the decision basically has to be an all-or-nothing response, but somehow punishing the banks (and their private owners) that have escaped the CDO debacle by nationalizing them does not seem the better option either.

Of course, it’s easy to criticize and complain about bad policy yet not offer any solution to the problem. Rather than shirk that responsibility, I’m going to offer a suggestion. Warren Buffett said it best when he uttered the phrase; “Capitalism without failure is like [Christianity] without hell.” Plainly put, the government needs to stop creating a safety net for these companies that are potentially insolvent. I don’t believe there continues to exist a global risk to the markets from the failure of these institutions. The market will suffer soon after, but the US has been there before and survived. Once the federal backstop is removed, we can finally shed some light onto the balance sheet of all these institutions. The weaker banks, or those with too great an exposure to CDOs will either seek to restructure, fade out of existence or be merged into their stronger and well-to-do competitors. Either way, once we swallow the bitter pill, we can finally get better and move on.

* I should note that in the examples I used, I make no distinction between investment banks and commercial banks. While it does allow me leeway to create scenarios in which nationalization is clearly the wrong choice, it should also be noted that neither the federal government, nor the press itself, take care to make the distinction. After all, they are all as concerned about nationalizing Bank of America and Citigroup as they are about Goldman Sachs and Morgan Stanley.

‡ As soon as the government announces which banks it would nationalize (and eliminate the bank’s private equity), those whose equity remain in the institution would immediate seek to recover the equity before the nationalization. The bank would not have sufficient capital to meet the demand of its equity holder and the increasing flight of equity will return the institution back into a position where it is over-levered (debt significantly higher than equity) and would lack the equity to meet its financial and regulation obligation to balance its debt, hence insolvency.

Ideologies

There is no greater complaint about economics among laymen than the sheer amount of disagreements between the so-called leaders in the field, that is assuming that said laymen do not first consider economics to be too boring and esoteric. Economists are always split between ideological lines: Should the government central plan the economy, or should markets be left to reign? Should central banks target economic stability through monetary policies (inflation and interest rate controls) or through fiscal policies (stimulating aggregate demand)? Are people rational creatures, or can they benefit from a nudge?

The current credit crisis has laid wreckage to numerous financial institutions and destroyed the value of many others. Yet in trying to devise solutions to the crisis, economists are still split across ideological lines and politicians all too blindly follow along these divides. With the release of the preliminary GDP for 4Q 2008 showing that GDP had contracted during that quarter at a rate of 6.2%, the Obama administration is quick on its heels to counter the recession. Conforming to the Democratic Party’s ideologies, the administration is utilizing the Keynesian approach to resolve the economic slowdown: stimulate aggregate demand and all else will follow through.

The road ahead for the administration is quite an arduous one. The administration needs to stimulate confidence in the stock markets to allow capital to flow back once again. GDP needs to grow in order to allow unemployment to reverse its current trends. After solving these issues, the administration can look forward to also attempting to resolve other issues in the financial, healthcare and energy sectors. The quandary is that there is no consensus on the solutions required to resolve these issues and no matter what approach the administration embarks, there will always be opponents. The test of this administration will be how they stand up and act (or react) amidst the onslaught of criticism that is sure to follow. Now, if only the administration can vet a little faster so that Geithner can complete his staff and begin working on getting out of this mess.

Recruiting In A Down Market

I was a bit shocked when I received the e-mail informing me of the seminar at Wharton given by Brian of Mergers & Inquisitions and Kevin of Management Consulted. I frequent their blogs to gain an insider’s insight into the investment banking and management consulting careers, and so when this opportunity presented itself, I knew I had to be present at this seminar.

After attending the seminar, Recruiting In A Down Market, I highly recommend it to anyone currently seeking employment in this market. Using a combination of anecdotal tales and tried-and-true methods, Brian and Kevin conveyed the excellent yet overlooked strategies for obtaining a job in the financial industry during this tumultuous time. The basic takeaway – do not rest on your laurels (or your school’s laurels for that matter) and instead, proactively pursue that job.

For anyone, and everyone, currently looking to obtain an internship or a full time position in the financial industry in this current economy, I would suggest you reach out to either gentleman, as they would provide insights that you might find pivotal.

Maybe A Silver Lining

When I stop by for a brief visit with my friends and family, the questions as to what I am currently doing always arise. While I usually attempt to feign interest towards unnecessary drivels like this, I have somewhat developed a disdain for this question in particular. Since almost everyone I know is either apathetic or ignorant of investment banking, this conversation usually ends in frustration on my part as the conversations usually follow the below sequence:

F&F: I haven’t seen you in a while, what are you up to now?

Shane: I am completing a bachelors program at Penn and hopefully after that, I can secure a great job on Wall Street working for a bank.

F&F: You want to be a teller at a bank?

Shane: No, this is not for a teller. This is for a position at the bank headquarters, usually on Wall Street, where the actual profits are being generated for the bank.

F&F: So you want to be a loan officer?

Shane: No, those are examples of job opportunities in commercial banks. I am aiming for an investment bank.

Person: An investor?

Shane: No, not an investor. These banks work with stocks and are more concerned with asset valuations of various companies. They provide services to corporation on numerous activities such as mergers and acquisitions, helping firms raise cash to conduct business, selling corporate securities to the public and advising on financial strategies.

Person: So a stockbroker?

Shane (in frustration): Yes, a stockbroker…that is exactly what I am hoping to do.

 

Now with the current credit crisis and the press that these banks are receiving, my latest conversation departed from the standard convention. It seems there is no more layman confusion (or at least reduced confusion – at least they’re in the ballpark now) as what constitutes an investment bank.

 

F&F: I haven’t seen you in a while, what are you up to now?

Shane: I am completing a bachelors program at Penn and hopefully after that, I can secure a great job on Wall Street working for a bank.

Person: Oh, you want to be like those assholes that ruined our economy.

Shane (in relief): Thank you, you saved me from seven minutes of excruciating and agonizing explanation.

Person: Of what?

Shane: Just be happy we skipped it, I am.

 

Maybe a silver lining indeed.

The Subprime Credit Crisis Explained

In case you needed another explanation of the credit crisis, I stumbled across this hilarious homemade clip and I thought it was only appropriate to share.

See it here

The Rise and Fall of Oil Prices: OPEC’s practical example of Game Theory

Over the summer, the price of oil hit a high of $147 a barrel driving the price of gas at the pump to a near high of $4.00 a gallon in some markets. Prices were rising due to the increased demand for oil over the summer months and the geopolitical conflict occurring in the Middle East. Due to the high price of a barrel, there were numerous calls for increased production of oil along with calls for a reduction in the demand of oil and increased investment in alternate forms of energy.

The high price of oil did correlate with a decrease in the market demand for oil as consumers started to fear the damage of $4.00 a gallon gas price on their income. As market demand for oil fell, the price of oil started to drop at an alarming rate. To counter the falling price of oil, the Organization of Petroleum Exporting Countries, OPEC, decided to cut back on the production of oil. Since OPEC operates as a cartel of twelve countries, all the countries must agree to cut back on their individual production.

For many of the countries in OPEC, the revenue from oil accounts for a substantial portion of their GDP and these countries’ government depend on the oil revenue as a necessary source of income. With the drop in oil prices, these countries experienced a broad constraint on their governmental expenditure. For all the OPEC countries, especially the ones described above, the necessity to increase the revenue from their oil exportation is essential.

If all the OPEC countries were to cut their oil production, the available supply of oil in the global market would decrease causing an upward pressure on the price of oil. Yet each individual OPEC country faces a different equilibrium than that of acting in the best interest of the group. If the said country chooses to cheat and produce at a higher level than the OPEC mandate, it stands to earn greater revenue. Each country lacks power to substantial influence the price with increased supply (market supply would still drop), but the increased supply by the country would contribute to overall revenue and profit. The problem inherent in this logic reasoning is that all the countries actually face the same incentives and are quite aware that other countries face this equilibrium as well. The below results are then possible:

	Individual Cheat	Individual Don’t Cheat
OPEC Cheat	Market – High supply, low price, low profit Individual – High supply, low price, low profit	Market – High supply, low price, low profit Individual – Low supply, low price, lower profits
OPEC Don’t Cheat	Market – Low supply, high price, high profit Individual – High supply, high price, higher profit	Market – Low supply, high price, high profits Individual – Low supply, high price, high profits

 

 

 

 

 

 

 

 

 

Although the fourth quadrant is the efficient equilibrium in that it benefits all OPEC countries if everyone cooperates, the incentives would lead to actions in the first quadrant. So, when OPEC announces its intention to cut supply, the news is widely ignored because it is now assumed that OPEC lacks the power to enforce the countries to produce in the fourth quadrant. So even with OPEC’s announcement, oil prices continued to decline. It seems the only thing today that can increase the price of oil is the increased demand of oil by consumers and a threat (or assumed threat) of increased geopolitical conflicts in OPEC countries that could potential disrupt oil production. 

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.

My quick understanding of what has been happening in the markets so far (Part 2)

At every stage of the process, from receiving the loans to buy inflated homes (consumers), to writing the loans (commercial banks), to collateralizing the loans (investment banks), to assigning dubious letter grades to assess risks (rating agencies), to insuring the loans (insurance companies), to trading the loan (traders), and to adding the loans as a lucrative part of an investment portfolio (investors and fund managers), there were profits to be made. This profit seeking, or greed, led to a speculative fever that gripped all that were involved. Homeowners were pushed into houses that they could barely afford hoping that they could sell the house at a lucrative price and recoup their initial investment plus a handsome profit in a few years. Commercial banks threw out all their risk management procedures and extended credit (sub-prime loans) to subprime borrowers above and beyond what they were reasonable expected to repay, often times turning a blind eye to inaccurate and/or missing information. Investment banks took the liberty to collateralize different grades of loans into a collective and complicated vehicle that they themselves might have found difficult to comprehend. The rating agencies, with no accurate procedure and no precedent to serve as a guide, assigned their letter grades that failed to predict the risk of the CDOs. Insurance companies were quick to insure these CDOs through credit default swap (CDS) without understanding the very assets they were insuring, settling instead for a short term gain from the premiums received rather than long term fundamentals. Traders held long and short positions with CDOs and magnified their bank’s gains and exposures through indulgent use of leverage in their proprietary trades. Investors and fund manager then snagged up all available CDOs pushing trading volumes to historic highs and neglecting the complexity of the CDOs.

But alas, the bubble was to be short lived. Soon, some sub-prime mortgage borrowers were having problems making their monthly mortgages payments, many of which were designed as ARMs. Simultaneously, the housing market started to correct itself and home prices and values started to decline. With decreasing home valuation, homeowners, especially those with little to more money down on their mortgage, were upside down in their homes (owing more on the mortgage than the house is worth). Struggling to pay the minimum on their mortgages and watching the value of their home equity declining, some homeowner chose to abandon their properties rather than continuing paying on a declining asset. Even when the homeowner, with the best of intentions, attempted to restructure their mortgage loans, it was impossible since the loans had been collateralized and were no longer the property of the bank, which now solely acted as an intermediary. Once these houses went into foreclosure, the banks had to settle for quick short sale to unload the houses at the best lowest price available in order to make payments on the CDOs. The huge supply of foreclosed home put an even greater downward pressure of the values of home that caused even prime borrowers to feel a bit of the systematic problems spreading through the housing industry. As defaults continued within the individual loans, havoc was being created in CDOs. It has hard to distinguish which CDOs were exposed to subprime mortgage and the market for CDOs stagnated. The holder of the CDOs suffering loses now looked at the insurance companies that insured the collateralized loans to pay for their losses. The insurance companies quickly found themselves singly attempting to hold back the floodgates. Still, the amount of losses that had to be insured soon outnumbered the available cash reserves to cover the redemptions and the most famous and biggest of them, AIG soon had to be rescued.

My quick understanding of what has been happening in the markets so far (Part 1)

Not a day goes by that the opportunity to discuss current market situations with someone new here at the University of Pennsylvania does not arise. Even with such a diverse population, I am at times aghast at all the different interpretations and beliefs as to the causes of the current credit crunch affecting the markets as well as exactly what role the federal government is playing or needs to play to mediate the effects. So below, I thought I should recap my own interpretation and understanding. After all, a little civil discourse never killed anyone (yet).

 

It all started with the Federal Reserve’s policy under the Greenspan era. To attempt to stimulate the stagnant economy post tech bubble, interest rates were cut to historic lows and held at these lows for some time. Concurrently, the federal government, under the Bush era, was actively pushing home ownership on families as one of the first steps towards financial security. Subject to these inputs, there was an influx of loans that were extended to consumers to purchase houses. Like any classic economic case of supply and demand, such spike in market demand for houses put an upward pressure on market price (both for new and existing houses). Yet with easy credit due to the federal government treatment of mortgage debt and interest rates at their historic lows, more funds kept chasing increasingly higher home valuations.

Meanwhile in a posh NYC office, the masters of the universe – or investment bankers in jargon-speak – decided the market for home loans was too lucrative to overlook. Now, the idea of collateralizing loans was by no means ingenious or new, but if the wheel was not broken, there was no real need to reinvent it – collateralized debt obligations (CDOs) had been in existence since the ’80s. As they had done numerous times before with other forms of debt, bankers began to collateralize these mortgages and market them as a new investment tool. Mortgage CDOs were touted as the new investment class with (very) generous returns but whose returns were uncorrelated to the market (S&P 500 used as a basis) and so could be used to diversify a portfolio and reduce overall non-systemic risk. The complexity and risk inherent in the CDOs were to be judged by the credit rating firms. Once rated, these mortgages CDOs would trade in the marketplace, as would any stock, bond, ETF or mutual fund would.

Broker-Banking Model No More

With Morgan Stanley’s decision to re-file as a holding company and Goldman Sach’s compelled decision to follow suit, the end of the large independent broker-banking model of investment banking is finally over. With this switch in designation to holding companies, these banks now have access to the Federal Reserve’s vault to secure their balance sheets but this also places these banks under the regulatory arm, scrutiny and restrictions of the Federal Government. As it follows, the more regulated an industry, the lower the profit margin of that industry. The newly enacted federal oversight will mean that these banks can no longer highly leverage their positions as they had operated in the past (it was rumored that Goldman was 36X levered, compared to the ailing insurance giant AIG at 11X and commercial banks at 10X)*.

It was the highly leverage balance sheets of the banks such as Lehman and Bear Stearns coupled with the bad positions of their bets on the subprime mortgage loans that contributed to their demise. So with federal regulation, there will be some much needed risk management injected into these banks at the opportunity cost of reducing overall industry margin (profits).

What should the future hold for students looking to enter into the industry in the upcoming years?

While no one is able to predict (accurately) how the industry will react or adapt to this recent crisis, it is clear that the notion of the broker-bank model will undergo a metamorphoses – the future of the giant broker-bank seem unsustainable. As investment banks rush to sell themselves to commercial banks or develop commercial banking arms, we can assume the financial industry will somewhat reflect the state of the industry before the existence of the Glass -Steagel Act. With the past success of banks such as JP Morgan Chase and UBS (commercial bank and wealth management firm respectively with substantial investment banking division), the future is not as gloom as Main Street anticipates, although still unpredictable. The job market will be tight as the overall available positions have suddenly contracted, but the future of investment banking is not doomed. There will still be roles and functions for these banks, as long as they are willing to adapt to the direction that the market is now leading them.

As for me, I will continue down my set path. I can hope that the four years that I will spend in school will be adequate time for the market to rid itself of the toxic assets out there, free up credits for transactions and allow deal making to resume. Until then, I will keep my eyes on that prize and keep on chugging along.

 

 

* These numbers are estimates that come form word-of-mouth information. These numbers are not backed by any data.