Why We Are Not Out Of the Woods: Treasury Plan Is UK Light and Still Does Not Deal With Toxic Assets As They Are

Having stated that, the transparency issue is still out there and it is still manifesting itself in various ways because there is still a substantial amount of uncertainty about what is happening. In order to address a problem, you have to know what the problem is and the cause and we still do not know.

First, it was very clear that the markets were de-leveraging last week but who was de-leveraging is still an open issue. It appears that the de-leveraging was a combination of factors: (i) European banks and others who were required to raise capitol and (ii) margin calls.

As I noted last week, we have a plethora of banks but in the current situation very few US banks have tanked. The three that have disappeared are Wachovia, Washington Mutual and Indy Mac. While they are big banks they represented less than 8% of the entire sum of deposits in the US combined.

However, there is a shadow world of wannabees out there that caused the problem and it now is clearer that what happened is that shadow world went across the oceans and then came back to the US with a vengeance. I refer to this as the ultimate “cross-reference or cross-reference” masher basher. As has been noted in various forums, US banks stayed out of most problem lending areas. However, European banks did not.

There is now a substantial amount of finger pointing over whether it was a mistake to let Lehman Brothers go down given what is now its global reach. Lehman had $691 billion of alleged assets at the end of 2007. This fateful date may have to be remembered in the future. It was the largest failure of an investment bank since the collapse of Drexel Burnham Lambert in 1990.

In contrast, the Fed and the U.S. Treasury moved quickly in mid-March to save a similar global investment bank in distress but half the size of Bear Stearns in 2008 by quickly lending and guaranteeing $29 billion to the large universal J. P. Morgan Chase bank in order to absorb it. It was the collapse in June 2007 of two internal Bear Stearns hedge funds that had been heavily invested in mortgage securities that kicked off the full-fledged market panic that started in 2007 and which started the current tsouris.

Why Bear Stearns was saved and Lehman went down probably has to do with personal relationships but it is what it is. Lehman's bankruptcy forced the global investment bank to quickly write down its huge portfolio of debt, a fair amount of it in bizarre debt.

Banks are creditors of each other - especially Lehman which dealt with large institutions had the consequence of spreading the American problem [outside of the traditional banking system] all over the world, and especially in Europe. Lehman's London office was a huge center of sale and distribution for its more or less bad derivative products all over Europe.

Many European banks had invested in Lehman's securitized paper, and when it failed, they were left with large losses. As a consequence, they had to curtail their domestic lending and that affected various indexes that affected US banks because of various accounting rules.

However, in addition, margin calls by CEO and fund managers had caused a major part of the gyrations.

The way margin works is that banks and brokerages offer investors loans against stock portfolios. Federal Reserve rules require that investors put up half of an investment with their own money as “initial margin” when they first buy a stock. After that, they must maintain a cushion of at least one-third of the value of the loan. Some brokerage firms require an even bigger cushion.

A margin call occurs when a bank tells a client who has borrowed money against his portfolio that because the value of the shares in the portfolio has fallen, the investor must put up more cash — or immediately sells his shares and pay back the loan.

As an example, if investor owns stock worth $1 million and borrows another $1 million from a bank or brokerage to buy even more shares. The portfolio is now worth $2 million. If the value of the portfolio falls by 40 percent, it will now be worth $1.2 million. But the equity in the account will have fallen much further, to only $200,000. The brokerage may then tell the investor to add another $600,000 in cash to the account as additional protection.

If the investor does not have the money available then the bank will seize the entire portfolio and sell $1 million of shares [with interest] to pay back the loan. The banks in effect dump that into the market to recover on the loan. When stock portfolios tank, executives and fund managers who had bought shares on margin have been forced to sell billions of dollars worth of stock to settle those loans with banks.

Margin calls affect ordinary people by flooding the markets with sell orders which send prices broadly lower for stocks that are already falling. The NY Times noted two incidents.

On Friday, Aubrey K. McClendon, the chief executive of Chesapeake Energy, issued a statement saying he had been forced to sell all of his 33.5 million shares in Chesapeake because of a margin call.
With Chesapeake trading above $60 a share, McClendon’s stake in the company was worth more than $2 billion — the vast majority of his net worth, which was reported at $2.1 billion in last year’s Forbes 400 so he is mehulah. Sumner M. Redstone, the chairman of Viacom and CBS, disclosed that he would sell $400 million in shares in those companies to pay down a loan.

Because margin loans are private transactions between banks and borrowers, it is difficult to know exactly how many executives or hedge funds may face margin calls as a result of the stock market’s gyrations. Corporate executives must report stock sales within two days of making them. But hedge funds do not have to disclose margin calls — and in some cases the first sign that they face calls may be their abrupt collapse.

Knowing exactly how many firms used those strategies is not out there. Margin debt increased steadily from late 2002 to 2007, according to the New York Stock Exchange, which requires its member firms to report their margin loans outstanding. It peaked at $381 billion in July 2007, just before stocks peaked. Margin loans have fallen. In August, the most recent month for which data is available, they were $292 billion. But those figures do not fully account for loans made internationally.

Two, as Floyd Norris of the NY Times noted in a piece today, there is the hope that a recapitalized banking sector will get the financial system working again, but Libor rates remain very high. Guaranteeing bank debt may bring them down soon.

However, the banks, meanwhile, seem to be in a complete panic about mark-to-market accounting which can act as a pac-man but which is the only means right now to value asset. The American Bankers Association is demanding the Securities and Exchange Commission stop the Financial Accounting Standards Board from requiring them to mark assets at depressed market values. The banks do not like the re-interpretation of the rule they liked only days before is not enough. There will be substantially more write downs.

The reason I believe that the Treasury injected $125 billion into Wells Fargo, B of A, Citigroup, JPMorgan Chase, Goldman Sachs, Morgan Stanley, Bank of New York, State Street, and Merrill Lynch {which will become part of B of A] is they are the strongest banks in the US and they are probably a vessel for international banking and any more rescue efforts. They do not appear to be at risk of sustaining large losses from credit default swaps – though there is a WAMU issue as JPMorgan-Chase. [On that note given that the US in effect is a major stakeholder in Wells and Citi group, it about time the nonsense with the lawsuit over Wachovia stop. Wells today filed a lawsuit to prevent Citigroup from pursuing liability claims against it. Wells in effect asked a federal court to block Citigroup from pursuing it claims against Wells Fargo.]

I think it is clear that the banks have to come clean on their losses. Did they issue credit default swaps or didn’t they, for example. How much do they have in mortgage backed securities? And there are other issues. There are some banks that are so far gone that the government should refuse to recapitalize them. Who they are we do not know.

Three, and most importantly, we still do not know the real state of mortgage backed securities and the insurance on them aka credit default swaps. It is clear that Fannie Mae and Freddie Mac are buying up mortgage backed securities but it is still unclear from whom – maybe European Banks [which has the effect of sterilizing the money supply]. Given that credit default swaps are tied to mortgage backed securities does Fannie and Freddie get the benefit of CDS’s on bad – relatively speaking – mortgage backed securities? The answer to that is still unclear. New York State is in the process of regulating CDS’s as insurance.

But even now, the total amount coming due is unknown because the market for CDS is not regulated or tracked through any clearinghouse of any sort. No one knows who owes this money, how much each counterparty owes, or whether any of these counterparties will now be in trouble themselves, with further potential problems for the financial markets. It is possible to buy and sell credit-default swaps without owning the underlying bonds. One trader can both buy and sell protection on the same bonds, too.

We saw the buyer-seller issue last week. It was thought that paying off on Lehman’s CDS issuance was $272 billion – then it was up to $362 billion – now it’s only several billions. Apparently, the reason is that the great majority of players are both buyers and sellers of the same credit default swaps – meaning they can net off their exposure. If A owes B $1200, but B owes A $1199, then the net amount owed is $1 billion. However, if A and B do not know each other then to pay bills they have to raise cash for the worst case scenario and that in many cases is what happened here. No one will know until October 21st on what the real Lehman situation is. This just shows that as John Chiang and others note this has to come out of the shadows and be regulated.

Even if Lehman is only a blip, we still do not know what happened at the Friday meeting at the Federal Reserve Bank of New York to clean this up. And, whatever happened Friday is an in futuro issue. Last night on CNBC I heard a person knowledgeable about this state that in the next 6 weeks or so at least 6 CDS contracts become due. WAMU CDS’s which is now owned by JP Morgan Chase come due in a week, Icelandic bank CDS auction [settlement] is the first week of November.

On that note – and not to endorse it but to note that there is always a market - Knight Capital Group said today it has introduced a platform that will enable credit default swaps to be settled electronically - the latest in a crowd of players wanting in on an exchange if it ever is created - competing for a share in the $55 trillion market.

Knight said its platform, NetDelta LLC, can be used to settle new trades and will soon be extended to allow the settlement of existing trades.

The Chicago Mercantile Exchange and Citadel Investment Group last week unveiled plans for an electronic exchange for credit default swaps which they said would be integrated with a central clearinghouse.

That initiative [and maybe Net-Delta] are competing against dealer-owned Clearing Corp which will act as a central counterparty to the market and is expected to launch by year-end.

I should note that several people in the CDS business testified today at the Senate Committee on Agriculture, Nutrition and Forestry suggested that problems from sub-prime loans, and not credit-default swaps, are the root of the problem. I would suggest that they fed off each other – and the hearing once again destroyed the canard that Freddie and Fannie created the problem.

The purpose of the hearing was to explore the role that credit-default swaps had in the financial meltdown and determine if the regulatory powers of the U.S. Commodity Futures Trading Commission should be expanded to oversee these largely unregulated over-the-counter markets.

It was asserted that a law passed in 1992 and a revision in 2000 essentially barred the Commodity Futures Trading Commission and the Securities and Exchange Commission from regulating swaps. It is clear that CDS played a role in the downfall of AIG and Lehman. [As to who voted for what, I expect to see hit pieces coming.]

At the hearing the head of the CME [which want to create a CDS exchange] testified before the committee and called on lawmakers to address what CME Group sees as a growing "conflict" between the CFTC's role in protecting market integrity and the "statutory exemptions" that have been inserted into the law for various "special interests." He told the committee that a lax regulatory atmosphere for swaps has resulted in significant problems.

I would urge folks to read the written testimony of Division of Clearing and Intermediary Oversight Commodity Futures Trading Commission Director Ananda Radhakrishnan before the Senate Committee on Agriculture, Nutrition, and Forestry.

Since the mid 1980's Irwin Nowick has worked for the California State Assembly and State Senate on a plethora of policy issues, most notably firearms legislation. He has been described as "The Assembly's resident genius" by a former Speaker of the Assembly and is seen frequently in the Capitol hallways and offices assisting legislators in drafting and amending pending legislation.