Financial Crisis or Market Correction?

Article by Dr. John Vong that was first published in the Investor Bulletin, Sacombank Vietnam, Issue October 2008.

"The fall of investment banks and announcements of taking over financial institutions by the US government within a period of 2 weeks is dramatic. For sure, these events will shape the future landscape of investment banking. Subprime mortgages that contributed to the crisis and its impact is yet to be fully understood. Rumors of (further) financial collapses will continue on Wall Street and there will be wild swings in share prices of financial institutions. But the world will not stop turning. This article attempts to clarify the events with a balanced view."

1. Change in market capitalization since Jan 2007

It is true that market capitalization of some major financial institutions have fallen substantially from the start of 2007. See table below.

Name of Financial Inst 30 Jan 2007
(US$b) 19 Sep 2008 (US$b) % Change

AIG 186 36 -80.6%
Citigroup 274 91 -66.8%
RBS 127 49 -61.4%
BOA 240 139 -42.1%
BankChina 167 116 -30.5%
HSBC Hlds 214 175 -18.2%
JP Morgan 168 139 -17.3%
Wells Fargo120 122 +1.7%

1. How did it happen?

Greed usually influences the direction of financial markets and has nurtured this so-called financial crisis. The beginnings of the crisis lie in the way that Wall Street, comprising giant investment houses, brokerage firms, hedge funds and "private equity" firms, has changed since 1980. Its present business model has three basic components.

Firstly, financial firms have moved beyond their traditional roles as advisers and intermediaries. Once, major investment banks such as Goldman Sachs and Lehman worked mainly for their clients. They traded stocks and bonds for major institutional investors (insurance companies, pension funds, mutual funds). They raised capital for companies by underwriting (or selling) new stocks and bonds for the firms. They provided advice to corporate clients on mergers, acquisitions and divestments. Now, most financial firms also invest for themselves. They use partners' or shareholders' money to place bets on stocks, bonds and other securities.

Secondly, Wall Street's compensation is heavily skewed toward annual bonuses, reflecting the profits traders and managers earned in the year. The higher a trader earns, the larger the bonuses. Dubious mortgages were packaged into bonds, sold and traded for the sake of more profits and higher bonuses.

Finally, investment banks borrow heavily. Lehman was typical. In late 2007, it held almost $700 billion in stocks, bonds and other securities. Meanwhile, its shareholders' equity was only about $23 billion. The remaining was borrowed money. The "leverage (or debt to equity) ratio" was 30 to 1. Leverage can create huge windfalls. Suppose you buy a stock for $1000. It goes to $1100. You made 10 percent. Now suppose you borrowed $900 of the $1000. If the price rises to $1010, you've made 10 percent on your $100 investment. Investment houses had huge incentives to increase leverage. While the housing boom continued, Fannie and Freddie were permitted to have leverage ratios that may exceed 60 to 1.

1. A dream product gone bad

Why is there a housing boom? Let us explain sub-prime lending first.

Subprime lending is a general term that refers to the practice of giving loans to borrowers who do not qualify for market interest rates because of their inability to prove that they have enough income to support the monthly payment on the loan for which they are applying.

Subprime loans or mortgages are risky for both creditors and debtors because of the combination of high interest rates, bad credit history, and murky personal financial situations often associated with subprime applicants.

The US pushed for lower interest rates just after 9/11, 2001 to up economic growth through a housing boom. Low interest rates make mortgages more affordable. The mortgages are then packaged into securities (eg collateralized debt obligations) that are sold to and bought by the Wall Street firms, banks and overseas funds

The combination of cheap mortgages and investor demand for these new financial products (that were traded like stocks BUT UNREGULATED) contributed to a housing boom. It is noteworthy that commercial banks are regulated by the Fed while investment banks are not.

In mid-2006, the housing bubble burst. Borrowers started defaulting on mortgages and lenders began to lose money. As at March 2007, the value of U.S. subprime mortgages was estimated at $1.3 trillion. As of Oct 2007, approximately 16% of subprime loans with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure proceedings.

1. Which bank was affected first?

Bear Sterns, which betted heavily on sub prime securities falls. The Fed arranges a sale to JP Morgan.

As defaults continue to rise, Fannie Mae and Freddie Mac suffered liquidity problems. The Fed took over both and also their US$5.4 trillion of mortgage debt.

This was followed by Lehman Bros, Wall Street’s 4th largest investment bank.

Merrill Lynch was then acquired by Bank of America.

AIG, the world’s largest insurance company, was taken over by Fed with a loan of US$85 billion. AID sells a product called credit default swaps, which is like an insurance product to protect the buyers of mortgage backed securities.

The latest is that of Wachovia Bank and now taken over by Wells Fargo.

1. Do we need to fear of a global collapse?

No doubt the events have been dramatic. In a space of 10 days:
The U.S. government took over two mortgage-bond giants, Fannie Mae, Freddie Mac and AIG;
Lehman Brothers came to an end with its valuable assets and employees transferred at a cheap price to Britain's Barclays Bank.;
Merrill acquired by Bank of America for about $50 billion.
Morgan Stanley and Goldman Sachs saw their stocks plummet and then boomerang back up.
Global stock indices lost and then gained trillions in value;
Central banks injected hundreds of billions to prevent the global economic system from freezing.
The U.S. government announced a far-reaching bailout plan that assumes the responsibility for the bad mortgages that triggered all this in the first place. [However the bailout plan was rejected (29/09/2008)].

The meltdown of Wall Street and the resulting government intervention are real and will reshape the industry. But it's much less apparent what the ramifications are beyond the financial industry.

Let us take a more positive view:
Trillion-dollar asset-management companies such as Fidelity and Vanguard, for instance, are doing fine, though the decline in stock prices is a negative for them.
Companies that make money processing transactions, ranging from massive banks like State Street and Bank of New York, haven't imploded.
Credit-card companies like Capital One, and Visa (which had one of the most successful initial public offerings in years earlier this summer) have not seen the consumer defaults that the dire rhetoric would suggest.
Parts of Wall Street are business as usual
Bank of America, flush with consumer deposits, paid up $50 billion to buy Merrill Lynch.

Scare rumors abound in Wall Street. Most people who report on Wall Street live in the same place as the people who work on Wall Street. The analysts, investors, and traders all live together and exchange the same stories. Rumors spread easily, and fear can get stoked to wildfire intensity in a matter of days. The 24/7 news cycle doesn't help; drama and crisis are good for TV shows.

It is true that there is a sad mood on Wall Street, but the world will not stop turning because of Wall Street. The Wall Street is not the world. It is an industry that is central to the financial world, but it is one part not the whole part. Since 1950s, Wall Street was a major source of global capital. Today, it needs to look elsewhere for capital. In the past five years alone, there has been a massive wealth transfer away from the US to both the oil-producing regions (Gulf States) and goods-producing regions (China). At least $7 trillion sits in the sovereign wealth funds and central banks of countries in Dubai and China. The total market cap of the five independent U.S. investment banks at their highest is less than $500 billion.

With the U.S. economy generating $14 trillion every year, the government is more than able to provide several hundred billion dollars assistance to bad mortgages, if that proves necessary to halt the rippling panic on Wall Street or contain the next bank failure, whether it is Washington Mutual or someone else.

In recent years the market has amassed fortunes, and today the market has lost a fortune. It is merely rebalancing itself. As stock markets continue their wild swings, stocks will go up just as quickly as they go down. Others will continue to put money in their retirement plans and may find years from now that those investments performed spectacularly. Wall Street will consolidate, and some firms will thrive and profit having picked up solid franchises of imploding companies. And the banking business will still continue.