Monday, 14 April 2008

Anatomy of a Crisis: The “Credit Woes” of the Summer of ‘07 – (10)

I said overnight the technicalities grow in importance. In fact, the important technicalities are always present. The next day, they merely come to the surface.

At 8:30am the next day, the term of the loan ends. The investor is due its $10 million (with the accrued interest). When it is paid, the collateral would be released. This is called unwinding. But where would the $10 million from? We only have $250,000. That is the given of the situation.

Our clearing bank comes to the rescue. As part of its function as the tri-party repo agent, it sends the investor the $10 million and takes the possession of the security as collateral. This is a temporary arrangement. The bank is making a “daylight” loan to us – paying for the security on our behalf – until a new investor is found (before 4:00pm.) When the new investor sends $10 million to the bank, the bank takes the money and transfers the possession of the security as collateral to the investor. Another overnight cycle thus begins.

Here comes the most critical aspect of the “structure of the US financial and capital markets”. If our clearing bank refuses to unwind the collateral, meaning that it refuses to send $10 million to the investor, it is the end of the line for us. Absolutely! And nothing – short of a flagrant intervention by the Federal Reserve – would save us.

To see this point, let us return to the fateful morning hour and consider a critical factor that we have so far left unconsidered: a change in the price of the security. Let us assume that the price of our security falls overnight to $9.5 million.

If that were to happen, our clearing bank that must send $10 million to the investor would be left with collateral worth $9.5 million. That would expose it to a potential $500,000 loss. Clearing banks manage trillions of dollars of collateral every day. They cannot afford such unanticipated exposure. And because, by virtue of having both money and collateral, they have the upper hand, they are quick to protect their interests.

To that end, our clearing bank sends us an ultimatum in the form of a “margin call”: Send $500,000 cash immediately or we would liquidate (sell) the collateral. Since we do not have $500,000, the bank sells the securities for $9.5 million and sends the money to the investor. The investor that lent us $10 million has now lost $500,000. That is the risk of every lending, including overnight lending. But that does not mean that the investor will let go of $500,000. It immediately files a suit to recover the damages. Woe to us with $250,000 equity and $500,000 in debt.

What follows is easy to see but it does not concern us. What needs emphasizing is that long before the matter reaches such critical point even a hint that we cannot meet the margin call will spell our doom. That follows from our business model. We never had money to pay for our purchase. From the get-go, we relied on the kindness of the strangers – a clearing bank here, a mutual fund or an insurance company there – to give us vital financial support. Anytime that support is withdrawn, we would not last an hour, certainly not a day.

That is why broker-dealers are so vulnerable to “rumors” and “reputational risk” – and why The Bank of England has officially declared a war on “rumour mongering”).

Reputations risk has nothing to do with “ungentlemanly”, downright vile or borderline unethical conduct; such “subjective” matters hardly matter in finance as long as you can deliver. The term, rather, unbeknownst to many of its users, refers to the perception in the market about a broker-dealer’s ability to meet the margin calls.

As broker-dealers grow, they expand into other branches of finance such as underwriting, private equity, venture capital and mezzanine financing; it is a logical strategy to diversify one’s revenue sources. The expansion and diversification makes them less dependent on their broker-dealer operation so they gradually become “investment banks” – “I-banks”, if you want to be more uppity. Such is the case with Merrill Lynch, Morgan Stanley, Goldman Sachs and Lehman Brothers. But we should not for a second let names obscure the fundamental nature of the business of these firms, with all the vulnerabilities that follow.

Bear Stearns did not go out of the business overnight because its underwriting fees vanished or its venture investments went sour. It went out of business, rather, because it became clear on the night of Sunday, March 16, that come Monday morning, no one would extend credit to the firm to carry its 200 odd billion dollar position. That was the end of the line for the firm.

In our example, we were bought $10 million bonds with $250,000 down payment. Our leverage was 40 to 1. Here is the leverage of the Big Five as of 12/31/07:
Merrill Lynch: 27.8 to 1

Morgan Stanley: 32.6 to 1

Goldman Sachs: 26.2 to 1

Lehman Brothers: 30.7 to 1

Bear Stearns: 32.8 to 1
That is why the comment of the Bear’s newly appointed CEO that “we are collective victims of violence” was so incredulous and betrayed a profound ignorance of how his firm worked. Both the man and the firm were doomed.

I will return with the epilogue.