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June 25, 2007
PAGE ONE
Wall Street Fears
Bear Stearns Is
Tip of an Iceberg
Near-Collapse of Funds
Stokes Broader Concerns
Over Murky Investments
By JUSTIN LAHART and AARON LUCCHETTI
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June 25, 2007; Page A1
The near-meltdown of two hedge funds at investment bank Bear Stearns Cos. last week underscored -and in some ways aggravated -- a growing fear on Wall Street: that hard-to-trade investments may
suddenly turn south and set off a broader market downturn.
The Bear Stearns funds, whose investors include wealthy individuals, other hedge funds and some of the
firm's own executives, are part of a recent boom in investment vehicles specializing in illiquid assets,
such as exotic securities, highways and timber lands.
REAL TIME ECONOMICS
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Unlike stocks or bonds listed on an exchange, such assets can't
be readily bought or sold. That makes it hard to establish an
accurate price for them. Fund managers have broad discretion
in attaching a value to these assets, and often don't reveal
many details of their trades.
Bear Stearns's High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit
Strategies Enhanced Leverage Fund ran into trouble when a downturn in parts of the housing market hurt
the funds' bets on complex securities backed by subprime mortgages, or home loans to borrowers with
troubled credit histories.
Such securities trade infrequently, which makes it hard to sell them quickly without incurring steep
losses. The funds, especially the Enhanced Leverage Fund, used borrowed money, or leverage, to amplify
returns. But leverage also amplifies losses when a fund's bets go sour.
Investors with plenty of cash on hand, thanks to years of low interest rates, have flocked to illiquid
investments in search of outsize returns, often with the help of borrowed money. Some market experts
worry that investing in illiquid assets, despite their inherent risks, has become almost mainstream.
In 2006, U.S. institutions such as pension
funds and endowments, had about $1 of
every $10 invested in less easily traded
assets -- such as hedge funds, real estate
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and private-equity funds -- up 27% from
2003, according to consulting firm
Greenwich Associates.
Endowments and foundations, among the
nation's richest investors, had about a
quarter of their portfolios invested in
less-liquid assets last year, Greenwich
says. These deep-pocketed institutions can
afford to wait a long time if they see big
returns on the horizon. But many other
investors, especially those backed by potentially nervous lenders, don't have that luxury.
"A lot of investors unfortunately are chasing returns rather than focusing on risk," says Leon Metzger, an
industry veteran who teaches hedge-fund management courses at Yale, New York and Columbia
universities.
Now, the problems at the Bear Stearns funds -- which prompted the firm to lend one of them up to $3.2
billion in a bid to rescue it -- show how hedge funds bent on short-term gains can go astray when holding
assets that can't be easily valued. That has stoked worries on Wall Street that other funds with similar
types of investments will suffer losses as fund managers reassess the value of those investments. Those
concerns contributed to last week's 279.22-point, or 2.1%, drop in the Dow Jones Industrial Average to
13360.26.
Many hedge funds and other institutions are paid in part on performance, so it is often in their interest to
price, or "mark," their assets aggressively, attaching the highest possible value to them. The higher the
value, the more compensation the fund manager receives from the fund's investors.
Moreover, hedge funds typically don't keep investors abreast of the details of day-to-day trading. As a
result, any losses the funds suffer may be significant by the time investors learn of them. That can be
especially true for illiquid assets, which may not show much price movement for months and then dip
sharply when confronted with the one-two punch of declining fundamentals and nervous investors.
The combination of illiquidity and leverage has long been a mainstay of financial crises. In 1994, hedge
funds run by Askin Capital Management sustained huge losses on leveraged bets on infrequently traded
mortgage-backed securities. The collapse of Long-Term Capital Management, which roiled markets
around the world in 1998, was sparked by its inability to unwind leveraged bets.
Last fall, commodity hedge fund Amaranth Advisors LLC lost about $6 billion when it couldn't easily
exit esoteric trades that went against it. (See article on page C1.) Earlier this year, Bank of Montreal lost
more than 600 million Canadian dollars (US$560 million) with a bad bet on natural-gas volatility.
Many investors have grown more comfortable with illiquid investments, based in part on the view that
even highly illiquid assets have become more liquid these days, thanks to low interest rates and an influx
of cash from the developing and oil-exporting countries that run trade surpluses with the U.S. What's
more, through sophisticated financial products, the risk inherent in illiquid assets can be offloaded to
hundreds of other players, making it more manageable.
Still, the increase in illiquid investments raises concerns. For one thing, even in liquid securities like
stocks, what can seem like a ready supply of cash can dry up quickly if investors get spooked. Those
problems are heightened when leverage is used.
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Even if a fund plans to invest in an illiquid asset for the long haul, creditors can force its hand. If a
leveraged investment racks up losses, the fund's lenders may demand more collateral, or even repayment
of their loans. To meet those demands, the fund, whose losses are already magnified by leverage, could
be forced to sell the investment well before the market recovers, adding to its burden.
"If the banks all pull the plug, that has a big impact on a fund's ability to ride out a short-term loss in
value," says Chris McNickle of Greenwich Associates.
And the use of borrowed money is on the rise. In May, the sum investors borrowed from brokerage firms
to buy stocks hit $317.99 billion, up about 14% from the previous record in March 2000, according to the
New York Stock Exchange. Net borrowings by large bond-market dealers stood at about $1.33 trillion
this month, up from $730 billion in 2003 and about $300 billion when the stock market peaked in 2000,
according to Chicago market-research firm Bianco Research LLC.
More than anything, this borrowing represents a triumph of greed over fear. Investors use loans to juice
up their bets without tying up much capital, and enjoy high-octane returns while holding seemingly
conservative assets like mortgage bonds. The risk is that recently placid markets start to crack, turning
these profitable leveraged bets into deepening losses. With funds that use leverage, it doesn't take a sharp
move in a market to create a sharp drop in a portfolio's value.
Figuring out the risk profile of illiquid assets -- and funds that invest in them -- can be tricky. Typical
methods for assessing risk rely on measuring volatility -- the choppier returns are, the riskier the
investment. But because illiquid assets don't trade regularly, marking to market -- or using recent sales
prices to determine an asset's value -- may not be possible. In these cases, a fund manager may instead
use a mathematical model to value an asset, a practice called marking to model.
Such models tend to smooth returns, making an asset look much less risky, says Massachusetts Institute
of Technology finance professor Andrew Lo, who is also a principal in AlphaSimplex Group LLC, an
asset-management company that runs a hedge fund.
Using broker-dealer quotes for illiquid assets can also damp volatility because they are often based on an
average of bid and offer prices rather than actual sales prices. What's more, price quotes can vary widely
from one dealer to the next.
The Bear Stearns funds' situation demonstrates the considerable leeway funds have in valuing illiquid
assets. The Enhanced Leverage Fund reported last month that it lost 6.75% of its value in April, but later
put that loss at a far steeper 18%.
One reason the Bear Stearns funds' troubles worry Wall Street is the fear that other players own similar
securities that have similarly been mispriced. If the funds' holdings were auctioned off, as their lenders
had threatened to do, there would be a market to mark to -- albeit one that, because of the fire-sale quality
of the auction, would value such securities well below what they otherwise might be worth.
Mr. Lo has found that returns for illiquid assets and funds that invest in them tend to have little variation
from one month to the next. Paradoxically, it is this smoothness of returns that show how illiquid, and
risky, a position might be.
Still, illiquid assets can be lucrative when held by investors with long time horizons, who don't have to
worry about creditors suddenly calling in loans and who understand the risk they've taken on. "If you're a
pension fund and you don't have any issues with being able to fulfill your obligations, illiquidity risk is a
very good way to earn extra returns," says Mr. Lo.
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Timber funds illustrate some of the potential, as well as the risks. These funds, in which investors hand
over money to a manager who buys and oversees forest lands, can lock up investors for 10 to 15 years,
typically returning their money after selling off the properties involved. Cashing out of a timber fund
early can mean selling at a discount of 20%. For a direct investor in timber, selling carries the same
vagaries of selling a home: You can guess what the price will be based on appraisals, but you won't know
for sure until you put it to market.
"This isn't a good investment for short-term investors -- there's too much volatility," says Dick Molpus,
of Mississippi-based timber-investment manager Molpus Woodlands Group.
--Tom Lauricella contributed to this article.
Write to Justin Lahart at justin.lahart@wsj.com3 and Aaron Lucchetti at aaron.lucchetti@wsj.com4
URL for this article:
http://online.wsj.com/article/SB118274074999546759.html
Hyperlinks in this Article:
(1) http://blogs.wsj.com/economics/
(2) http://blogs.wsj.com/economics/
(3) mailto:justin.lahart@wsj.com
(4) mailto:aaron.lucchetti@wsj.com
Copyright 2007 Dow Jones & Company, Inc. All Rights Reserved
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June 27, 2007
PAGE ONE
LENDING A HAND
DOW JONES REPRINTS
How Wall Street Stoked
The Mortgage Meltdown
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Lehman and Others
Transformed the Market
For Riskiest Borrowers
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By MICHAEL HUDSON
June 27, 2007; Page A1
Twelve years ago, Lehman Brothers Holdings Inc. sent a vice president to California to check out First Alliance Mortgage Co. Lehman was thinking abou t tapping into First Alliance's
lucrative business of making "subprime" home loans to consumers with sketchy credit.
The vice president, Eric Hibbert, wrote a memo describing First Alliance as a financial "sweat shop" specia lizing in "high pressure sales for people who are in a weak state." At First
Alliance, he said, employees leave their "ethics at the door."
The big Wall Street investment bank decided First Alliance wasn't breaking any laws. Lehman went on to lend the mortgage company roughly
$500 million and helped sell more than $700 million in bonds backed by First Alliance customers' loans. But First Alliance later collapsed.
Lehman landed in court, where a federal jury found the firm helped First Alliance defraud customers.
Today, Lehman is a prime example of how Wall Street's money and expertise have helped transform subprime le nding into a major force in the
U.S. financial markets. Lehman says it is proud of its role in helping provide credit to consumers who migh t otherwise have been unable to buy
home, and proud of the controls it has brought to a sometimes-unruly business.
Read the first article in this series:
'Subprime' Aftermath: Losing the Family Home 1
5/30/1007
Now, however, that business is in deep trouble, and some consumer advocates and policy makers are pointing the finger at Wall Street. Rough
13% of subprime loans stand in or near foreclosure, bringing turmoil and sometimes eviction to tens of thou sands of homeowners. Dozens of
lenders have gone out of business. Bear Stearns Cos. is trying to bail out a hedge fund it manages that was hurt by subprime mortgage losses.
Critics say Wall Street firms helped create the mess by throwing so much money at the market that lenders had a growing incentive to push through shaky loans and mislead borrowers.
At a hearing in April, Sen. Robert Menendez (D., N.J.), said Wall Street firms "looked the other way" as th ey profited from questionable loans, "fueling a market that has very little
discipline over itself."
Federal Reserve chief Ben Bernanke said in a May speech that some lenders focused more on feeding the marke tplace than on the quality of loans, in part because most of the risks that
loans would go bad were passed to investors. As a result, "mortgage applications with little documentation were vulnerable to misrepresentation or overestimation of repayment capacity
both lenders and borrowers," he said.
2
A generation ago, housing finance was different. Bankers took in deposits, lent that money to home buyers a nd collected interest and principal
until the mortgages were paid. Wall Street wasn't much involved.
Now it plays a central role. Wall Street firms provide working capital that allows thousands of mortgage fi rms to make loans. After lenders sign
up consumers for home loans, investment banks pool the income streams from these loans into bonds known as mortgage-backed securities. Th
banks sell them to yield-hungry investors around the world.
Before the mid-1990s, mortgage-backed securities consisted mostly of loans to borrowers with good credit an d cash to make ample down
payments. Then investment banks found they could do the same with riskier loans to borrowers with modest in comes and flawed credits. Poolin
the loans created a cushion against defaults by diversifying the risk. The high interest rates on the loans made for bonds with high yields that
investors savored. New technology helped make it easier for lenders to collect and collate mounds of inform ation on borrowers.
Lehman, one of Wall Street's biggest players in the subprime boom, says it has gone to great lengths to scr een loans for fraud and vet the lenders it works with. "No financial institution
would knowingly want to make or securitize a loan that it expected would later go into default," David Sher r, Lehman's head of securitized products, told Mr. Menendez and other senato
"Rather, the success of mortgage-backed securities as an investment vehicle depends upon the expectation th at homeowners generally will make their monthly payments, since those
payments form the basis for the cash flows to bondholders."
At the sector's peak in 2005, with the housing market booming, loan defaults remained low. Wall Street pool ed a record $508 billion in subprime mortgages in bonds, up from $56 billion
2000, according to trade publication Inside Mortgage Finance. The figure slid to $483 billion last year as the housing market slumped and subprime defaults picked up.
3
Lehman topped other Wall Street firms over the past two years, packaging more than $50 billion in subprime- mortgage-backed securities in bo
2005 and 2006. Overall, Lehman officials say the subprime business has accounted for 3% of the firm's overa ll revenues in recent quarters, or
roughly $500 million in 2006.
Lehman has also been a leader in investment banks' push to buy their own lenders. Through its subprime unit BNC Mortgage Inc., it lends dire
to consumers, bringing in more fees and giving it more control over the quality of the loans.
Lehman's deep involvement in the business has also made the firm a target of criticism. In more than 15 law suits and in interviews, borrowers a
former employees have claimed that the investment bank's in-house lending outlets used improper tactics dur ing the recent mortgage boom to p
borrowers into loans they couldn't afford.
Twenty-five former employees said in interviews that front-line workers and managers exaggerated borrowers' creditworthiness by falsifying tax forms, pay stubs and other information,
by ignoring inaccurate data submitted by independent mortgage brokers. In some instances, several ex-employ ees said, brokers or in-house employees altered documents with the help of
scissors, tape and Wite-Out.
"Anything to make the deal work," says Coleen Columbo, a former mortgage underwriter in California for Lehm an's BNC unit. She and five other ex-employees are pursuing a lawsuit in
state court in Sacramento that claims BNC's management retaliated against workers who complained about frau d.
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Lehman officials say there's no evidence to support such claims. They say the firm has tough antifraud cont rols and goes to great lengths to ensure that it works with mortgage brokers an
lenders who meet high standards and that loans are based on accurate information.
Lehman says company records clearly refute specific details of the accounts given by these former employees. It says most of them never raised concerns during their tenures at Lehman
lending units, even though that was a requirement of their jobs. Some employees contacted by The Wall Stree t Journal said they weren't aware of improper practices.
"We think it is misleading to extrapolate from a handful of cases, in each of which we have a strong defens e, and make a judgment about the way we conduct our business," Lehman says
Lehman's history in subprime goes back to the mid-1990s, when the sector was still tiny. Back then, Lehman established itself as a leader in the market for subprime-mortgage-backed
securities. It built a staff of experts who had worked at other securities firms and established relationsh ips with subprime-mortgage lenders.
WALL STREET PRIMER
• The Issue: Wall Street firms helped turn the
subprime business into a mortgage powerhouse.
• The Situation: Critics say big players such as
Lehman Brothers showered so much money on the
market that lenders cut corners.
• What's Next: Lehman says it has instituted strong
controls on its own lending units and remains
committed to the business.
One of them was First Alliance. Mr. Hibbert, the Lehman vice president, traveled to Orange, Calif., in June 1995 to help decide whether Lehm
should provide financing to First Alliance and underwrite its mortgage-backed bonds. In his memo, Mr. Hibbe rt reported back that there was
"little risk of fraud or impropriety" at First Alliance. But he also said it was clear it made some loans " where the borrower has no real capacity
repayment."
Lehman officials say Mr. Hibbert ultimately supported going forward with First Alliance, a decision the inv estment bank made on the basis of
extensive discussions and a 140-page memo. They also note that the $25 million line of credit that Lehman i nitially wrote for First Alliance wa
small compared with what other firms were putting up to finance the lender.
By late 1998, Prudential Securities and other investment banks had abandoned First Alliance. Federal regula tors and seven states were investigating allegations it used deceptive sales
tactics to get borrowers into loans with excessive upfront fees. First Alliance trained loan officers to us e a sales pitch designed to "confuse and mislead" borrowers and disguise fees, U.S
District Judge David Carter in California found in a 2003 bankruptcy-related proceeding.
During the turmoil, Lehman helped keep First Alliance afloat with more loans. In early 1999, an internal Le hman memo noted the proliferation of government probes targeting the lender
and the possibility that involvement with the lender might produce bad publicity for the investment bank. B ut the memo recommended going forward, arguing that First Alliance's
borrowers rarely defaulted on their loans and noting that Lehman stood to earn millions in fees by managing the lender's mortgage-backed securities deals.
Lehman officials say they took close account of First Alliance's practices. Its reviews showed the lender w as committed to improving its practices -- it
hired a new in-house counsel, along with a chief financial officer who once worked at Lehman.
First Alliance shut down in March 2000 as pressure from lawsuits and investigations grew. In 2003 a federal jury in California delivered a $50.1
million verdict in a class action against First Alliance, attributing 10% of the damages -- $5.1 million -- to Lehman. (A federal appeals panel upheld the
jury's decision but instructed the trial court to recalculate the dollar award. That decision is pending.) Lehman also settled a lawsuit filed in Broward
Country Circuit Court by Florida authorities who said Lehman was an "accomplice" in First Alliance's frauds . The investment bank admitted no
wrongdoing but agreed to pay $400,000 and review its practices.
Lehman calls the First Alliance saga an aberration, and says it is unfair to use it to draw conclusions abo ut how it does business more than a decade
later.
The subprime market contracted between 1999 and 2001, as continuing ripples from that era's Russian debt cr isis and the collapse of hedge fund
Long-Term Capital Management prompted investors to pull back from riskier markets. The crisis also presente d a buying opportunity.
In 1999 Lehman started operating its own subprime lending unit, Finance America, as a joint venture with an ailing subprime lender named Amresco
Inc. as a minority partner. It bought out Amresco in 2001 and another minority investor in 2004. Lehman als o took an ownership stake in
California-based BNC Mortgage in 2000 after helping management take the company private. It bought out mana gement's remaining stake in 2004 and
last year merged Finance America into BNC. Earlier this month, it said it would merge BNC with its Aurora L oan Services unit.
With interest rates low and the economy recovering, the market took off, and BNC and Finance America grew q uickly. They ballooned from $3 billion in total loan originations in 2001 t
$24 billion in 2005, ranking Lehman No. 11 among all subprime lenders.
As subprime grew, Lehman officials say, fraudulent schemes pushed by rogue mortgage brokers and others beca me more sophisticated throughout the industry. By taking full ownership
BNC and Finance America, the firm says, it was in a better position to combat these practices.
When Lehman consolidated its control of the two companies in 2004, Lehman officials say, the lenders' pract ices were consistent with industry standards. But they acknowledge the lend
-- like others in the subprime industry -- had problems with loan quality and fraud prevention. "Since then , we have worked long and hard, as we have taken control, to make these
companies models for the industry on best practices for fraud detection and borrower protection," the firm says.
Since the start of 2004, BNC has nearly doubled the size of its staff devoted to quality control, fraud inv estigations and other jobs that help ensure the lender makes good loans.
Some former employees claim, however, that the pressure to boost loan volume during the boom years of 2004 and 2005 prompted some workers at the lending units to step over the line
and push through questionable loans.
Dena Ivezic, a mortgage underwriter for both companies in Downers Grove, Ill., in late 2005 and early 2006, says some staffers at her branch used "cut and paste" techniques to fabricate
documents they needed to get loans approved. Some workers tried "to take a stand" against such practices, s he says, but "they were reprimanded for not being cooperative -- not wanting
be creative about making deals work....Everybody else just kind of bottled up and just never said anything, because you needed a job."
Cedric Washington, a former regional sales manager for Finance America in California, contended that employ ees at the lender actively pushed through questionable loans. In a 2005
employment-discrimination lawsuit in state court in Sacramento, Mr. Washington said he witnessed a fellow m anager alter a loan document by forging a borrower's initials. Later, he said
he discovered Finance America employees forged borrowers' signatures on credit disclosures and used falsifi ed documents to inflate loan applicants' incomes.
In one instance, the lawsuit said, a loan officer submitted a loan on a duplex that was "not a home or dupl ex at all but merely a greenhouse." Mr. Washington complained the loan was
backed by falsified collateral, the suit said, but a Finance America executive refused to pull the loan.
BNC officials said Mr. Washington himself was complicit in fraud, which he denied, according to the lawsuit . Lehman officials say his lawsuit "had no merit" and was "not brought in go
faith." It was settled last year for an undisclosed sum. As for Ms. Ivezic, Lehman says she worked at BNC f or just 4½ months and her experiences are "hardly representative of BNC's
employee base."
Other former employees contacted by the Journal said that fraud wasn't a problem at the lenders. They say their managers didn't hesitate to reject fishy loans. "Everything we did was by t
guidelines," says Barbara Webb, a loan underwriter for both Finance America and BNC in Texas from 2004 into 2006.
Lehman officials say they have procedures in place to prevent mortgage brokers and others in the loan proce ss from bending rules. BNC reviews brokers before putting them on its
approved list and rechecks them annually, searching state licenses and lawsuits and making sure they're not on federal officials' watch list for problem brokers.
BNC says it has stopped doing business with more than 900 since 2003, largely because of fraud. It works wi th an average of about 1,800 brokers a month.
At BNC's headquarters in Irvine, Calif., officials say they've designed their business with an eye to weeding out bad loans. Mortgage underwriters and loan processors -- who make sure
loan-application data is accurate -- get extensive training in how to spot fraud. Under BNC's organizationa l chart, they're set apart from sales, to avoid pressure to let problem loans slip
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through, BNC officials say.
Lehman notes the Office of Thrift Supervision, BNC's regulator, received just three complaints about the co mpany from April 2006 through March 2007, a tiny fraction of the roughly
60,000 loans it made during that span.
Some complaints have surfaced in court. Borrowers' lawsuits in Pennsylvania, Louisiana, Mississippi and oth er states have alleged Finance America and BNC took advantage of
unsophisticated borrowers or used falsified information to approve loans.
A lawsuit in state court in Saginaw, Mich., by UAW/GM Legal Services Plan, which serves auto workers and re tirees, alleges a mortgage broker "confused and pressured" an elderly cou
into signing up for a BNC loan that obligated them to pay as much as 17.5% as the interest rate adjusted up ward. The suit says BNC was aware of "the seamy details of what happened he
because it prepared the documents, vetted the application and gave the broker "a set of instructions for ho w to proceed."
George and Evelyn Lee's July 2006 loan was pooled by Lehman with nearly 4,000 other subprime home loans fro m BNC into a securities deal that produced more than $800 million in
mortgage-backed bonds.
The broker in the case, Real Financial LLC, has been the subject of 25 complaints to Michigan financial reg ulators and a fraud lawsuit that's pending in federal court in Michigan. State
regulators dismissed many of the complaints, but have upheld eight of them and referred others for investig ation.
Real Financial's attorney says the allegations stem from an unfavorable economy that's sparked rising foreclosures and unjustified complaints against lenders and brokers.
Lehman says it wasn't aware of complaints about Real Financial until the lawsuit was filed, but has since r emoved the firm from its broker list. "BNC was not aware of anything wrong w
the Lees' loan because all it saw was the loan application which was in good order," Lehman said. "Real Fin ancial was not BNC's agent, and BNC gave it no 'instructions' whatsoever. W
strongly believe BNC has been added to this case only as a 'deep pocket.'"
Despite the controversy that's emerged in the subprime business, Lehman officials say they're proud of their role in helping the market grow and offering access to credit for consumers w
might not otherwise have the chance.
"We think it's a business we should all be working to improve, not diminish," the firm says.
Write to Michael Hudson at michael.hudson@wsj.com4
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• Refinance car loan - Rising rates squeeze state banks Milwaukee Journal Sen... c13.homefinancial.org
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June 28, 2007
PAGE ONE
DOW JONES REPRINTS
Market's Jitters
Stir Some Fears
For Buyout Boom
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Takeover-Related Debt
Gets Chilly Reception;
Hearing 'Wake-Up Call'
By SERENA NG, TOM LAURICELLA and MICHAEL ANEIRO
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June 28, 2007; Page A1
As several debt offerings faced resistance yesterday, bankers and investors began to wonder whether the
tremors coursing through the nation's debt markets signaled that the buyout boom is in jeopardy or just
suffering a temporary setback.
Much of the recent record wave of takeovers has been built on borrowed money, fueled by easy credit
terms and low interest rates. But on Tuesday, investors rejected a $3.6 billion buyout-related
bond-and-loan deal by U.S. Foodservice Inc., the nation's second-largest food distributor, which
subsequently pulled the bond offering and postponed plans to sell the loans.
That left underwriters of U.S. Foodservice, which is being acquired for $7.2 billion by private-equity
firms Kohlberg Kravis Roberts & Co. and Clayton, Dubilier & Rice Inc., holding the debt on their own
books, something the Wall Street firms wanted to avoid.
IS CHANGE IN THE WIND?
• Capital: Market's Shock Absorbers
Have Improved Since 19871
• Heard on the Street: Banks on a Bridge Too
Far?2
• Investors Wonder When Buyout Spree Will
There wasn't any similar-sized stumble yesterday. But
Catalyst Paper Corp., citing "adverse" market conditions,
scrapped a $200 million offering of junk bonds the Canadian
company planned to use for funding its business and other
investments or acquisitions.
Cool3
Meanwhile, underwriters delayed the launch of a
buyout-financing deal for Myers Industries Inc. in the hope
that the market would settle down in coming days. Late in the day, Magnum Coal Co. became the latest
company to postpone a junk-bond offering, this one for $350 million.
In Europe, Arcelor Finance, the borrowing vehicle for Arcelor SA, which is being acquired by Mittal
Steel Co., put off its plans to issue more than €1 billion ($1.34 billion) in bonds, citing the turbulent debt
market. In Malaysia, shipping company MISC Bhd. put plans for a $750 million bond offering on the
back burner.
In another sign that investors may be developing some indigestion from the buyout boom, Blackstone
Group, the buyout firm that listed shares on the New York Stock Exchange last week, fell 2.7% in 4 p.m.
composite trading yesterday to $29.92, below its offer price of $31 a share.
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'The Biggest Risk'
Taken together, the setbacks are stoking unease across Wall Street. "The biggest risk we face -- and there
are a lot of things that contribute to this risk -- would be a very big crisis in the credit markets," Lloyd
Blankfein, chief executive of Goldman Sachs Group Inc., told an audience at The Wall Street Journal's
Deals & Deal Makers conference in New York. A "sentiment shift," he said, "could unravel very
quickly" the vast wealth that has been created by the takeover boom.
At the same conference, Treasury Secretary Henry Paulson called
the market jitters "a wake-up call to focus on excesses" that have
developed in recent years in the debt markets.
Several factors underlie the new pushback against buyout
financings. One is the growing awareness that investors have been
demanding very little in return for the risk they have accumulated in
snapping up buyout-related loans and debt.
Yields on junk bonds, when compared with ultrasafe U.S. Treasury
securities, hit historic lows around a month ago. The near-collapse
of two Bear Stearns Cos. hedge funds that invest in risky
subprime-mortgage debt also sparked broader investor worries about
risky investments.
Still, it isn't clear if the latest credit-market turmoil represents the kind of shift in sentiment that Mr.
Blankfein and others worry about. Mr. Blankfein himself, and many others at the conference, said they
expected a soft landing for the market. Underpinning that hope: The global economy remains in strong
shape. Growth is robust, and inflation and interest rates are low.
And some deals are still moving forward, including debt offerings by Dollar General Corp. and ITT
Switches, a unit of ITT Corp., both of which are being acquired by private-equity firms. Banks handling
the Dollar General deal intend to sell investors $2.4 billion of loans and an additional $1.9 billion in junk
bonds with provisions that give the company leeway if it struggles. To entice investors, the underwriters
have been offering higher interest rates.
Other less-risky bond sales were completed yesterday, including a $3 billion junk-bond offering by
Community Health Systems Inc., a hospital operator.
In recent years, easy credit has allowed private-equity investors to raise gobs of cash to take private such
corporate giants as student lender Sallie Mae, utility TXU Corp. and hospital operator HCA Inc.,
transferring them from public markets into private hands. The low-interest-rate loans and bonds behind
these takeovers also have increasingly given borrowers extra leeway if their operations struggled.
Last year, announced private-equity buyouts in the U.S. hit $395 billion in value, including the
companies' existing debt, according to Thomson Financial. Already this year, the total has reached $308
billion.
If buyers of these loans and bonds -- typically institutional investors like mutual funds, pension funds,
hedge funds and endowments -- start to turn sour on these borrowings, it could slow, if not derail, the
buyout boom.
Some big buyout-related deals remain in the pipeline. Investors are looking ahead at $250 billion of new
debt coming to market in the next several months. Just this week, Chrysler Group, which is being sold to
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Cerberus Capital Management by German parent DaimlerChrysler AG, began marketing a debt fund
raising that will total more than $60 billion.
In addition to demanding higher interest rates, investors are resisting many bonds and loans whose terms
they believe to be too easy on borrowers. Investors have rejected a number of recent deals that included
"payment-in-kind" provisions, which allow companies to postpone debt payments to their lenders if they
run short of cash. Investors also have rejected loans that are light on certain common performance
requirements, known as covenants.
"A lot of managers are starting to get miffed about deals with no covenants and the fact that underwriters
seem to have little regard for the risks investors are assuming," said Bradley Kane, who manages a
portfolio of corporate loans at SCM Advisors LLC in San Francisco.
Banks in several cases have been stuck holding portions of loans or bonds they planned to parcel out to
investors, something that could make them more selective in underwriting deals. Meanwhile, companies
and their private-equity buyers face bigger drains on their cash flow as their interest costs rise.
The debt offering by U.S. Foodservice, which is being sold by Ahold NV of the Netherlands, is
emblematic of the type of deal that just a month or two ago was getting snapped up, largely by hedge
funds.
Tuesday evening, a group of Wall Street underwriters canceled a $1.55 billion bond offering and a $2
billion sale of corporate loans for U.S. Foodservice after failing to find enough investors to take on the
debt. The underwriters had to finance the $3.6 billion in debt on their own via a "bridge" loan to the
company.
On the surface, U.S. Foodservice ought to have been an attractive investment. The company, which
distributes food to 250,000 restaurants, hotels and schools nationwide, provides the kind of stable cash
flow that debt investors like.
Frosty Reception
The offering was handled by Citigroup Inc., Deutsche Bank AG, J.P. Morgan Chase & Co., Morgan
Stanley, Goldman Sachs and RBS Greenwich. But when the underwriters began to shop the offering
around two weeks ago, they met a frosty reception from analysts and portfolio managers at big
mutual-fund companies and other potential buyers.
Investors were concerned about the large amount of debt U.S. Foodservice was taking on to finance the
buyout. For such risky loans, they typically look for protections should the company run into trouble.
One protection is collateral to seize if the company goes into default. But most of U.S. Foodservice's
assets were already securing other debt obligations.
The loans in the deal also had minimal covenants, and the bonds included payment-in-kind features.
Neither of those facts sat well with potential investors, who refused to buy the debt on the proposed
terms.
"We didn't think investors were being compensated for the risk," said Andrew Cestone, head of the
high-yield team at Evergreen Investments, a money-management arm of Wachovia Corp. Evergreen
turned down the deal.
Market participants said hedge funds, which had been reliable buyers of even the most speculative
offerings, were also suddenly absent from the marketplace.
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It quickly became clear that the deal would struggle, participants say. U.S. Foodservice's underwriters
were soon making calls to investors, asking what would make the deal more enticing. The main demands
from potential buyers were structural -- get rid of the payment-in-kind feature and add in covenants. Then
there were the returns being offered investors; the yields were below what fund managers thought they
needed in view of the deal's risk.
But the underwriters said they couldn't budge on those terms. They also didn't cede much ground on
price, and investors continued to say no thanks. Now, the offering sits on the underwriters' books. They
hope to distribute the loans and bonds to investors in the months ahead.
--Gregory Zuckerman and Dana Cimilluca contributed to this article.
Write to Serena Ng at serena.ng@wsj.com4, Tom Lauricella at tom.lauricella@wsj.com5 and Michael
Aneiro at michael.aneiro@dowjones.com6
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(4) mailto:serena.ng@wsj.com
(5) mailto:tom.lauricella@wsj.com
(6) mailto:michael.aneiro@dowjones.com
Copyright 2007 Dow Jones & Company, Inc. All Rights Reserved
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8/20/2007 10:25 AM
Banks Delay Sale Of Chrysler Debt As Market Stalls - WSJ.com
1 of 4
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July 26, 2007
PAGE ONE
DOW JONES REPRINTS
Banks Delay Sale
Of Chrysler Debt
As Market Stalls
By DENNIS K. BERMAN, SERENA NG and GINA CHON
July 26, 2007; Page A1
Wall Street's corporate-debt machine has helped to finance the increasingly
exotic takeover deals of the buyout boom and to shore up some of the
nation's ailing industries with cheap loans and bonds. Now, that machine is
sputtering.
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Yesterday, Chrysler Group became a signpost for the high-yield-debt market's strain as bankers for the
ailing auto giant postponed a $12 billion sale of debt to investors as part of a buyout severing Chrysler
from German parent DaimlerChrysler AG.
The move isn't expected to prevent the Aug. 3 closing of hedge fund Cerberus Capital Management's deal
to buy an 80% stake in Chrysler.
But the higher borrowing costs that are growing out of the recent
debt-market turmoil promise to crimp the returns of buyout firms,
potentially shrinking their influence and their ambitions. And
companies, particularly struggling ones like Chrysler or Tribune
Co., the media company, could feel the pinch. Until now, they have
been able to obtain cheap loans to work out their problems or
finance other plans.
At the same time, the shifting environment could open the way for
more conventional mergers, such as Siemens AG's $7 billion
takeover of medical-diagnostics company Dade Behring Holdings
Inc. Backed by stock and strong credit ratings, they don't usually
rely as much on debt financing, and still have access to the capital
they need to do deals.
In the Chrysler deal, banks had planned to fund the operations of the
newly independent auto maker with money raised from bond and
loan investors. Instead, the underwriters of the deal, including J.P.
Morgan Chase & Co., Citigroup Inc. and Goldman Sachs Group
Inc., will have to pony up much of the money themselves, at least until the market settles down. Cerberus
and DaimlerChrysler will also be contributing to the kitty.
An additional $8 billion fund raising, which will be used to bolster Chrysler's finance arm, is expected to
proceed in coming days, though at higher interest rates than originally planned.
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"For all practical purposes the markets are closed right now," said Chad Leat, co-head of Global Credit
Markets at Citigroup. "But they're not closed forever," he added, noting that his firm expects activity to
pick up in the fall.
Debt markets have been chaotic for weeks, as investors coped with more than $200 billion of deals
waiting to get funded. There is also nervousness about how much risk the market can bear. While
corporate defaults still hover near record lows, the recent turmoil in the subprime-mortgage market
illustrates how quickly conditions can change.
Yesterday's setback doesn't necessarily mean the buyout boom is over. Bankers managed to sell investors
$325 million in junk bonds to fund Dubai Aerospace Enterprise Ltd.'s $1.9 billion purchase of two
aircraft servicing companies from the Carlyle Group LP, though they postponed a separate sale of $937
million in loans tied to the same deal.
But with banks now sitting on an expanding pile of unwanted loans and high-yield bonds, Wall Street's
top bankers have begun to acknowledge that deals will get more expensive.
That means the five-year run of leveraged buyouts that has poured cash into struggling industries like
automobiles and newspapers, will slow considerably. Most of those takeovers were fueled by large sums
of money borrowed at low interest rates.
The market's new wariness is already redefining the standards of the buyout game, which once let
private-equity firms dictate terms to banks, while using the easy availability of debt to finance ever-richer
offers for takeover targets.
"Prices have gotten much higher than historical trading levels for many of these companies," said Scott
Sperling, co-president of buyout firm Thomas H. Lee Partners, in an interview. "That's probably not
sustainable if debt markets adjust to more normalized levels."
The higher borrowing costs mean auto companies, for example, will be paying out more money in debt
service, leaving less money available to develop new products and technology, which are critical to
attracting customers in an increasingly competitive market.
Chrysler was already facing a buyout-related increase of at least $200 million-a-year in its debt costs.
That's roughly equivalent to the sum needed to give a significant facelift to a car model. Now, those
interest costs could potentially go even higher.
In recent months, cheap loans have given even weak companies more time to work out their problems. In
December, Ford Motor Co. easily raised $23 billion in loans and bonds to help fund its restructuring. In
late May, Tribune Co. obtained more than $7 billion in loans to finance the first part of a going-private
transaction. The media company yesterday posted a 59% drop in second-quarter net income, slightly
above market expectations.
For others, that road may be closed. "The escape hatch is completely gone," says Michael Difley, a
high-yield portfolio manager at investment firm American Century. "They're going to have to fix their
businesses or instead look for a strategic buyer."
Deals across the globe are getting pinched. In Europe, bankers say they have had to hit the brakes on
nearly all big private-equity-related deals.
One such deal is the sale of Cadbury Schweppes PLC's drinks business, which has attracted attention
from a host of private-equity firms including Blackstone Group and Kohlberg Kravis Roberts & Co.
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The business was expected to fetch as much as $15 billion. Now, potential buyers are saying that due to
lending conditions the deal could be postponed by months.
Europe's biggest private-equity deal to date -- the $20 billion purchase of pharmacy chain Alliance Boots
PLC by KKR and an Alliance Boots executive -- has also run into trouble. Yesterday, the banks that
arranged financing for the deal said they would hold the main £5.05 billion ($10.4 billion), eight-year
term loan portion of the debt off the market until conditions are calmer. (See related article1.)
Few industries are as exposed to a turn in debt-market conditions as the auto industry. Detroit is already
far down the path of selling assets and issuing debt to raise cash as it tries to sort out a hornet's nest of
problems, including declining U.S. sales and massive health and pension obligations to workers. But the
process is far from complete.
Ford, for instance, is still trying to sell its Jaguar and Land Rover brands. Parts suppliers like Delphi
Corp. are also on the block. Uncooperative debt markets could complicate these sales, putting added
pressure on the companies and their work forces.
"It's a challenged auto industry running into a challenged financing market," says Brett Barragate, a
partner in the banking and finance group at law firm Jones Day. "This means deals will become more
expensive and take longer to get done."
Earlier this week, Wall Street firms postponed a sale of $3.1 billion in loans to finance the buyout of
General Motors Corp.'s Allison Transmission by Carlyle Group and Onex Corp. The buyout will go
forward, but again banks will be on the hook, possibly making them wary of getting involved in future
auto-related financings.
Just four weeks ago, such deals would have been a cinch for a corporate seller. Debt investors had for
years gobbled up hundreds of billions of bonds used to fund buyouts for vast tracts of the stock market,
ranging from Dunkin' Donuts to pipeline operator Kinder Morgan Inc. These investors seemed to
tolerate increasingly risky terms, helping fuel Wall Street's imagination as bankers and private-equity
firms batted around $50 billion and $100 billion deals.
But the rapid pace of deal making has created an oversupply of high-yield debt securities for the hedge
funds, insurers, and other institutions who buy it. They have now simply turned their backs on deals
coming to the market, causing some embarrassing turnabouts.
After struggling for weeks to find investors to buy $20 billion of Chrysler Group debt, Wall Street firms
postponed the sale of $12 billion in loans for the loss-making auto maker. Instead, they will fork out $10
billion from their own pockets to finance the deal, according to people familiar with the matter.
Both Cerberus and Daimler will be lending $2 billion to Chrysler's auto business after investors shunned
the risky loans. The debt underwriters, which also include Bear Stearns Cos. and Morgan Stanley, will
initially lend the auto maker $10 billion, but intend to sell some of that to institutional investors later on.
Chrysler also needs to raise $42 billion, much of it to compensate Daimler for existing Chrysler debt it
still holds.
The new climate in the debt market is likely to be more conservative, reining in prices paid for
companies in leveraged buyouts and tightening the lending terms underlying those purchases. But just
how conservative is a subject of debate on Wall Street.
One top lender said it would be possible over the next few weeks to stage leveraged buyouts of at least
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$10 billion, and perhaps as large as $15 billion. That's a far cry from the $50 billion deals some
envisioned a few weeks ago, but still far from a moribund market. Others said it would be months before
there was real clarity about the market's appetite.
The market could tighten further, pinching banks hoping for an easier fund-raising environment in
September. In one notable development, issuance of investments called collateralized loan obligations
has waned sharply. CLOs, as they are known on Wall Street, hold large numbers of corporate loans, the
same way a mutual fund holds securities like stocks. The decline in demand for these products could be a
sign of a deeper downturn in investor demand for corporate debt.
--Tom Lauricella and Jason Singer contributed to this article.
Write to Dennis K. Berman at dennis.berman@wsj.com2, Serena Ng at serena.ng@wsj.com3 and Gina
Chon at gina.chon@wsj.com4
URL for this article:
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Copyright 2007 Dow Jones & Company, Inc. All Rights Reserved
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Chrysler's Bankers May Take On Debt
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The Domino Effect: As LBOs Lose Luster, A Stock-Price Prop Falls
Banks May Sweeten Terms Of Loans for Chrysler Deal
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8/20/2007 10:24 AM
Stocks Tumble As Wary Investors Reassess Risks - WSJ.com
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July 27, 2007
PAGE ONE
DOW JONES REPRINTS
Stocks Tumble
As Wary Investors
Reassess Risks
July 27, 2007; Page A1
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By bidding up stock prices all year, investors were effectively betting the housing slowdown wouldn't eng ulf the broader economy. Yesterday, that
confidence appeared to be shaken.
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By MICHAEL HUDSON, PETER A. MCKAY and AARON LUCCHETTI
Stocks and corporate-bond markets tumbled amid selling that was more widespread than during the three pre vious days of triple-digit declines this
month. Along with risky bonds and anything connected to the housing market, investors sold off stocks, em erging-markets bonds and even high-quality corporate debt. The record
trading volume in stocks reflected rising anxiety.
Meanwhile, roughly 1,300, or nearly 17%, of the around 7,800 stocks that trade on U.S. exchanges hit thei r lowest price of the past 12 months.
1
To many investors, that made yesterday's selloff more ominous than other big declines this year. Sid Baks t, a senior portfolio manager at
investment firm Robeco Weiss, Peck & Greer, said the steady drip of bad news on subprime-mortgage loans and the failure of some
leveraged buyouts to get long-term financing has made investors increasingly nervous.
"As each day has gone by, things have been leaking a bit more," Mr. Bakst said. "But today there was full -blown carnage."
The Dow Jones Industrial Average sank 311.50 points, or 2.3%, to finish at 13473.57, after being down as much as 440 points at
midafternoon. At the New York Stock Exchange, trading curbs designed as safeguards against a crash remain ed in effect for nearly all of
yesterday's trading session.
The selloff marked the biggest three-day point drop for the Dow industrials in five years and wiped $105. 9 billion off the average's market value.
The Dow is clinging to an 8.1% gain on the year but has already fallen 2.7% this week, including two dail y drops of more than 200 points.
The broader Standard & Poor's 500-stock index slid 35.43 points, or 2.3%, to 1482.66, leaving it up 4.5% on the year. The technology-focused Nasdaq Composite Index shed 48.83
points, or 1.8%, to 2599.34, and was up 7.6% on the year.
And, in a sign that investors are increasingly worried that small companies may be least able to weather the weaker economy that may lie ahead, the Russell 2000 Index of small
stocks fell 21.02 points, or 2.6%, to 791.48, near its break-even point for the year.
The decline of small-capitalization stocks, which had led the market for the past several years, is also a signal that investors believe the pace of leveraged buyouts will slow in the
coming months. Typically buyout firms snap up shares of small and midsize companies, and many of these stocks were trading at prices that suggested they would be taken over.
Record Volume
Yesterday's volume on the nation's three major stock exchanges totaled 10.59 billion shares, up 34% from the previous record, which was set earlier this year. The exchanges
handled the heavy load with few hitches. When volume is high, investors take big market moves more seriou sly.
As investors sold stocks and corporate bonds, they bought U.S. Treasurys, sending yields lower. The
yield on the 10-year Treasury note fell to 4.78%; its yield has declined a half percentage point in the
past several weeks, one of the market's biggest moves in recent years. One bright spot in yesterday's
markets was that lower Treasury yields translate into lower mortgage rates, which could put a cushion
under the housing market.
But investors don't see lower mortgage rates as a panacea for the economy. The moves in the stock and
bond markets, and discouraging news about home sales and orders for capital equipment, led the
federal-funds futures markets -- where traders can bet on the Federal Reserve's next move -- to
conclude that the central bank is now much more likely to cut interest rates sometime this year.
The futures market is putting the odds of a rate cut as soon as September at 50%. It sees a
quarter-percentage-point rate cut to 5% as a near certainty by mid-December. Of course, the markets
earlier this year anticipated the Fed would cut rates, only to be dissuaded by the vitality of the econom y
and Fed Chairman Ben Bernanke's warnings about inflation pressures.
Yesterday, investors sold off stocks whose performance is tied to the ups and downs of the economy, like energy companies, industrials and basic-materials companies, a sign
investors now think the economy will slow down. Those sectors were among the market's leaders this year. Sectors such as health care and small-ticket consumer goods, which hold
up during times of economic weakness, fell but fared better than the overall market.
Energy stocks, which were up 25% on the year before yesterday, led the way down after ExxonMobil Corp. reported weaker-than-expected earnings. The energy sector had
accounted for roughly a third of the stock market's earnings growth over the past two years, meaning high oil prices actually had a positive impact on stocks. But now energy prices,
which have flirted with new highs recently, are clearly a drag on the market.
The meltdown in the subprime-mortgage market was clearly the factor that set off the cascade of declines. Investors fears have been heightened by the sheer complexity of
collateralized-debt obligations and other structured finance vehicles, which makes it difficult for inves tors to judge just how bad conditions are in the subprime sector, said Arthur
Tetyevsky, chief U.S. credit strategist at HSBC. "Now it's a much broader, much more nebulous, much more intimidating issue for the market. And that's adding to the duress that
we've seen in the market," Mr. Tetyevsky said.
SCORECARD: DEBT DILEMMAS
CDOs are investment vehicles that pool together mortgages and other assets and then spin off bonds that c arry varying levels of risk.
By spreading to other markets, the subprime mess is driving up interest rates for borrowers of all sorts, which can lead to a credit crunch.
8/20/2007 10:24 AM
Stocks Tumble As Wary Investors Reassess Risks - WSJ.com
2 of 2
Click here2 for a list of bond deals, hedge funds and
LBOs affected by tightening credit conditions.
http://online.wsj.com/article_print/SB118549309797479652.html
Many bearish observers thought the housing slump might cause an economic slowdown by cutting into consume r spending, which
accounts for about two-thirds of the U.S. economy. Consumer spending has held up reasonably well, however , and now worries about the
economy are focused on whether tighter credit will undermine companies' ability to borrow money so they c an expand and keep boosting
their stock values.
Bond Impact
The impact of tighter credit is already apparent in the market for high-grade debt. Yesterday, for exampl e, Tyco Electronics Ltd. pulled a $1.5 billion bond deal "due to unfavorable
conditions in the debt markets," the company said. Selling bonds for a company like Tyco, which has put i ts past scandals behind it, is normally a routine affair.
As another example, Mr. Tetyevsky pointed to the price action on a $1.5 billion bundle of 30-year bonds i ssued two weeks ago by Lehman Brothers Holdings Inc. By yesterday
the quoted yield on those bonds was roughly 2.4 points above the yield on 30-year Treasurys, widening fro m a spread of roughly 2.15 points on Wednesday and 1.7 points back on
July 12. That's a big increase for the investment-grade bond market and a sign that investors are nervous and want to get paid more for risking their money, even on bonds that are
considered to have a very low chance of default.
Some analysts said the credit market, which had rallied strongly for several years, was due for a downtur n. RBC Capital Markets fixed-income strategist T.J. Marta said the
high-grade-bond market's move may simply be a symptom of the air being let out of a credit bubble that ha d gotten too big. "But the concern is that this is a fairly disorderly and
hysterical move, and that always carries the risk that you hit a tipping point where things get out of co ntrol," Mr. Marta said.
Juggling his phone on the floor of the New York Stock Exchange, broker Steven Grasso weighed in on a stoc k market where investors' fear has replaced greed as the
most-prominent emotion. The bond market "is a huge concern," said Mr. Grasso. "It's been overhanging the market. New companies keep getting lumped into what's happening to
subprime....People thought it would be a handful of companies, but we're seeing a marketwide impact."
Mr. Grasso said many companies' borrowing costs will go higher, lowering their earnings. Rising borrowing costs also make leveraged buyouts, which have helped fuel the run-up
in stocks, more expensive. That could remove another factor that has been propping up stock prices in rec ent months. "The LBO chatter will come down to a low whisper," he
predicted.
Until recently, emerging-market bonds had largely weathered the turmoil in the U.S. and European credit m arkets. That's a testament to the strong economic fundamentals and
financial stability of many emerging economies. But, in another sign of the disquiet in the markets, Russ ian energy giant OAO Gazprom abruptly postponed a bond offering
planned for yesterday.
"It's kind of like catching a falling knife right now," said Edwin Gutierrez, an emerging-market portfoli o manager at Aberdeen Asset Managers in London, of yesterday's trading. "I
wouldn't be in a hurry to add risk."
U.S. investors awoke to overnight selling in key Asian and European markets. In addition, the Australian asset-management firm Absolute Capital announced that it was halting
withdrawals from two funds with about $200 million in assets invested in credit instruments, including CD Os.
As the morning progressed, the Commerce Department released data showing that new-home sales in the U.S. fell 6.6% in June -- more than quadruple the decline expected by
economists in a survey by Dow Jones Newswires. The government also announced a smaller-than-expected rise of 1.4% in June orders for big-ticket items known as durable goods.
'Buying Opportunity'
Some investors appeared undeterred by the selloff. Larry Reno, a retired civil servant in Fayetteville, G a., was tinkering on his recreational vehicle yesterday morning when he heard
about the market's rout on the radio. "Today is like the day-after-Christmas sale -- this is a buying opp ortunity," said Mr. Reno, who estimates his stock portfolio to be worth about
$750,000.
Mr. Reno, who owns about 35 stocks, said he isn't concerned about the subprime-mortgage market or the pro spect for a weakening credit cycle.
"This is a flash in the pan. It's a great day to be in the market to increase positions," he said.
But mutual-fund investors have picked up their selling as volatility has increased recently, according to TrimTabs Investment Research.
--Joanna Slater and Robin Sidel contributed to this article.
3
4
Write to Michael Hudson at michael.hudson@wsj.com , Peter A. McKay at peter.mckay@wsj.com and Aaron Lucchetti at aaron.lucchetti@wsj.com5
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8/20/2007 10:24 AM
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August 1, 2007
PAGE ONE
Wall Street, Bear Stearns Hit Again
By Investors Fleeing Mortgage Sector
By KATE KELLY, LIAM PLEVEN and JAMES R. HAGERTY
August 1, 2007; Page A1
The nation's weak housing sector sent another shudder through Wall Street,
with insurers and lenders taking further hits and Bear Stearns Cos.
shutting off withdrawals from a mortgage-investment fund.
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The stock market, which had been up sharply early yesterday, reversed
course abruptly amid renewed concerns about loans and securities derived from home mortgages. The
Dow Jones Industrial Average, which had been up more than 140 points, closed down 146.32 points, or
1.1% from a day earlier, at 13211.99 -- a swing of nearly 300 points, or more than 2%. U.S. Treasury
bonds rallied as investors sought the stability of government-backed bonds.
The nervousness was fed by rumors of troubles at hedge funds that are invested heavily in mortgage
securities. Bear Stearns, its reputation already dented after two of its hedge funds that bet heavily on
securities connected to risky home loans blew up in June, has prevented investors from taking their
money from another fund that put about $850 million into mortgage investments.
In recent weeks, as the housing market continued to weaken and trading firms began to price many
mortgage investments at discounted levels, Bear executives realized their Asset-Backed Securities Fund
was facing a rough July, said people familiar with their thinking.
Unlike Bear's other two funds, these people said, the asset-backed fund borrowed no capital and had
practically no exposure to subprime mortgages, as home loans extended to people with weak credit are
known. But a combination of markdowns on a broad range of mortgages and a series of refund requests
could force the fund out of business eventually, according to one person familiar with the situation.
A spokesman for the firm disputes that, however. "There are no plans to shut down the fund," said
Russell Sherman, a Bear spokesman. "We believe the fund portfolio is well positioned to wait out the
market uncertainty. And we believe by suspending redemptions, we can ensure the best long-term results
for our investors. We don't believe it's prudent or in the interest of our investors to sell assets in this
current market environment."
Traders said yesterday's stock-market selloff was ignited by a warning from American Home Mortgage
that pressure to repay its creditors may cause it to liquidate its assets. Its shares subsequently plunged
89% to $1.13. Several Wall Street firms have loaned money to American Home, the 10th-largest U.S.
home-mortgage lender in this year's first half, according to Inside Mortgage Finance, a trade publication.
The Melville, N.Y., company said turbulent mortgage-market conditions forced it to mark down the
value of its portfolio of home loans and loan-backed bonds. Some financial backers want their money
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back, and the company said it needs to hold on to cash in case the credit environment worsens.
The insurance sector was also singed as two large mortgage
insurers saw their share prices drop sharply after announcing
• Complete Coverage: Debt Dilemmas1
that their stakes in a firm that invests in subprime mortgages
• Scorecard: Funds, LBOs Hit by Debt Tremors2
had been "materially impaired." What spooked investors in
MGIC Investment Corp. and Radian Group Inc. was the
firms' holdings in Credit-Based Asset Servicing and Securitization LLC. As of June 30, each insurer had
more than $465 million of equity in C-BASS, which invests in mortgages and related securities.
DEBT DILEMMAS
Shares of MGIC closed at $38.66 in 4 p.m. composite trading on the NYSE, down 14.92%. Shares of
Radian closed at $33.71, down 16.14%.
"The market [for mortgage securities] is pretty much terrified at this point," said David Castillo, senior
managing director at Further Lane Securities, a dealer based in New York. "It's starting to sink in that this
is a broad-based issue that's not going to go away any time soon."
Nor is the pain limited to U.S. firms. Another Australian high-yield fund, Macquarie Bank Ltd.'s Fortress
Investments Ltd., said late yesterday that investors in the funds face losses of up to 25%. Fortress is the
third fund manager in Australia to flag serious problems, and fund watchers say that as niche funds
heavily exposed to U.S. credit markets assess their value at the end of July, more may report significant
falls in value.
The director of Macquarie Fortress Investments, Peter Lucas, said the average price of assets in the
portfolios had fallen by 4% in June and may have fallen a further 20% to 25% in July, so the funds face
possible margin calls from their lenders if they aren't able to sell enough assets to reduce leverage.
So far, though, broader market fallout from the growing subprime crisis has been limited. Even as the two
giant Bear hedge funds blew up this summer, for instance, the stock market reached new heights. But the
hope that subprime troubles will remain contained is being tested.
Although corporate balance sheets are largely in good shape, for example, corporate bonds have been hit
hard over the past month, pushing yields sharply higher, notes ITG economist Robert Barbera. One
reason: The securities backed by corporate debt and subprime mortgages have similar structures, leading
many investors to question whether the design rather than the underlying assets is the real problem. This
suspicion has driven up the yields corporate issuers must pay investors, which in turn has hurt stocks by
making it more expensive for companies to finance share buybacks and for private-equity players to
finance buyouts.
This crisis of confidence is at the root of both American Home's and Bear's current woes.
In American Home's case, banks including UBS AG, Bear Stearns and J.P. Morgan Chase & Co. said
they wouldn't extend the company any more funds. Some lenders have demanded the return of money
already lent. As for the latest Bear hedge fund to run into trouble, investors began demanding their
money back even though the fund wasn't heavily exposed to subprime mortgages.
Bear's fund has roughly $50 million of cash at the moment and stands to take in tens of millions of
dollars in coming months, according to someone familiar with its performance. But it doesn't have
enough cash to meet investors' current redemption requests, say other people close to the matter, and an
estimated July loss to the fund of 10% or more convinced Bear executives that those requests should be
frozen.
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Investor and lender skittishness can feed on itself. The funds being hit by investors' redemption demands
or their banks' margin calls -- requests for additional cash or collateral -- can be forced to sell their
holdings at reduced prices, further lowering the market value of these assets. That in turn hurts other
investors who hold similar assets.
It is too soon to determine whether such a cycle is setting in. In fact, some investors are circling in search
of bargains in bond and loan investments, a sign of underlying demand that could help stabilize these
markets.
Still, even relatively high-quality mortgage assets are being marked down. One investor received an
email from Credit Suisse Securities, a unit of Credit Suisse Group that was acting as a dealer rather than
as a principal, seeking bids of 70 cents to 80 cents on the dollar for certain mortgage loans pledged as
collateral by American Home -- suggesting the loans had lost at least a fifth of their value.
For Bear, the decline in the asset-backed fund is yet another black eye for its Bear Stearns Asset
Management unit. The weakening and eventual failure of two structured-credit funds in June and July,
known as the High-Grade Structured Credit Strategies Fund and the High-Grade Structured Credit
Strategies Enhanced Leverage Fund, cost investors as much as $1.6 billion and forced the ouster of the
asset-management unit's chairman.
Perhaps more importantly, the events have delivered a blow to Bear's longstanding reputation on Wall
Street as a savvy risk manager. Since the beginning of the year, Bear's shares have dropped 25.5%. Late
in New York Stock Exchange trading yesterday, Bear shares closed down nearly 5%, at $121.22.
And late last month, Bear's asset-management unit learned it would lose portfolio manager James
O'Shaughnessy, a respected strategist whose investing guide "What Works on Wall Street" made the New
York Times business-bestsellers list. On July 23, Mr. O'Shaughnessy, who joined Bear in 2001, disclosed
plans to leave the firm at the end of September to open his own institutional-investing business, to be
called O'Shaughnessy Asset Management.
Executives at Bear, which will have a stake in the new company, characterize the departure as
long-planned and amicable. Nonetheless, with about $12 billion of assets under management, Mr.
O'Shaughnessy's group of funds controlled a significant portion of the Bear unit's roughly $43 billion.
Mr. O'Shaughnessy referred a call for comment to Bear's press office. In an interview with an industry
trade publication, the money manager said his exit had nothing to do with Bear Stearns Asset
Management's hedge-fund travails.
Investors' concerns about Bear's creditworthiness are showing up in other ways, too. The annual cost of
protecting a notional amount of $10 million of the firm's bonds against a possible default for five years
was at $93,000 Tuesday afternoon, according to GFI Group, a New York-based interdealer broker. That
is significantly higher than the $21,000 it cost for the same protection at the beginning of the year,
signaling that derivatives traders increasingly view Bear as a junk-rated credit.
This comes as investor appetite for junk-quality securities has virtually dried up, according to IndyMac
Bancorp, another large home-mortgage lender. That will force lenders like itself to make
more-conservative loans that they can either retain as investments or sell to Fannie Mae or Freddie Mac,
the two government-sponsored providers of mortgage funding.
C-BASS, the firm that invests in mortgages and related securities, said yesterday that it was "subject to
an unprecedented amount of margin calls from our lenders" and that the calls "have adversely affected
our liquidity." C-BASS also said it was "in advanced discussions with a number of investors to provide
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increased liquidity and is exploring all options to mitigate the liquidity risk in this difficult market."
The New York company, formed in 1996 by several Wall Street mortgage traders, specializes in buying
subprime home loans. C-BASS packages many of those loans into securities for sale to other investors
but retains much of the default risk. In July, C-BASS acquired a small subprime lender, Fieldstone
Investment Corp. Through its Litton Loan Servicing unit, C-BASS also is involved in collecting
payments and handling other administrative tasks on home loans.
--Justin Lahart, Cynthia Koons, Carolyn Cui and Aparajita Saha-Bubna contributed to this article.
Write to Kate Kelly at kate.kelly@wsj.com3, Liam Pleven at liam.pleven@wsj.com4 and James R.
Hagerty at bob.hagerty@wsj.com5
URL for this article:
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8/20/2007 10:21 AM
Market Swoons As Bear Stearns Bolsters Finances - WSJ.com
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August 4, 2007
PAGE ONE
Remodeling Job
DOW JONES REPRINTS
Market Swoons
As Bear Stearns
Bolsters Finances
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Brokerage Raises Cash,
Cuts Short-Term Debt;
Spector Expected to Exit
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By KATE KELLY and RANDALL SMITH
August 4, 2007; Page A1
Bear Stearns Cos., a Wall Street trading titan that recently suffered the collapse of two mortgage-bond
funds, took extraordinary measures to bolster its financial position amid investor fears that knocked down
its shares and fed a broad stock-market swoon.
The big securities firm also plans to oust Warren Spector, Bear's powerful chief of stock and bond trading
and one of the firm's two presidents, according to a person familiar with the matter. Mr. Spector, 49 years
old, had been widely viewed as a leading candidate to become the firm's next chief executive. Bear's
board is set to meet Monday to discuss Mr. Spector's departure, the person said.
CONFERENCE CALL
A spokesman for the firm declined to comment.
1
"Every financial institution, Bear Stearns
included, is facing an extremely
challenging market environment. I've
been involved in the securities industry for more
than four decades and I have seen a broad
spectrum of market dislocations. In the stock market
crash in the late '80s, fixed income troubles in the
mid '90s, and the bursting of the Internet bubble in
2001, this is not the first time and certainly will not
be the last time that Wall Street and the financial
community will work through difficult conditions." -Jimmy Cayne, Chairman and CEO
Read a full transcript2 of the Bear Stearns
conference call, by arrangement with Thomson
StreetEvents (www.streetevents.com3). Adobe
Acrobat is required4.
In addition to detailing the steps it has been taking to raise
cash, Bear said it has reduced its reliance on short-term loans
so it isn't vulnerable to being shut off from the day-to-day
loans required to fund its trading operations. Wall Street firms
are especially vulnerable to crises of confidence, because they
depend on lenders to finance their day-to-day securities
trading and other operations.
During a call with investors held early Friday afternoon,
Bear's senior executives attempted to quell investor fears,
saying the firm is working to offset further drops in the credit
markets, which have been roiled in recent weeks.
Besides turning to loans with longer maturities, it hedged
existing positions that looked risky, such as securities based on pools of so-called subprime mortgages -loans made to borrowers with weak credit.
Bear said it reduced its short-term unsecured debt known as commercial paper to $11.5 billion from $23
billion in January. Treasurer Robert Upton said the company has unused committed secured bank lines
that are "of over $11.2 billion, $4 billion of which is available to be drawn on an unsecured basis."
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Over the past eight months, it has raised more than $11 billion of cash. Mr. Upton also said the firm has
"unencumbered collateral" -- or assets not underpinning loans -- exceeding $18 billion.
"We're facing an extremely challenging market environment," James E. Cayne,
Bear's 73-year-old chairman and chief executive, said.
After 22 years in the securities business, "this is about as bad as I've seen it in the
fixed-income market," Bear's finance chief, Samuel Molinaro, said during the
call. Fixed-income securities generally refer to bonds and other interest-bearing
securities.
The firm is in a delicate position: It needs to demonstrate to the market that it has
a strong, liquid balance sheet without suggesting it is seriously weakened or
taking desperate measures to strengthen its balance sheet.
Rather than soothe frayed nerves, however, the somber comments exacerbated the
market drop, with Bear stock and the Dow industrials -- which had been off about 50 points before the
conference call -- falling further.
"They called it the worst fixed-income markets in 20 years, grouping it with 1987 and the bursting of the
Internet bubble, and said they needed a better August just to get to the lower end of their historical range
of returns," said Mike Mayo, an analyst at Deutsche Bank AG.
Bear, which employs 13,566 people, has seen its stock-market value shrink by more than one-third
during 2007, bringing its total market value to about $12.5 billion -- a relatively small figure for such an
institution. Some analysts have suggested the firm could be takeover bait -- a notion that Bear executives
have rejected.
The Dow Jones Industrial Average, which was in the red for most of the day, started to sink further after
Bear's announcement. The index ended the session down 281.42 points, or more than 2%, at 13181.91.
Although the Dow is still up 5.8% this year, it has fallen nearly 6% from its record close of 14000.41 on
July 19. The Standard & Poor's 500-stock index fell 2.7% Friday, while the tech-heavy Nasdaq slid 2.5%.
(See related article5.)
As U.S. housing prices have weakened and many subprime loans have fallen into default this year, the
stock of firms like Bear and Lehman Brothers Holdings Inc., which play heavily in the origination,
trading and packaging of mortgages, have taken a beating. More recently, the dry-up in leveraged
financing, which until recently was fueling the most euphoric buyout boom in history, has thrown a
wrench into the brokerage firms' bond underwriting and advisory businesses, which could crimp earnings
even more.
Concerns about Bear hit financial stocks particularly hard, amid mounting concern that banks are
carrying more risk for mortgages and other loans now that investors have lost their appetite to buy
securities backed by such debt. Lehman was downgraded by a securities analyst on Monday after it
disclosed it has $43 billion of contingent commitments to finance debt-backed acquisitions by buyout
firms and others, up from $13 billion six months earlier.
Lehman stock was hit particularly hard Friday, falling nearly 8%, or $4.67, to $55.78. Lehman says such
commitments may be hedged or repriced to reflect market conditions. What that means is that Lehman
might make offsetting trades or mark down the value of the positions if the market further deteriorates.
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The market moves yesterday highlight just how jittery investors have become about the welfare of Wall
Street's biggest firms, which depend on a combination of goodwill and short-term financing to stay in
business.
"Everybody's waiting for the second, third and twentieth shoe to drop," said Mike Vogelzang, president
of the money-management firm Boston Advisors.
During morning trading, Bear shares fell nearly 8% to $106.55, a new 12-month low. At that price, Bear
stock was trading below 1.2 times its book value, or the difference between its assets and liabilities-the
lowest of any major Wall Street firm.
The cost of credit protection -- or the amount investors bet against the chances that a company will
default on its credit obligations -- for Bear is more than seven times higher than what it was at the start of
the year. "The financial system relies on confidence, and investor confidence has been shaken in recent
weeks," said Tim Compan, a corporate-bond portfolio manager at Cleveland-based Allegiant Asset
Management, with $10 billion of fixed-income assets under management.
The downdraft started early in the day when ratings agency Standard & Poor's cut its outlook on Bear
Stearns from stable to negative, saying its "reputation has suffered from the widely publicized problems
of its managed hedge funds, leaving the company a potential target of litigation from investors who have
suffered substantial losses."
The stock started to recover when Bear put out a statement saying the 84-year-old institution was
"profitable and healthy and our balance sheet is strong and liquid."
Bear, traditionally a bond powerhouse specializing in mortgages, has been among the Wall Street firms
most exposed to the turmoil and illiquidity afflicting the markets for mortgage and asset-backed bonds.
Already, the portfolio manager who ran the two high-grade hedge funds and the executive who had run
Bear's asset management division have been sidelined after an embarrassing meltdown that cost investors
as much as $1.6 billion and led to a bankruptcy filing.
Based on a relatively bullish bet on certain mortgage-related securities and an enormous amount of
borrowed capital, the High-Grade Structured Credit Strategies Fund and a more leveraged sister fund
performed well until late this spring, when the prices of those securities precipitously dropped. After poor
returns spurred a slew of investor requests for their money back, the two High-Grade funds were faced
with lender demands for additional cash and collateral that couldn't be met, ultimately forcing their
closure.
Mr. Spector wasn't on yesterday's conference call. He has spent his entire career
at Bear. Armed with little other than a business degree and a sharp intellect, he
started at the firm in 1983 and quickly established his reputation for savvy
mortgage-bond trading. Even in his late 20s, he was making such big bonuses that
he caught the attention of Mr. Cayne, who had not yet become chief executive,
and established a close rapport.
At 30, about two years after being named a senior managing director, Mr. Spector
was given a board seat at the firm. Then a few years later, he was named co-head
of fixed income, Bear's most important business unit.
In recent years, Mr. Spector, an established bridge player and golfer with homes
in Manhattan's Greenwich Village section and on Martha's Vineyard, has
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overseen Bear's entire capital markets business - a plumb but demanding job that includes monitoring
stock and bond trading.
The recent downturn in its bond business, notably in mortgage-backed securities, is a rare weak spot for
Bear, a firm known for its quick-witted trading and risk management as well as its expertise in the world
of home loans. And while Bear's chief financial officer, Mr. Molinaro, took note of gains in the equity
and international businesses that will help to offset the revenue downturn in mortgage securities, the
firm's business mix is weaker than that of peers such as Lehman, which has a robust investment-banking
division as well as a huge mortgage unit.
At the right price, Bear would be an attractive candidate for a range of potential acquirers. But it has a
history of resisting overtures even when times are good and is seen as unlikely to sell at a discount. Bear
has extensive trading operations, as well as a prime brokerage serving hedge funds and processing their
trades. The company also runs an investment bank that puts together mergers and acquisitions and
corporate bond deals.
That mix of capabilities could prove desirable to a large commercial bank looking to expand ways to
deploy its capital. That could include the likes of Swiss giant UBS AG, or even U.S. banks such as
Wachovia or Bank of America.
--Dennis K. Berman and Aparajita Saha-Bubna contributed to this article.
Write to Kate Kelly at kate.kelly@wsj.com6 and Randall Smith at randall.smith@wsj.com7
URL for this article:
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Hyperlinks in this Article:
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8/20/2007 10:20 AM
Mortgage Fears Drive Up Rates On Jumbo Loans - WSJ.com
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August 7, 2007
PAGE ONE
DOW JONES REPRINTS
Mortgage Fears
Drive Up Rates
On Jumbo Loans
August 7, 2007; Page A1
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Turmoil in the U.S. home-mortgage market is starting to pinch even buyers of high-end homes with good credit records, in the
latest sign of rising anxiety among lenders and investors.
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By JAMES R. HAGERTY
This surge in rates on so-called jumbo loans is particularly notable because rates on 10-year Treasury bonds have been falling. Normally, mortgage rates
move in tandem with Treasurys, but market jitters have caused investors to ditch mortgage securities.
Meanwhile, American Home Mortgage Investment Corp. finally succumbed yesterday to the mortgage-sector chaos that had crippled it in recent weeks
and filed for protection from creditors under Chapter 11 of U.S. bankruptcy law. And executives at Fannie Mae, the government-sponsored entity that
along with Freddie Mac provides funding for home loans, asked the companies' government overseer to raise the maximum amount of home mortgages and
related securities Fannie can hold in its investment portfolio. The goal would be to boost demand for mortgages in general, proponents of the idea said.
Among other signs of distress, Aegis Mortgage Corp., Houston, notified mortgage brokers that it is unable to provide
funds for loans already in the pipeline, a spokeswoman said. And Luminent Mortgage Capital Inc. of San Francisco
said it faced calls for repayments from creditors and is suspending its dividend.
Lenders -- having already slashed lending to subprime borrowers, as those with weak credit records are known -- now
are jacking up rates on jumbo mortgages for prime borrowers. These mortgages exceed the $417,000 limit for loans
eligible for purchase and guarantee by Fannie and Freddie. They account for about 16% of the total mortgage market,
according to Inside Mortgage Finance, a trade publication, and are especially prevalent in California, New Jersey,
New York City, Washington, D.C., and other locales with high home costs.
Lenders were charging an average 7.34% for prime 30-year fixed-rate jumbo loans yesterday, according to a survey
by financial publisher HSH Associates. That is up from an average of about 7.1% last week and 6.5% in mid-May.
The higher costs for such loans will put further downward pressure on home prices in areas where homes typically
bought by middle-class people can easily cost $500,000 to $700,000.
INTERACTIVE GRAPHICS
1
• Map: Global Credit Squeeze
• Credipedia: What's a CDO?2
• Scorecard: Deals Affected by Credit
Tremors3
• Subprime Shakeout: Stricken Lenders4
• Debt Dilemmas: Complete Coverage5
Mortgages are typically packaged into securities and sold to investors. But
as subprime weakness has made investors skittish, lenders are becoming
more cautious in issuing mortgages. Though defaults have soared on
subprime loans and are rising on Alt-A mortgages, a category between
prime and subprime, losses on most types of prime mortgages have
remained very low. Even so, lenders have raised rates on prime jumbo
loans defensively because they are unsure what rattled investors may be
willing to pay for them, said Doug Duncan, chief economist of the
Mortgage Bankers Association.
The jump in jumbo-mortgage rates is the latest gust in a subprime storm that has sunk two hedge funds run by Bear Stearns Cos., knocked American Home
and dozens of other lenders out of business, battered an already weak housing market and fueled weeks of stock-market turmoil. Yesterday, the Dow Jones
Industrial Average rebounded 286.87 points, or 2.2%, to 13468.78.
Alarmed by weakness in the housing market and rising foreclosures, investors who buy loans and securities backed by mortgages have fled the market for
almost any loan that isn't guaranteed by Fannie Mae or Freddie Mac, Mr. Duncan and others said. That means lenders must either hold loans, at least
temporarily, and face the risk of falling values for them, or seek out borrowers who qualify for loans that can be purchased by Fannie and Freddie.
For other types of loans, Mr. Duncan said, "there is no market." He said it isn't clear how long the market will remain disrupted, but said some mortgage
bankers fear the current paralysis could last weeks. "We're getting calls from members [of the lenders' association] who are quite desperate about their
circumstances," Mr. Duncan said. Large banks have the capacity to retain loans on their books, but many other lenders can only make loans that can be sold
quickly.
Since defaults on lower-grade mortgages began hitting worrisome levels late last year, several dozen lenders have closed. American Home, until recently
the 10th-largest U.S. home-mortgage lender in terms of loan volume, was forced to stop lending and lay off most employees last week after the Melville,
N.Y., firm's creditors cut off further funding and demanded repayments.
The latest mortgage ripples come as Federal Reserve policy makers prepare to meet today to discuss the economy and interest-rate policies. They are
expected to keep the target for short-term interest rates at 5.25% and maintain their focus on holding down inflation, but acknowledge increased risk to
economic growth from jitters in the credit market and the weak housing sector.
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Pressure is likely to grow for the Fed and other regulators to take steps to reassure mortgage lenders and home buyers.
The Office of Federal Housing Enterprise Oversight, or Ofheo, which oversees Fannie and Freddie, last year ordered both mortgage issuers not to make any
substantial increases in their holdings because of problems with accounting and financial controls at the two companies.
But Fannie officials have argued that raising the ceiling on their mortgage purchases could help calm turmoil in the mortgage market and avoid disruptions
in the flow of credit, people familiar with the situation said.
A Fannie spokesman declined to comment, as did a spokeswoman for Ofheo. David Palombi, chief spokesman for Freddie, said one other possible response
to the market turmoil would be to allow the two companies to buy larger mortgages, those above the current $417,000 cap.
Ofheo's director, James Lockhart, has said the two companies have made progress in redressing their accounting and financial-control problems but need
further improvement. That view could be an impediment to raising the cap.
The market disruption came as crushing news for Gary Cecere, a mechanic who lives in Croton-on-Hudson, N.Y. Mr. Cecere said he learned yesterday that
Wells Fargo & Co. was no longer willing to complete a planned package of two mortgage loans that would allow him to buy a $410,000 four-bedroom
home in Mahopac, N.Y. Hugo Iodice, a branch manager at Manhattan Mortgage Co. who is acting as a loan broker for Mr. Cecere, blamed tighter standards
imposed by Wells Fargo on Alt-A loans. A Wells Fargo spokesman had no immediate comment.
"I was getting ready to close [on the home purchase] this week, and they basically pulled the carpet out from under my feet," said Mr. Cecere. For now, he
said, his wife, five children, two cats and a dog are cramped into a two-bedroom temporary apartment, awaiting a move. Mr. Iodice said he is trying to find
an alternative loan for the family.
Even borrowers with good credit records who can afford a large down payment are finding rates surprisingly steep if they can't qualify for a loan that can be
sold to Fannie or Freddie. Rates on prime jumbo loans have risen so fast that "nobody in their right mind would pull the trigger" and accept one now, unless
they couldn't delay a home purchase, said Darren Weisberg, president of PFG Mortgage Services Inc., a mortgage broker in Lake Forest, Ill.
Some lenders are pulling the plug on whole categories of loans. Yesterday, National City Corp., a Cleveland banking company, said it has suspended its
offerings of home-equity loans or lines of credit made through brokers rather than the bank's branches. The company cited market conditions.
Write to James R. Hagerty at bob.hagerty@wsj.com6
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8/20/2007 10:20 AM
How Credit Got So Easy And Why It's Tightening - WSJ.com
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August 7, 2007
PAGE ONE
DOW JONES REPRINTS
How Credit Got So Easy
And Why It's Tightening
By GREG IP and JON E. HILSENRATH
August 7, 2007; Page A1
An extraordinary credit boom that created many first-time homeowners and financed a wave of corporate takeovers seems to
be waning. Home buyers with poor credit are having trouble borrowing. Institutional investors from Milwaukee to Düsseldorf
to Sydney are reporting losses. Banks are stuck with corporate debt that investors won't buy. Stocks are on a roller coaster,
with financial powerhouses like Bear Stearns Cos. and Blackstone Group coming under intense pressure.
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The origins of the boom and this unfolding reversal predate last year's mistakes. They trace to changes in the banking system provoked by the collapse of
the savings-and-loan industry in the 1980s, the reaction of governments to the Asian financial crisis of the late 1990s, and the Federal Reserve's response to
the 2000-01 bursting of the tech-stock bubble.
When the Fed cut interest rates to the lowest level in a generation to avoid a severe downturn,
then-Chairman Alan Greenspan anticipated that making short-term credit so cheap would have unintended
consequences. "I don't know what it is, but we're doing some damage because this is not the way credit
markets should operate," he and a colleague recall him saying at the time.
Now the consequences of moves the Fed and others made are becoming clearer.
Low interest rates engineered by central banks and reinforced by a tidal wave of overseas savings fueled
home prices and leveraged buyouts. Pension funds and endowments, unhappy with skimpy returns,
shoved cash at hedge funds and private-equity firms, which borrowed heavily to make big bets. The
investments of choice were opaque financial instruments that shifted default risk from lenders to global
investors. The question now: When the dust settles, will the world be better off?
"These adverse periods are very painful, but they're inevitable if we choose to maintain a system in which
people are free to take risks, a necessary condition for maximum sustainable economic growth," Mr.
Greenspan says today. The evolving financial architecture is distributing risks away from highly
The Journal's Jon Hilsenrath discusses the origins of the credit leveraged banks toward investors better able to handle them, keeping the banks and economy more stable
boom and some of the lessons to be learned from its demise.
than in the past, he says. Economic growth, particularly outside the U.S., is strong, and even in the U.S.,
unemployment remains low. The financial system has absorbed the latest shock.
So far. But credit problems once seen as isolated to a few subprime-mortgage lenders are beginning to propagate across markets and borders in unpredicted
ways and degrees. A system designed to distribute and absorb risk might, instead, have bred it, by making it so easy for investors to buy complex securities
they didn't fully understand. And the interconnectedness of markets could mean that a sudden change in sentiment by investors in all sorts of markets could
destabilize the financial system and hurt economic growth.
Side Effects of Deflation Fight
When a technology stock and investment plunge and the Sept. 11 terrorist attacks pushed the economy into
recession in 2001, the Fed slashed interest rates. But even by mid-2003, job creation and business investment
were still anemic, and the inflation rate was slipping toward 1%. The Fed began to study Japan's unhappy bout
with deflation -- generally declining prices -- which made it harder to repay debts and left the central bank
seemingly powerless to stimulate growth.
Fourth in a series
• Page One: Mortgage Mess Shines Light on
Brokers' Role1
7/5/07
• Page One: How Wall Street Stoked The Mortgage
Meltdown2
6/27/07
• Page One: 'Subprime' Aftermath: Losing the
Family Home3
5/30/07
"Even though we perceive the risks [of deflation] as minor, the potential consequences are very substantial and
could be quite negative," Mr. Greenspan said in May 2003. A month later, the Fed cut the target for its key
federal-funds interest rate, a benchmark for all short-term rates, to 1%. It said the rate would stay there as long as
necessary, figuring low rates would bolster housing and consumer spending until business investment and
exports recovered. The rate stayed at 1% for a year.
Mr. Greenspan raised vague fears with colleagues over the possibility this policy could create distortions in the
economy, but he says today that such risks were an acceptable price for insuring against deflation. "Central banks
cannot avoid taking risks. Such trade-offs are an integral part of policy. We were always confronted with
choices."
Fed officials who were there at the time generally maintain their policy was right, even in hindsight. The economy has grown steadily, avoiding both
deflation and serious inflation. Yet some say they may have planted seeds of excess in the housing and subprime-loan markets.
Robert Eisenbeis, retired research director at the Federal Reserve Bank of Atlanta, says the Fed overreacted to the threat of deflation and kept rates low for
too long. As a result, it "overstimulated the housing market, and now we're dealing with the consequences."
Edward Gramlich, a Fed governor in Washington from 1997 to 2005, says he failed to realize at the time that low rates were making it so easy for lenders to
8/20/2007 10:27 AM
How Credit Got So Easy And Why It's Tightening - WSJ.com
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market subprime mortgages with low introductory rates. The Fed and other regulators could have prevented some of the resulting pain with more rigorous
supervision of mortgage lenders besides banks, he says. "We didn't have that, and we're paying for it now."
4
In June 2004, the Fed began to raise the short-term target rate, eventually taking it to 5.25%, where it has been for
the past year. Such a boost usually leads to a rise, as well, in long-term rates, which are important to rates on
30-year conventional mortgages and corporate bonds. This time, it didn't. Mr. Greenspan expressed concern that
investors were willing to accept low returns for taking on risk. "What they perceive as newly abundant liquidity
can readily disappear," he said in August 2005, six months before retiring. "History has not dealt kindly with the
aftermath of protracted periods of low risk premiums."
Looking back, he says today: "We tried in 2004 to move long-term rates higher in order to get mortgage interest
rates up and take some of the fizz out of the housing market. But we failed."
Something besides Fed policy was at work. Both Mr. Greenspan and his successor, Ben Bernanke, point to an unanticipated surge in capital pouring into the
U.S. from overseas.
'Global Saving Glut'
In June 1998, U.S. Treasury officials made a plea to China that they would be reminded of repeatedly in the following years. Thailand had devalued its
currency in 1997, touching off a crisis in the region that led other countries to devalue and in some cases default on foreign debt. The yen was sliding.
Chinese officials, who pegged their currency to the U.S. dollar, "let it be known...that if things kept going this way they'd have no choice but to devalue,"
recalls Ted Truman, a Treasury official at the time. The U.S., fearing such a move would trigger another round of devaluations, urged the Chinese to hold
their peg, and praised them when they did so.
But times changed. As recessions and depressed currencies held down imports and goosed exports in other Asian countries, the countries ran trade surpluses
that replenished foreign-exchange reserves. Determined never to be so tied to the onerous conditions of the International Monetary Fund, they have kept
those policies in place. Thai reserves, effectively exhausted in 1997, now stand at $73 billion.
INTERACTIVE GRAPHICS
• Map: Global Credit Squeeze5
• Credipedia: What's a CDO? 6
• Scorecard: Deals Affected by Credit
Tremors7
• Subprime Shakeout: Stricken Lenders8
• Debt Dilemmas: Complete Coverage9
Long after the crisis passed, China's economic fundamentals suggested its currency should rise against the dollar.
China let it rise only slowly, continuing to juice exports and produce trade surpluses that pushed China's
foreign-exchange reserves above $1 trillion. When the U.S. pressed China to let its currency float, China
reminded the U.S. of the fixed exchange rate's stabilizing role in 1998. China put much of its cash -- part of what
Mr. Bernanke has called a "global saving glut" -- into U.S. Treasurys, helping hold down long-term U.S. interest
rates. Chinese government entities also recently poured $3 billion into U.S. private-equity firm Blackstone.
Mortgages for All
Lou Barnes, co-owner of a small Colorado mortgage bank called Boulder West Inc., has been in the mortgage business since the late 1970s. For most of that
time, a borrower had to fully document his income. Lenders offered the first no-documentation loans in the mid-1990s, but for no more than 70% of the
value of the house being purchased. A few years back, he says, that began to change as Wall Street investment banks and wholesalers demanded ever more
mortgages from even the least creditworthy -- or "subprime" -- customers.
"All of us felt the suction from Wall Street. One day you would get an email saying, 'We will buy no-doc loans at 95% loan-to-value,' and an old-timer like
me had never seen one," says Mr. Barnes. "It wasn't long before the no-doc emails said 100%."
Until the late 1990s, the subprime market was dominated by home-equity lines used by borrowers to consolidate debt and by loans on mobile homes. But
when the Fed held rates down after 2001, lenders could offer borrowers with sketchy credit histories adjustable-rate mortgages with introductory rates that
seemed affordable. Mr. Barnes says customers were asking about "2/28" subprime loans. These offered a low starter rate for two years, then adjusted for the
remaining 28 to a rate that was often three percentage points higher than a prime customer normally paid. Customers, he says, seldom appreciated how high
that rate could be once the Fed returned rates to normal levels.
Demand from consumers, on one side, and Wall Street and its customers on the other side prompted lenders to make more and more subprime loans.
Originations rose to $600 billion or more in both 2005 and 2006 from $160 billion in 2001, according to Inside Mortgage Finance, an industry publication.
At first, delinquencies were surprisingly low. As a result, the credit ratings for bonds backed by the mortgages assumed a modest default rate. Standards for
getting a mortgage fell. About 45% of all subprime loans in 2006 went to borrowers who didn't fully document their income, making it easier for them to
overstate their creditworthiness.
The delinquency rate was a mirage: It was low mainly because home prices were rising so much that borrowers who fell behind could easily refinance.
When home prices stopped rising in 2006, and fell in some regions, that game ended. Borrowers with subprime loans made in 2006 fell behind on monthly
payments much more quickly than mortgages made a year or two earlier.
When banks get in trouble, federal deposit insurance encourages depositors not to flee, and in extreme circumstances, banks can borrow directly from the
Fed. But banks are no longer the dominant lenders. After the S&L crisis in the 1980s and early 1990s, regulators insisted banks and thrifts hold more capital
against risky loans. This tipped the playing field in favor of unregulated lenders. They financed themselves not by deposits but by Wall Street credit lines
and by "securitization" of their loans -- in effect, the sale of the loans to investors.
The consequences proved painful. New Century Financial Corp., founded in 1995 by three former S&L executives, was the nation's second largest
subprime lender by 2006. When its borrowers began falling behind, Wall Street cut off its lines of credit and forced it to buy back some of its poorly
performing loans. New Century couldn't fall back on deposit insurance or the Fed. It filed for bankruptcy protection in April, wiping out shareholders and
triggering market-wide fears about the health of the subprime business.
LBO Boom
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Home buyers were not alone. In August 2002, Qwest Communications International Inc. -- heavily indebted, beaten down by the telecom bust and under
investigation by the Securities and Exchange Commission -- decided to sell its Yellow Pages business. Private-equity firms Carlyle Group and Welsh,
Carson, Anderson & Stowe agreed to buy it for $7 billion, about $5.5 billion of it borrowed. The business produced steady cash flow that could be used to
pay down the debt.
The buyers were worried they might not be able to borrow as much as they needed. "We were coming out of a pretty bad credit cycle," says Daniel
Toscano, managing director at Deutsche Bank, which helped to manage the fund-raising. Instead, they tapped into a gusher. Within a year, Dex Media Inc.,
as the business became known, was back in the market. It borrowed $889 million to pay a dividend to Carlyle and Welsh Carson, and then $250 million
more to pay another dividend. In just 15 months, the private-equity buyers made back most of their investment and still owned the company.
By 2006, the volume of such leveraged buyouts was smashing records from the 1980s. Generous credit markets enabled private-equity firms to do larger
deals and pay themselves bigger dividends. They boosted returns -- and attracted more investors, which enabled even bigger deals.
As in subprime mortgages, lenders began to ease borrowing requirements. They agreed, for instance, to "covenant-lite debt," which dropped once-standard
performance requirements, and "PIK-toggle" notes, which allowed borrowers to toggle interest payments on and off like a faucet.
Bankers began marketing debt deals for companies that, unlike Yellow Pages, didn't have comfortable cash flow. There was Chrysler, burning cash rather
than producing it. And there was First Data Corp., whose post-takeover cash flow would barely cover interest payments and capital spending, according to
Standard & Poor's LCD, a unit of S&P which tracks the high-yield market.
Last month, investors began to balk. Now many banks find themselves having committed to lend about $200 billion that they had intended to turn over to
investors, but can't.
Let's All Look Like Yale
The subprime and LBO booms required willing lenders. The stock-market collapse and low interest rates of 2001 to 2004 nurtured a class of investors and
products to fill that role. Managers of pension and endowment funds long had divided their assets among domestic stocks, bonds and cash. The funds saw
their performance suffer when the stock market and then bond yields tumbled.
A few endowments, most notably at Yale and Harvard, had for years been spreading their investments more broadly, going into hedge funds, real estate,
foreign stocks, even timberland. The goal was holdings that wouldn't suffer in sync with stocks in a bear market. Sure enough, in 2000 and 2001, even as
stocks tumbled, Harvard Management Co. earned returns of 32.2% and -2.7% respectively. Yale's returns were 41% and 9.2%.
Other institutions wanted their money managed the same way, seeding a flood of hedge funds that bought other untraditional investments such as credit
derivatives. University endowments poured roughly $40 billion into hedge funds between 2000 and 2006, according to Hedge Fund Intelligence, a
newsletter. "I call it the 'Let's all look like Yale effect,'" says Jeremy Grantham, chairman of Boston money manager GMO LLC.
Low interest rates made many investors willing to buy exotic securities in an effort to boost returns. Wall Street had just the vehicle: securitization, or
turning loans that once sat quietly on banks' books into securities that can be sold in global markets.
Securitization, long common in conventional mortgages, had been supercharged in the early 1990s when the federal Resolution Trust Corp. took over S&Ls
that held more than $400 billion of assets. Though some thought it would take the RTC a century to unload them, it took only a few years. The agency
successfully securitized new classes of assets, such as delinquent home loans or commercial loans.
In the late 1990s, Wall Street went a step further, packaging bigger pools of securities into collateralized debt obligations, or CDOs, and carving them into
"tranches," each with a different level of risk and return. Riskier tranches suffered the first losses if some underlying loans defaulted. Other tranches offered
lower returns because riskier tranches would take the first hits if the business went sour.
Because of the way they were structured, some CDO tranches got triple-A ratings from Moody's Investors Service and Standard & Poor's even though they
contained subprime loans. That lured traditionally conservative investors such as commercial banks, insurance companies and pension funds.
The upside was evident: Many borrowers got loans they wouldn't otherwise have had. The taxpayer-backed deposit fund was less likely to bear the cost of
sloppy lending practices. Banks shifted risks to investors more willing to bear them -- leaving the banks able to make more loans. Investors could pick either
more-risky or less-risky slices. And Wall Street middlemen made handsome profits.
Now the downside, too, is painfully evident. Final investors were so many steps removed from the original loans that it became hard for them to know the
true value and risk of securities they bought. Some were satisfied with a triple-A rating on a CDO -- seemingly as safe as a U.S. Treasury bond but with
more yield. Yet as defaults ate through the cushion of lower-rated tranches with unexpected speed, rating agencies were forced to rethink their models -and lower the ratings on many of these investments.
Some structures were so opaque that markets couldn't value them. But ratings cuts sometimes forced an acknowledgment that securities owned weren't
worth as much as thought. In May, Swiss bank UBS AG shut down a hedge fund after a $124 million loss. In June, two Bear Stearns hedge funds saw as
much as $1.6 billion of investor capital wiped out by bad mortgage bets and pulled credit lines. The trouble spread to hedge funds in Sydney, Australia, a
mortgage insurer in Milwaukee and a bank in Düsseldorf, Germany.
Even Harvard has been hit. The university lost about $350 million through an investment in Sowood Capital Management, a hedge-fund firm founded by
one of the university's former in-house money managers.
Casino Night
Recent events show that financial innovations meant to distribute risk can end up multiplying it instead, in ways neither regulators nor investors fully
understand. Mr. Grantham, the Boston money manager, says his portfolios are behaving in ways he hadn't expected.
Fed officials believe that even if their policies led to housing and debt bubbles, the strength of the overall economy shows that the policy was, on balance,
the right one. Of course, that assumes the current problems don't culminate in a recession.
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Market veterans predict the most egregious underwriting practices and products will disappear, but the benefits of innovation will continue.
Lessons have been learned -- the hard way. "The structures are here to stay," says Glenn Reynolds, chief executive of research firm CreditSights. "But you
have to run it like a prudent risk-taking venture, not like it's casino night and you're on a bender."
Write to Greg Ip at greg.ip@wsj.com10 and Jon E. Hilsenrath at jon.hilsenrath@wsj.com11
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(7) http://online.wsj.com/public/resources/documents/info-BondTurmoil0707-sort.html
(8) http://online.wsj.com/public/resources/documents/info-subprimeloans0706-sort.html?s=3&ps=false&a=up
(9) http://online.wsj.com/page/2_1312.html
(10) mailto:greg.ip@wsj.com
(11) mailto:jon.hilsenrath@wsj.com
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8/20/2007 10:27 AM
Impact of Mortgage Crisis Spreads - WSJ.com
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August 10, 2007
PAGE ONE
Impact of Mortgage Crisis Spreads
Dow Tumbles 2.8%
As Fallout Intensifies;
Moves by Central Banks
By GREGORY ZUCKERMAN, JAMES R. HAGERTY and DAVID GAUTHIER-VILLARS
August 10, 2007; Page A1
Fallout from the intensifying credit crisis stretched from a French bank to
the largest home-mortgage lender in the U.S., triggering unusual
central-bank interventions and driving the Dow Jones Industrial Average to
its second-worst drop this year.
• What's Happening: Losses related to housing
loans are emerging in more investment funds,
leading investors to wonder who will be next.
• The Latest Fallout: After markets closed
yesterday, mortgage-lender Countrywide Financial
said 'unprecedented disruptions' could affect its
financial condition. Earlier, BNP Paribas stopped
trading in three funds, and apartment builder
Tarragon raised doubts about its ability to stay in
business.
• Market Impact: The news unnerved
already-jittery markets, helping to push blue-chip
shares down 2.8% yesterday.
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The troubles demonstrated both the global reach of the crisis
and its impact on a widening circle of markets and companies.
The first jolt came from French bank BNP Paribas, which said
early in the day that it was freezing three investment funds
once worth a combined $2.17 billion because of losses related
to U.S. housing loans. That prompted the U.S. and European
central banks to inject cash into money markets to keep
interest rates down. (See related article1.)
The unease accelerated in the U.S. with news that several
hedge funds were in the red and selling off assets. Apartment
and condominium builder Tarragon Corp. raised doubts about its ability to remain in business amid
weak demand and an inability to raise new financing. After markets closed, mortgage-lender
Countrywide Financial Corp. said "unprecedented disruptions" in credit markets could affect its
financial condition.
The stock market, which on Wednesday had risen sharply on hopes credit problems were being
contained, swooned as hedge funds, many of which borrowed increasing amounts of money in recent
years to boost returns amid placid markets, scrambled to sell holdings and cut their borrowings. The Dow
Jones Industrial Average ended down 387.18 points, or 2.8%, at 13270.68. (See related article2.)
After the close of trading, Renaissance Technologies Corp., a hedge-fund company with one of the best
records in recent years, told investors that a key fund has lost 8.7% so far in August and is down 7.4% in
2007. Another big fund company, Highbridge Capital Management, told investors its Highbridge
Statistical Opportunities Fund was down 18% as of the 8th of the month, and was down 16% for the year.
The $1.8 billion publicly traded Highbridge Statistical Market Neutral Fund was down 5.2% for the
month as of Wednesday.
Meanwhile, Countrywide, of Calabasas, Calif., said in a Securities and Exchange Commission filing that
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it was shoring up its finances and had "adequate funding liquidity." (SEC filing3) But the company, the
nation's largest home-mortgage lender in terms of volume, warned that "the situation is rapidly evolving
and the impact on the company is unknown." Reduced demand from investors is prompting Countrywide
to retain more of its loans rather than selling them.
The statement could send shivers through financial markets
READ MORE
today. It came just a week after Bear Stearns Cos., the Wall
Paribas?4
Street trading giant, had to reassure investors that it had ample • Commentary: Et tu,
5
• See the SEC filing from Countrywide Financial.
cash on hand amid concern that it faced funding problems
because of deteriorating credit-market conditions and the
implosion of two of its hedge funds.
On Friday, markets in Asia tumbled in early trading. (See related article6.) After the Nikkei 225 index
fell more than 2%, Japan's central bank injected $8.39 billion into money markets. That followed actions
Thursday by the European Central Bank, which provided more than $130 billion to money markets, and
the U.S. Federal Reserve, which added $24 billion in reserves to the U.S. banking system.
What started late last year as worry over a sharp rise in defaults on subprime mortgages has mushroomed
into a crisis for the entire home-loan industry and investors world-wide. By March, late payments were
reaching worrisome levels on Alt-A mortgages, a category between prime and subprime that includes
many loans for which borrowers "state" rather than verify their incomes. Most prime loans continue to
perform well, but Countrywide has reported a rapid rise in delinquent payments on certain prime
home-equity loans that were used by people stretching themselves to buy homes with little or no money
down.
Payments were at least 30 days late on about 20% of "nonprime" mortgages serviced by Countrywide as
of June 30, up from 14% a year earlier, the company said. Nonprime includes loans to people with weak
credit records and high debt in relation to their income, as well as to people who don't document their
income or assets. On prime home-equity loans, the delinquency rate was 3.7%, up from 1.5% a year
before. For all loans, the rate was 5%, up from 3.9%.
In a sign of the growing difficulty in selling loans, Countrywide said that it transferred $1 billion of
nonprime mortgages from its "held for sale" category to "held for investment" in the first half -- meaning
they will stay on the books instead of being sold. Countrywide marked the value of those loans down to
$800 million. Despite its current woes, the company argues that it is well-placed to gain market share
from weaker rivals.
Rattled by a constant stream of bad news, investors in recent days have been shunning nearly all
mortgages except for those that can be sold to Fannie Mae and Freddie Mac, the government-sponsored
investors that guarantee payments on loans that "conform" to their standards. That has prompted lenders
to boost rates on prime "jumbo" loans -- those totaling $417,000 or more, too big to be guaranteed by
Fannie or Freddie -- to as much as 7.25% or 8%. Usually, such loans cost only about a quarter percentage
point more than "conforming" mortgages, but the gap has ballooned to as much as 0.8 point during the
past week.
In financial markets, several entities thought to be insulated
from the subprime meltdown now turn out to be affected,
leading investors to wonder who might be next. For instance,
BNP just last week had said the three funds were conducting
business as usual. But Europe's sixth-largest bank by
stock-market value said yesterday that it had been forced to
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suspend the funds on Tuesday because of a sudden and
unexpected dearth of buyers and sellers.
"The market for the assets has just disappeared," said Alain
Papiasse, head of BNP Paribas's asset-management-services
division. "Since the start of this week, there are no prices for
instruments that carry, directly or indirectly, some types of
U.S. assets."
In the U.S. the latest crop of hedge funds to be hit hard by the
market's turmoil includes those that focus on "market-neutral"
strategies, or strategies that seek to do as well in both falling
and rising markets. The strategy has been embraced by some of the biggest names in hedge funds, in part
because it's popular with institutional investors who hunger for gains in any kind of market.
Many market-neutral funds have been wagering on high-quality stocks, or stocks that trade at low
valuations based on various metrics, and betting against stocks that look expensive. Because this stance is
seen as relatively conservative, the funds felt comfortable borrowing money to boost returns.
But as banks began getting worried about their hedge-fund clients in recent weeks, some hedge funds
were asked to put up more collateral to back the loans, or anticipated these requests. The funds sold some
of their holdings of high-quality stocks to raise the cash, and closed out "short" trades, or bets against
companies, by buying back shares of companies seen as expensive. Others sold positions simply to
become more conservative, in a rocky market.
Since market-neutral funds often are guided by similar computer models and share similar holdings, the
actions magnified moves in asset prices. The last week has been the worst on record for many large
hedge funds focusing on this strategy, worrying traders across Wall Street, many of whom look to these
firms for signs of stability in difficult markets.
AQR Capital Management LLC, a $38 billion fund based in
Greenwich, Conn., has seen losses in recent days in investments
employing market-neutral strategies, although the firm's other
strategies, which represent the majority of its assets under
management, are holding up, according to a person close to the
matter.
Other big funds also are hurting. A Goldman Sachs Group Inc.
fund, known as GS North American Equity Opportunities, saw the
value of its holdings fall more than 15% between the beginning of
the year and July 27, according to investors familiar with the fund.
The Equity Opportunities fund lost more than 11% between July 1
and 27, according to the investors, some of whom are current and
former Goldman partners.
News of that fund's problems came just a day after word that
Goldman's most widely known internal fund, the $9 billion Global
Alpha, has liquidated certain positions to curb its risk profile. That
fund was rumored to be facing liquidation -- a notion a Goldman
spokesman has called "categorically untrue." Yesterday Goldman
also dismissed published report that the Equity Opportunities hedge
fund is liquidating.
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Those developments shook the market in part because Goldman is renowned for trading prowess. The
sales at Goldman's two funds follow bigger losses at rivals such as Bear Stearns Cos., which has been
forced to shut down two hedge funds in recent weeks after crippling losses on securities tied to subprime
loans.
Tykhe Capital LLC -- a New York-based quantitative, or computer-driven, hedge-fund firm that manages
about $1.8 billion -- has suffered losses of about 20% in its largest hedge fund so far this month, and is
moving quickly to trim its investment positions, according to an investor in the firm briefed by Tykhe
executives. Tykhe isn't closing down, according to the investor. Calls to Tykhe seeking comment weren't
returned.
During the past several days, a number of other quantitative funds have also been hard-hit. These funds
generally operate by building computer models of market behavior and then allowing computer programs
to dictate trading. With the recent trouble in financial markets, many lenders, funds and brokerages were
following statistical models that grossly underestimated how risky the environment had become.
--Kate Kelly, Alex Frangos, Henny Sender, Anita Raghavan and Ian McDonald contributed to this article.
Write to Gregory Zuckerman at gregory.zuckerman@wsj.com7, James R. Hagerty at
bob.hagerty@wsj.com8 and David Gauthier-Villars at David.Gauthier-Villars@dowjones.com9
URL for this article:
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(4) http://online.wsj.com/article/SB118669529375093479.html
(5)
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(6) http://online.wsj.com/article/SB118670711949793768.html
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(8) mailto:bob.hagerty@wsj.com
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Copyright 2007 Dow Jones & Company, Inc. All Rights Reserved
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8/20/2007 10:19 AM
How Subprime Mess Ensnared German Bank; IKB Gets a Bailout - WSJ.com
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August 10, 2007
PAGE ONE
GLOBAL SCALE
DOW JONES REPRINTS
How Subprime Mess
Ensnared German Bank;
IKB Gets a Bailout
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By CARRICK MOLLENKAMP, EDWARD TAYLOR and IAN MCDONALD
August 10, 2007; Page A1
DÜSSELDORF, Germany -- Five years ago, a little-known bank that lent to small and midsize German companies decided it
wanted to broaden its business. An affiliate of the bank started buying complex bonds invented in the U.S.
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The strategy brought a sharply higher industry profile for IKB Deutsche Industriebank AG. Moody's Investors Service endorsed its move, crediting the
bank last year with "successfully diversifying."
Today, IKB is on the receiving end of a bailout, organized over a weekend of emergency meetings by Germany's financial regulator, with contributions
from major German banks. To rally the banks, the lead regulator warned that they needed to head off the risk of what could become the country's worst
financial crisis since the 1930s. The safety net for IKB consists of about €3.5 billion, or $4.789 billion, available now to cover possible losses, plus a further
financial backstop of €14.6 billion to keep afloat IKB and the affiliate that invested in fixed-income securities.
MORE
• Central Banks Grapple With Rate
Decisions as Markets Tumble1
• Map: Global Blowups2 | Scorecard3 |
The case shows how quickly global investors' abrupt new appreciation of credit risk can ricochet around the
world. As some strapped homeowners in the U.S. fail to make their monthly mortgage payments, among those
touched by their defaults are institutions in Europe that borrowed to buy bonds backed by the mortgages. Their
troubles, in turn, affected others in the market and injected worry into markets for even some safe securities.
Complete Coverage4
IKB is housed in a seven-story stone-clad building a short distance from the Rhine. Since its founding 83 years
ago, its main business has been to provide long-term financing to the smaller German companies called the
Mittelstand -- companies like Trumpf Group, a maker of machine tools.
The affiliate IKB set up for bond investing five years ago is Rhineland Funding Capital Corp. The purchases included bonds backed by subprime
mortgages, those issued to home buyers with weak credit. It was a global circuit: Rhineland partly funded its bond purchases through short-term debt issued
to U.S. investors, such as a suburban Minneapolis school district and the city of Oakland, Calif.
But Rhineland's short-term borrowings had to be renewed frequently. And when investors realized that their collateral for the borrowings included U.S.
subprime mortgages, they shut off the spigot. Suddenly, Rhineland couldn't repay other debt that was coming due. If other German banks hadn't agreed to
bail it out a week and a half ago, Fitch Ratings believes IKB "would have defaulted," says a Fitch credit analyst in Frankfurt, Sabine Bauer. IKB is using
bailout funds to repay the short-term borrowings, which are known as commercial paper.
Credit Problem
This wasn't the only U.S.-related credit problem to surface in Europe yesterday. The big French bank BNP Paribas SA suspended withdrawals from three
investment funds, citing volatility in the U.S. asset-backed-securities market. That led to a scramble for cash. Short-term money-market interest rates spiked
above their target levels in both Europe and the U.S. In response, the European Central Bank, in an extraordinary step, injected €94.8 billion in short-term
funds into the system to get rates back down. The U.S. Federal Reserve injected $24 billion through its Open Market operations.
The crisis at IKB unfolded quickly. As recently as July 20, the German bank told
investors it was fine. But days later, it began having trouble selling commercial
paper.
That instrument is a staple of money-market funds and other risk-averse investors,
regarded as one of the safest investments apart from U.S. Treasurys. It's often
issued by big companies that use the proceeds for day-to-day expenses. But even
the haven of commercial paper has been rattled in recent weeks, as investors began
to worry about securities that might be tied in some way to subprime mortgages.
Rhineland's difficulty in issuing new commercial paper didn't go unnoticed by
Deutsche Bank AG, one of several banks that helped Rhineland sell the paper.
Deutsche Bank tipped off Germany's financial watchdog, called BaFin. Within 48
hours, the banks and regulators had structured a bailout package.
Three of IKB's top executives, including Chief Executive Stefan Ortseifen,
departed. The bank formed a task force to sort out its problems. Its stock is down
33% since the crisis began to develop about two weeks ago. Mr. Ortseifen declined
to comment.
Tax Haven
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IKB dreamed up Rhineland in 2002 as a way to move beyond its German client base of smaller companies. IKB set up Rhineland in Delaware and Jersey, a
tiny tax haven in the English Channel, so it could borrow from investors in the U.S. and Europe.
Rhineland poured the proceeds into a highly rated portfolio of bonds. Seeking high yields, it often invested in bonds or bundles of bonds backed by other
securities, including subprime mortgages. According to people familiar with IKB, it was courted by banks such as Lehman Brothers Holdings Inc., J.P.
Morgan Chase & Co. and Deutsche Bank AG, which sought to sell it securities including collateralized debt obligations. Known as CDOs, these are pools
of debt broken into tranches, or slices, that offer investors various levels of yield and risk.
IKB was such a good customer that banks would adjust which assets they bundled together in CDOs on IKB's wishes. For example, IKB's risk team didn't
like airplane loans, so banks would often remove them. The banks declined to comment.
Rhineland's profit was the difference between what it had to pay for its commercial-paper borrowings and the return on the bonds it bought with the
proceeds. On its commercial paper, Rhineland had to pay approximately the London interbank offered rate, or Libor, a common benchmark. The bonds it
bought returned about a full percentage point above Libor. IKB is just one of many banks that set up companies to use this strategy. They're usually
off-balance-sheet so that banks don't have to set aside capital to cover the liabilities.
To sell its paper, Rhineland often looked to U.S. investors. Robbinsdale Area Schools district in a northwestern suburb of Minneapolis bought some last
year, thus lending money to Rhineland. It did so on the advice of a Citigroup Inc. broker in St. Paul, says Gary Hauan, director of finance. Citigroup
declined to comment.
'We Don't Take Risks'
Oakland, Calif., also bought some of the paper, figuring that the collateral-backed debt was safe. "We don't take risks," says Katano Kasaine, the city's
treasury manager. Also buying Rhineland commercial paper was the Montana Board of Investments, which manages a $13.2 billion fund.
All three say they won't be buying any more of this issuer's commercial paper. They shouldn't have to worry about what they did buy, despite IKB's
troubles, because its affiliate can repay the paper with proceeds of the IKB bailout. The Montana board, however, is looking through the rest of its
commercial-paper holdings to see if any others are tied to CDOs, says its executive director, Carroll South.
IKB, started in 1924, helped Germany rebound from the decimation of World War II by lending to companies rebuilding. But in 2002, when German bank
profits were hurt by an economic slowdown, ratings agencies pressured the country's banks to diversify away from lending to companies.
A trio of IKB officials came up with the idea for Rhineland, led by a banker and lawyer named Dirk Röthig. He joined IKB in 2001, bringing with him
experience working with bonds in Europe for the U.S. bank State Street Corp. Alongside him was a longtime IKB official, Winfried Reinke.
The venture was a success. IKB's fledgling asset-management arm earned fees for selecting Rhineland's investments. IKB bought similar bonds for
Rhineland and its own portfolios, according to IKB's annual report.
Paying Commissions
In the fiscal year ended March 31, IKB earned just under €180 million, with €108 million of that coming from fees and commissions. Rhineland paid
roughly half of the commissions, according to IKB's annual report.
The bank and other banks established a line of credit -- to be tapped only in the most drastic of situations -- promising to cover liabilities if Rhineland
couldn't pay off the commercial paper.
Rhineland grew quickly. In September 2003, it held €4.8 billion of debt. By January 2006, it had €9 billion.
Its commercial-paper program, led by Deutsche Bank, won an award in 2003 from Banker Magazine. In 2004, Mr. Röthig told industry publication Risk
magazine, "This adventurous portfolio building was the outcome of a carefully planned strategy. We wanted to diversify in asset classes as well as
geographically because we were pretty much dependent on the German economy." The next year, at an investment conference in Barcelona, Spain, Mr.
Röthig sat alongside executives from banking heavyweights -- France's Société Générale SA and Dresdner Bank AG -- on a panel on how to pick
investments in U.S. asset-backed and mortgage backed-securities.
Fast Expansion
But executives at Rhineland disagreed about how fast to expand. In January 2006, Mr. Röthig left after others overruled his objection to growing so quickly,
he said. "I made several proposals for a more sophisticated portfolio management to address expected negative market developments," which weren't
accepted by IKB, he said in a statement. IBK declined to comment.
Growth accelerated after he left. Between then and this July, Rhineland boosted its assets -- that is, the bonds and other debt it had purchased -- to €14
billion from €9 billion. That was a large investment in view of IKB's stock-market value, which was just a bit over €2.6 billion at the end of this March.
Home-Equity Loans
A December 2006 report by Moody's credited IKB for its success and noted, "IKB has over the last few years been successfully diversifying its business
activities by expanding outside Germany." Earlier this year, IKB founded another Rhineland-type vehicle, called Rhinebridge, to invest in bonds backed by
U.S. home-equity loans.
By February, though, U.S. subprime mortgages written in 2005 and 2006 were showing increasing delinquencies, as home prices weakened and some
borrowers' mortgage rates adjusted higher. As defaults rose, the value of securities backed by those mortgages began to tumble.
In a financial update July 20, IKB said it wasn't incurring problems. It acknowledged that both Moody's and Standard & Poor's had downgraded some debt
securities but said, "It is worth noticing that the bulk of our investments are in portfolios of corporate loans."
But Rhineland's commercial-paper investors were getting jittery, as they saw erosion in the value of the bonds backing their investments. Even if the
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company wanted to sell bonds to pay off creditors, it would have a tough time finding buyers, some worried. About a week after IKB's financial report, the
bank started having difficulty finding buyers for additional commercial paper. At SEI Investments Co. in Oaks, Pa., Sean Simko, head of fixed-income asset
management, says his firm stopped buying Rhineland paper last month because of growing volatility.
By Friday, July 27, IKB was in trouble. Some of the commercial paper was maturing, and investors needed to be repaid. But buyers for new commercial
paper had vanished. It couldn't sell CDO assets to raise funds, because the market for CDOs had dried up.
Rhineland was going to turn to IKB, Deutsche Bank AG and others that had promised a credit line to pay its bills in an emergency. That strategy had its
own pitfalls. If they provided Rhineland with the money, Rhineland's bills would move to IKB's modest balance sheet, a scenario that could topple the bank.
Even worse, the banks, including Deutsche Bank, that had standing agreements to lend IKB money backed out. Deutsche Bank declined to comment.
Instead, Deutsche Bank, Germany's biggest bank, phoned BaFin, the German financial supervisory agency, to tell it there was a problem with IKB, people
familiar with the matter say.
State-Owned Shareholder
That same day, according to a person familiar with the matter, IKB's management board reported the problems to the bank's biggest shareholder: KfW
Group, which is state-owned.
BaFin called for a special probe of IKB's books. Over the last weekend in July, it convened a crisis meeting at IKB's Düsseldorf headquarters near the Rhine
River. Representatives from KfW, BaFin and IKB met in the large auditorium of IKB's headquarters.
On Sunday, July 29, executives from Germany's banks as well as regulators began meeting at IKB as well. BaFin repeated that it wanted to prevent panic
selling of IKB shares when the markets opened the next morning. Joining Jochen Sanio, the BaFin chief, were Joerg Asmussen, a department head at the
German finance ministry, and Ingrid Matthaeus-Maier, head of KfW. From his office at Deutsche Bank's headquarters in Frankfurt, CEO Josef Ackermann
participated by phone, along with Klaus-Peter Mueller, chief of German bank Commerzbank AG.
One CEO was missing. IKB's Mr. Ortseifen had agreed to resign.
KfW's Ms. Matthaeus-Maier said the extent of the assets at risk was unclear. Other executives disagreed over the structure and size of the rescue deal.
Negotiations dragged on late Sunday night, as BaFin's Mr. Sanio grew impatient.
Rescue Package
They finally settled on a plan for KfW, the state-owned institution, to shoulder most of the rescue package. The rest would come from other German banks,
the Association of German banks, and other associations. IKB got a new chief executive: Günther Bräunig, an executive of KfW.
The next day, stock markets reopened, and IKB's shares tumbled 20%.
IKB hasn't yet decided what to do with the Rhineland portfolio of bonds and CDOs. An IKB spokesman, asked about the bank's statement July 20 that it
didn't face any trouble, said it was an "attempt to calm fears. Nobody anticipated that the market for commercial paper would develop in such a way."
Moody's analysts, meanwhile, are monitoring small and midsize European banks, looking for other subprime stress, according to a report the firm published
after the IKB bailout. Like IKB, Moody's analysts wrote, some of these smaller banks in Europe have boosted profits in recent years the way IKB did, by
creating off-balance-sheet affiliates.
Write to Carrick Mollenkamp at carrick.mollenkamp@wsj.com5, Edward Taylor at edward.taylor@wsj.com6 and Ian McDonald at
ian.mcdonald@wsj.com7
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8/20/2007 10:28 AM
Markets Crisis Tests Resolve Of Fed, Officials - WSJ.com
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http://online.wsj.com/article_print/SB118695042791895347.html
August 13, 2007
PAGE ONE
DOW JONES REPRINTS
Markets Crisis
Tests Resolve
Of Fed, Officials
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By GREG IP, DEBORAH SOLOMON and DAVID WESSEL
August 13, 2007; Page A1
WASHINGTON -- As an academic, Federal Reserve Chairman Ben Bernanke
studied the policy mistakes that led to the Great Depression and the ways
dislocations in financial markets can affect the rest of the economy.
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Now he is getting a chance to put theory into practice.
Amid strained credit markets and a volatile stock market, the Fed, the European
Central Bank and their counterparts in other parts of the world last week pumped
billions of dollars and euros into money markets to keep short-term interest rates from
rising as demand for short-term funds overwhelmed the supply. It was the biggest such
maneuver since the Sept. 11, 2001, terrorist attacks.
For its part, the Bush administration declined to lift regulatory limits on mortgage
giants Fannie Mae and Freddie Mac to allow them to buy more mortgages. President
Bush and Treasury Secretary Henry Paulson instead sought to bolster confidence, a
key commodity at times like this, by emphasizing the fundamental strength of the
global economy.
How Mr. Bernanke and authorities around the world respond in the days ahead will
affect whether the crisis passes without lasting damage or deepens to the point where the Fed and other central
banks set aside anxieties about inflation and reluctance to appear to be bailing out investors who made bad
bets.
What more can policy makers and regulators do? The next step
would be for the Fed to cut interest rates to make borrowing
cheaper -- affecting banks, hedge funds, businesses, holders of
adjustable-rate mortgages and consumers -- and credit more
available. Overseas, the European Central Bank, Bank of England
and Bank of Japan could defer previously anticipated rate increases.
• A Primer: How Does the Fed Inject Money into
the Economy?1
• Video: WSJ's Wessel, Nomura's Resler on Fed's
options2
• Complete Coverage: Debt Dilemmas3
A serious deterioration in markets or spreading credit crunch could prompt a quick Fed move. Futures markets
have priced in the possibility of a rate cut even before the Fed's next scheduled meeting, Sept. 18. If the
situation doesn't improve, a Sept. 18 rate cut is likely.
But if markets stabilize and credit begins to flow normally, as Fed officials hope, the central bank is likely to
hold its key rate at 5.25% a while longer to fend off inflation. The Bank of Japan is set to weigh rates next
week and the ECB on Sept. 6.
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Comparisons to 1998
Today's turmoil is creating obvious comparisons to 1998. Then, a financial crisis at first crippled emerging
Asian economies without threatening the U.S. or other Western economies. But when Russia devalued its
currency and defaulted on foreign debts in August, it sent a shock wave through global markets.
In early September, then-Fed Chairman Alan Greenspan declared the U.S. couldn't "remain an oasis of
prosperity unaffected by a world...experiencing greatly increased stress." A few weeks later, hedge fund Long
Term Capital Management imploded. Trading in numerous markets came to a near halt. The New York Fed
organized a rescue of LTCM, and the Fed cut interest rates by three-quarters of a percentage point between
late September and mid-November. The U.S. escaped recession.
Whether today's credit crisis looks as bad is a subject of intense dispute. "In 1998, a lot of big boys were really
scared," said a former government official and veteran of '98. "Right now a lot of the big boys are saying,
'How can I profit from this?' That feels a little different." Big corporations -- such as Merrill Lynch, Kraft
Foods, Citigroup, IBM, even Bear Stearns & Co. -- have been able to sell debt recently.
By one quantifiable indicator, the 2007 episode isn't yet as severe as 1998. When markets are stressed,
investors pay more for the most liquid, or most easy to sell, securities. In 1998, the spread between yields on
the most heavily traded Treasury debt -- the easiest to sell -- and less heavily traded, but still secure, Treasury
issue widened by more than two-tenths of a percentage point. That was a huge gap that showed just how
risk-averse investors had become. In recent weeks, the analogous spread has widened less than
two-hundredths of a percentage point.
But comparisons are difficult. The greatest stresses today are in markets that were far less important in 1998.
Their evolution since then has made it much harder for regulators or Wall Street CEOs to know precisely
where the risks lurk.
Among today's big fears: that commercial and investment
banks, thinking they have used derivatives to lay off the risk
of defaults, will discover they effectively bought insurance
from hedge funds whose financial survival depends on credit
from those same commercial and investment banks; that big
firms are exposed to troubled markets in ways they don't
realize or haven't disclosed; or that players with heavy
borrowing will have to dump their holdings and make
everything worse.
WSJ's Phil Izzo and David Wessel, and David Resler, chief
economist of Nomura Securities, talk about the global credit and
the Fed's pledge to inject more liquidity into the markets.
One unusual feature of the current crisis is that the problems
started in the U.S. -- in the subprime mortgage market -- but
seem to be most acute in Europe. Consequently, the ECB
has been more aggressive than the Fed in putting money into
markets to relieve strains. The German government, not the
U.S., has had to organize the rescue of a troubled institution,
IKB Deutsche Industries Bank AG, which had invested
heavily in U.S. mortgage-backed securities.
Today's crisis, in large part, reflects an inability to accurately value collateral -- such as pools of mortgages -and uneasiness about the computer models used to value complex securities. That leads those who have money
to insist on higher rates and tougher terms, and in some cases to keep more money in reserve just in case.
The authorities' goal isn't to stop prices of stocks, bonds and mortgage-backed securities from falling as the
market reassesses risks. It is to prevent either a generalized loss of confidence that freezes markets or a
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generalized credit crunch in which even credit-worthy borrowers can't get loans.
In an unusual move that reflected unusual circumstances, the Fed last week encouraged dealers through which
it operates to offer government-guaranteed mortgage-backed securities alone as collateral for short-term loans
instead of the usual custom of using them with Treasury debt and bonds issued by Fannie Mae and Freddie
Mac. The Fed hasn't done that at all this decade.
The move sparked some speculation that the Fed was trying to prop up the price of mortgage-backed
securities. In a statement Friday, the Federal Reserve Bank of New York cited a desire for "operational
simplicity." Outside analysts said the Fed was trying to make it easier for dealers to finance their inventories
of mortgage-backed securities and possibly to avoid aggravating a possible shortage of Treasurys available for
use as collateral.
Officials outside the Fed, aware that their most significant contribution may be to avoid undermining public
and investor confidence, have been careful not to suggest anything approaching panic. Mr. Bush took off on a
planned vacation. Christopher Cox, chairman of the Securities and Exchange Commission, is on vacation in
Alaska, though in touch with his staff. Mr. Paulson did two television interviews on Wednesday, and has been
invisible since.
The market turmoil prompted the President's Working Group on Financial Markets -the Treasury, the Fed, the SEC and the Commodities Futures Trading Commission -to trigger protocols established by Mr. Paulson shortly after he took office last year.
They include a detailed list of who is going to call financial institutions, risk managers,
traders and chief executives to keep tabs, how often they should call and the like.
When he first joined Treasury from Goldman Sachs, Mr. Paulson instructed Emil
Henry, then the Treasury official in charge of financial institutions, to craft guidelines
for five or six "meltdown" scenarios. One was a catch-all "General Withdrawal from
Risk Taking." Others include a liquidity crisis, stock-market meltdown and oil shock.
The Working Group has held conference calls, principally among staff, at least once a
day in recent days.
Predominant Worry
Just last Tuesday, at a regularly scheduled meeting, the Fed decided to leave rates unchanged and reasserted
that its predominant worry remains inflation. Since then, credit markets have grown tighter, and problems
have spread from subprime mortgages to larger mortgages and asset-backed commercial paper. "If credit is
becoming more restricted...and the Fed doesn't do anything, it is accommodating a tightening," said Ray Stone
of Stone & McCarthy Research Associates.
Some Fed officials worry a rate cut now might suggest the bank is focused on the markets rather than on the
economy. Others see a growing economic justification for easing.
Some analysts suspect Mr. Bernanke, who has been in office for 18 months, will be reluctant to cut rates in
order to expunge belief in the "Greenspan put" -- Wall Street's term for the perceived readiness of his
predecessor to cut rates and bail investors out of bad decisions. (A put option protects its holder against
investment losses.) Senior Fed officials insist the Fed never acted that way, noting that it raised rates in 1994
even though that inflicted damage on the bond market and it didn't protect stock-market investors from heavy
losses early in the 2000s. Mr. Bernanke, they say, will be motivated by conventional considerations: growth,
inflation and financial stability.
--Kara Scannell contributed to this article.
Write to Greg Ip at greg.ip@wsj.com4, Deborah Solomon at deborah.solomon@wsj.com5 and David Wessel
8/20/2007 10:29 AM
Goldman Wagers On Cash Infusion To Show Resolve - WSJ.com
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DOW JONES REPRINTS
Goldman Wagers
On Cash Infusion
To Show Resolve
By HENNY SENDER, KATE KELLY and GREGORY ZUCKERMAN
August 14, 2007; Page A1
Goldman Sachs Group Inc.'s injection of $2 billion into one of its flagging
hedge funds opens a new window on the difficulties even some of the
world's premier financial players are having as credit-market anxiety infects
a widening circle of investors.
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After a week when financial markets were spooked by losses in several Goldman funds -- among other
startling setbacks in the financial world -- the big investment bank yesterday said three of its funds have
seen the net value of their assets fall a total of about $4.7 billion so far this year.
Goldman announced just before New York's financial markets opened that it led a
high-profile group putting $3 billion into Goldman's Global Equity Opportunities
Fund. The fund, worth $3.6 billion before the new money arrived, lost more than
30% of its value last week during one of the market's most turbulent stretches in
years, Goldman said.
The move, which the firm described as a solid investment that will pay off in
time, helped calm markets. But it also amounts to a bold gamble by one of Wall
Street's most respected names: By drawing attention to its conviction that this is a
turning point -- and by bringing some heavyweight investors on board -Goldman is betting it can shore up confidence in one of the worst-hit areas of the
market and pave the way for a rebound.
"We are investing not because we have to, but because we want to," said Goldman Chief Financial
Officer David Viniar.
Goldman provided about $2 billion of the hedge-fund infusion. The rest came from others including C.V.
Starr & Co., Perry Capital LLC and Eli Broad, a Los Angeles-based entrepreneur. Starr is run by former
American International Group Inc. executive Maurice "Hank" Greenberg; Perry Capital is run by former
Goldman trader Richard Perry.
Other hedge funds that have sustained losses also are raising money for new investments. AQR Capital
Management LLC, a $38 billion hedge fund in Greenwich, Conn., that took hits in recent days, received
commitments from current and new investors for about $1 billion to invest in a variety of its funds,
according to someone close to the matter.
CONFERENCE CALL TRANSCRIPT
1
David Viniar, Goldman Sachs's chief
financial officer: "This is not a rescue.
This is two things. First, given the
dislocation in the markets, we believe that this is a
good investment opportunity for us and the other
investors that we have brought in. We also think at
the same time this will be very helpful to the current
fund investors because it will give the fund the
wherewithal to also take advantage of these market
In Goldman's situation, the risk is whether losses mount
further in coming weeks. The attention drawn to Goldman's
Global Equity Opportunities Fund, which relies heavily on
computer-driven programs to buy and sell, could also spark
renewed concern about funds pursuing similar strategies. Like
Goldman, many used a great deal of borrowed money, known
in financial markets as leverage.
While Goldman is hardly the only fund manager to suffer
setbacks in recent weeks, the firm's reputation as one of Wall
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opportunities. And so we think it is both of those
2
things but not a rescue." Read the full transcript ,
provided by Thomson StreetEvents
(www.streetevents.com3).
http://online.wsj.com/article_print/SB118700623907895861.html
Street's savviest players has taken some knocks. In addition to
the Global Equity Opportunities Fund, two of its other funds
have taken a beating.
Its Global Alpha Fund is down 27% so far this year, with half
that loss occurring last week. Alpha now has about $7.3 billion under management, down from about $10
billion earlier this year. And the North American Equity Opportunities Fund was down 25%. The firm
said it has no plans to put more cash into these two funds.
Goldman shares, which along with other financial firms have been battered in recent weeks, fell 1.7% to
close at $177.50 in New York Stock Exchange trading yesterday.
The infusion into the Global Equity Opportunities Fund, made in the span of a day and half last week,
comes as the chieftains of global finance have been working overtime to stabilize markets and restore
investors' waning confidence. Central banks in Europe, the U.S. and Japan continued a trend begun last
week by again pouring cash into their money markets yesterday.
That initially helped stocks, with European markets moving sharply higher and the Dow Jones Industrial
Average at one point rising 98.61 points. However, jitters continued and most U.S. major indexes
finished with small declines, with the Dow ending down 3.01 points to 13236.53.
Goldman's funds, like many others, have been buffeted by some of the biggest stock-price swings in
years. The problems began in late July as a credit-market squeeze set in and losses on securities tied to
the struggling subprime-mortgage market spread.
Around that time, Bear Stearns Cos. announced it was closing two subprime funds, despite earlier efforts
to rescue one of the funds with a $1.6 billion infusion of cash.
Last week, so-called quantitative funds -- "quants" in Wall Street parlance -- were hit especially hard.
These funds employ computer models to make trades and design investment strategies that attempt to
profit whether markets are falling or rising. But the computer models didn't take into account some
unusual trends in the market -- or the popularity of the models themselves, which left many funds trying
to escape the same trades at exactly the same moment.
On Wednesday, a group of senior Goldman officials huddled in Chief Executive
Lloyd Blankfein's office to figure out how to handle the firms' floundering funds,
a person close to the matter says. The Global Equity Opportunities Fund, a quant
that had fallen steeply during the first few days of the week, was the most urgent
concern.
As the markets gyrated, this person said, the executives were undecided as to
whether it made economic sense to inject new capital into the fund, known as
GEO for short. Surrounded by Mr. Viniar and co-presidents Gary Cohn and Jon
Winkelried, among others, Mr. Blankfein posed what seemed like a rhetorical
question, according to the person familiar with the events. Goldman had never
made a substantial investment to try to stabilize one of its funds. But, Mr.
Blankfein asked, "If a third party came to us and said, 'Here's a portfolio that
looks like GEO,' would we buy it?" The answer was a resounding yes.
Over the next 36 hours, a handful of top Goldman executives reached out to select investors, asking if
they would be interested in joining Goldman in quickly putting additional cash into the GEO fund. By
Friday, according to the person familiar with the matter, $3 billion was in place, about $1 billion of
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August 15, 2007
PAGE ONE
CREDIT AND BLAME
DOW JONES REPRINTS
How Rating Firms' Calls
Fueled Subprime Mess
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Benign View of Loans
Helped Create Bonds,
Led to More Lending
By AARON LUCCHETTI and SERENA NG
August 15, 2007
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In 2000, Standard & Poor's made a decision about an arcane corner of the mortgage market. It said a type
of mortgage that involves a "piggyback," where borrowers simultaneously take out a second loan for the
down payment, was no more likely to default than a standard mortgage.
While its pronouncement went unnoticed outside the mortgage world, piggybacks soon were part of a
movement that transformed America's home-loan industry: a boom in "subprime" mortgages taken out by
buyers with weak credit.
Six years later, S&P reversed its view of loans with piggybacks. It
said they actually were far more likely to default. By then,
however, they and other newfangled loans were key parts of a
massive $1.1 trillion subprime-mortgage market.
Today that market is a mess. As defaults have increased, investors
who bought bonds and other securities based on the mortgages
have found their securities losing value, or in some cases difficult
to value at all. Some hedge funds that feasted on the securities
imploded, and investors as far away as Germany and Australia
have suffered. Central banks have felt obliged to jump in to calm
turmoil in the credit markets.
It was lenders that made the lenient loans, it was home buyers who
sought out easy mortgages, and it was Wall Street underwriters that
turned them into securities. But credit-rating firms also played a
role in the subprime-mortgage boom that is now troubling financial
markets. S&P, Moody's Investors Service and Fitch Ratings gave top ratings to many securities built on
the questionable loans, making the securities seem as safe as a Treasury bond.
Also helping spur the boom was a less-recognized role of the rating companies: their collaboration,
behind the scenes, with the underwriters that were putting those securities together. Underwriters don't
just assemble a security out of home loans and ship it off to the credit raters to see what grade it gets.
Instead, they work with rating companies while designing a mortgage bond or other security, making sure
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it gets high-enough ratings to be marketable.
The result of the rating firms' collaboration and generally benign ratings of securities based on subprime
mortgages was that more got marketed. And that meant additional leeway for lenient lenders making
these loans to offer more of them.
The credit-rating firms are used to being whipping boys when things go badly in the markets. They were
criticized for being late to alert investors to problems at Enron Corp. and other companies where major
accounting misdeeds took place. Yet they also sometimes get chastised when they downgrade a
company's credit.
The firms say that since first asked to rate securities based on
subprime loans more than a decade ago, they've done the best
• Find complete coverage of the troubles
they could with the data they've had. "The housing market has
in the credit markets.
proven to be weaker than a lot of expectations," says Warren
Kornfeld, co-head of residential mortgage-backed securities at
Moody's. This summer, the firms downgraded hundreds of mortgage bonds built on subprime mortgages.
They say those bonds represent only a small part of the subprime-mortgage market.
2
SHAKY CREDIT
1
The subprime market has been lucrative for the credit-rating firms. Compared with their traditional
business of rating corporate bonds, the firms get fees about twice as high when they rate a security
backed by a pool of home loans. The task is more complicated. Moreover, through their collaboration
with underwriters, the rating companies can actually influence how many such securities get created.
Moody's Investors Service took in around $3 billion from 2002 through 2006 for rating securities built
from loans and other debt pools. This "structured finance" -- which can involve student loans, credit-card
debt and other types of loans in addition to mortgages -- provided 44% of revenue last year for parent
Moody's Corp. That was up from 37% in 2002.
When Wall Street first began securitizing subprime loans, rating firms leaned heavily on lenders and
underwriters themselves for historical data about how such loans perform. The underwriters, in turn,
assiduously tailored securities to meet the concerns of the ratings agencies, say people familiar with the
process. Underwriters, these people say, would sometimes take their business to another rating company
if they couldn't get the rating they needed.
"It was always about shopping around" for higher ratings, says Mark Adelson, a former Moody's
managing director, although he says Wall Street and mortgage firms called the process by other names,
like "best execution" or "maximizing value."
Executives at both ratings firms and underwriters say the back-and-forth stopped short of bargaining over
how to construct securities or over the criteria used to rate them. "We don't negotiate the criteria. We do
have discussions," says Thomas Warrack, a managing director at S&P, which is a unit of McGraw-Hill
Cos. He says the communication "contributes to the transparency" preferred by the market and
regulators.
Some critics, such as Ohio Attorney General Marc Dann, contend the rating firms had so much to gain by
issuing investment-grade ratings that they let their guard down. They had a "symbiotic relationship" with
the banks and mortgage companies that create these products, says Mr. Dann, whose office is
investigating practices in the mortgage markets and has been talking to rating firms.
Slicing It Up
In assembling a security such as a mortgage bond, an underwriter first pulls together thousands of loans
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that will serve as collateral. Before marketing the security, the underwriter slices it into perhaps 10
"tranches" with varying levels of risk and return.
The riskiest tranche has the highest potential return, but it ought to, because the buyer is taking a great
risk: This tranche will absorb the first defaults that occur in the pool of mortgages. The next-lowest
tranche is the second-hardest-hit by any defaults. Because of this structure, most of the higher tranches
traditionally were considered well-enough insulated from defaults to merit investment-grade ratings -- in
some cases, triple-A ratings.
The process, in a bad market, is like prisoners walking the plank on a pirate ship. The holders of the
riskiest securities are at the front of the line and go overboard first. What's happening in the
subprime-mortgage market is that investors further back than many imagined possible are going
overboard as well.
Had the securities initially received the risky ratings that some of them now carry, many pension and
mutual funds would have been barred by their own rules from buying them. Hedge funds and other
sophisticated investors might have treated them more cautiously. And some mortgage lenders might have
pulled back from making the loans in the first place, without such a ready secondary market for them.
Many money managers lacked the resources to analyze different pools of assets and relied on ratings
companies to do so, says Edward Grebeck, chief executive of a debt-strategy firm called Tempus
Advisors. "A lot of institutional investors bought these securities substantially based on their ratings, in
part because this market has become so complex," he says.
Back in 2000, piggyback mortgages were just one among a handful of new loan varieties that credit
analysts were having to evaluate. Until that point, few borrowers used piggyback loans to stretch beyond
their means. But lenders began proposing these structures as a way to make homes affordable as their
prices rose.
Because buyers putting less than 20% down may have less incentive or ability to avoid default, they
normally had to buy private mortgage insurance to protect the lender if they fail to make the payments.
But as interest rates slid and home prices rose, plenty of lenders were willing to provide a second,
piggyback mortgage for all or part of the 20%, without insisting on mortgage insurance.
The big mortgage buyers Fannie Mae and Freddie Mac wouldn't purchase these piggyback deals, which
didn't meet their standards. But Wall Street firms would, because they found they could turn them into
high-yielding securities. And there were plenty of buyers for such securities: With interest rates low,
many investors were in search of higher-yielding instruments.
Data provided by lenders showed that loans with piggybacks performed like standard mortgages. The
finding was unexpected, wrote S&P credit analyst Michael Stock in a 2000 research note. He nonetheless
concluded the loans weren't necessarily very risky.
S&P didn't let loans with piggybacks completely off the hook.
S&P said in 2001 that it wouldn't penalize a subprime mortgage
pool so long as the value of loans with piggybacks didn't exceed
20% of the overall value. Any more than that, and it would impose
a rating penalty, S&P said. The firm notes that its assumptions
"remained appropriate for several years."
Despite this limit, S&P's stance was good news for underwriters
and lenders. For underwriters, the S&P decision made it easier to
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create investment-grade securities based on pools of subprime
loans. And underwriters' appetite for the loans, in turn, made it
easier for lenders to originate them.
Trends then converged to create explosive mortgage-market
growth. Falling interest rates -- as the Federal Reserve sought to
prop up the economy after the tech-bubble burst -- made home
financing less expensive. New technologies let bankers construct
bonds from the payments of thousands of different mortgages. The
fastest-growing segment was subprime loans. Lenders brought out
loans in which borrowers didn't have to document their income, or
could at first pay only interest and no principal -- or could use a
piggyback to, in effect, borrow the whole cost of the home.
Loan Pools
At first, underwriters creating mortgage securities made sure the
loan pools they based them on didn't have more than 20% with
piggybacks. But by 2006, some were willing to accept a ratings
penalty. They created securities like those structured from a pool
of 14,500 loans from Washington Mutual Inc.'s mortgage arm. About 52% of the pool's value consisted
of loans with piggybacks, a prospectus showed.
By 2006, S&P was making its own study of such loans' performance. It singled out 639,981 loans made
in 2002 to see if its benign assumptions had held up. They hadn't. Loans with piggybacks were 43% more
likely to default than other loans, S&P found.
In April 2006, S&P said it would raise by July the amount of collateral underwriters must include in
many new mortgage portfolios. For instance, S&P could require that mortgage pools have extra loans in
them, since it now expected a larger number to go bad.
Still, S&P didn't lower its ratings on existing securities, saying it had to further monitor the performance
of loans backing them. It thus helped the market for these loans hold up through the end of 2006.
Some investors, however, grew concerned, as newer mortgage securities appeared that were based not
just on piggyback loans but on loans with other risky attributes as well. One money manager, James
Kragenbring, says he had five to 10 conversations with S&P and Moody's in late 2005 and 2006,
discussing whether they should be tougher because of looser lending standards. "I'd think there would be
more protection to guard against defaults," Mr. Kragenbring, from Advantus Capital Management, says
he said to the rating companies.
He says he was told that for much of 2005 and 2006, subprime loans were performing about the same as
in previous years. Other analysts recall being told that ratings could also be revised if the market
deteriorated. Said an S&P spokesman: "The market can go with its gut; we have to go with the facts."
In the second half of 2006, Mr. Kornfeld at Moody's noticed a troubling trend. In an unusually large
number of subprime loans, borrowers weren't making even their first payments. The market's great
strength "could not continue," Mr. Kornfeld recalls thinking at the time. He called staff meetings to
discuss his concern, and in November Moody's said publicly it saw signs of deterioration.
In March 2007, S&P said it expected home prices to be stagnant this year but grow 3% to 4% in 2008.
By early July, S&P had lowered this forecast. It said its chief economist projected that home prices
would fall 8% from the 2006 peak to a trough expected in the first quarter of 2008.
8/14/2007 11:53 PM
How Rating Firms' Calls Fueled Subprime Mess - WSJ.com
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Defaults and delinquencies rose. Hard-pressed borrowers found it harder to get a new loan to bail them
out or to sell their homes and pay off the loan that way. By July, almost a third of the loans in
Washington Mutual's subprime pool were delinquent or in foreclosure. This performance, much worse
than what credit-rating firms had expected, forced Moody's and S&P to slash their ratings on several
securities backed by those loans. On some, S&P cut an initial A-minus investment-grade rating by five
notches, to a below-investment-grade BB.
The downgrading, begun late last year, became an avalanche this summer. On July 10, Moody's cut
ratings on more than 400 securities that were based on subprime loans. S&P put 612 on review, and
downgraded most two days later. The moves jolted financial markets and prompted some investors to
criticize the ratings firms for misjudging the market.
The firms said that the soaring market of 2005-06 had reduced the relevance of their statistical models
and historical data.
Money mangers unloaded on a July 12 conference call with Moody's analysts. "You had reams upon
reams of data," said Steve Eisman, a managing director of hedge fund Frontpoint Partners, which had
made bets against the subprime market. "Despite all that data, your original predictions of the
performance of 2006 loan pools have proven to be completely and utterly wrong." He asked why the
rating firms waited to take major steps.
'Early Warnings'
The chief credit officer at Moody's, Nicholas Weill, replied that some of the original subprime data
provided to rating firms weren't "as reliable as expected." He also said Moody's put out "early warnings"
of downgrades as far back as November 2006. Instead of cutting ratings right away, he added, Moody's
needed time to see whether the loans would start to recover. "What we do is assess information available
at the time," Mr. Weill said.
S&P, Moody's and Fitch Ratings have reacted by repeatedly toughening their ratings methodology for
new subprime bonds, requiring significantly bigger cushions. They now assume more and quicker
defaults among pools of loans, especially those with piggybacks.
The changes have had an effect. About 27% of loans made in the first quarter of this year had piggybacks
attached, down from 35% a year earlier, according to S&P research. Overall, issuance of
subprime-mortgage bonds is down 32.5% this year through June, according to Inside Mortgage Finance.
That is resulting in lower Wall Street profits and tighter lending standards for consumers.
Committees in the U.S. House and Senate are broadly examining the mortgage market, as are various
state and federal agencies. It's not clear whether ratings firms will become a focus of the inquiries.
Write to Aaron Lucchetti at aaron.lucchetti@wsj.com3 and Serena Ng at serena.ng@wsj.com4
URL for this article:
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Hyperlinks in this Article:
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8/14/2007 11:53 PM
Today's Markets - WSJ.com
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August 16, 2007 4:18 p.m. EDT
TODAY'S MARKETS
By JOANNA OSSINGER
Stocks Fall at First, But Recover
After Global Markets Tumble
August 16, 2007 4:18 p.m.
As liquidity dried up around the globe, signs of investor panic started to
emerge, but a remarkable run late in the afternoon brought the indexes back
near even.
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The Dow Jones Industrial Average fell 15.69 points to 12845.78, after
having been down more than 300 points at various times during the day.
The S&P 500 rose 4.55 to 1411.25, and the Nasdaq Composite Index lost 7.76 to 2451.07.
All three indexes traded for much of the day down about 10% from their July highs during the day, one
definition of a market "correction." Trading curbs were put in place twice at the NYSE, and removed
each time. Volatility was high ahead of an options-expiration day Friday.
Market watchers were tossing around words like "panic" during much of the day, as the major indexes
each lost 2% or more and oscillated madly through much of the session. However, talk about an oversold
condition and possibilities of a Federal Reserve rate cut started to gain a foothold late in the day, which
helped the financial sector in particular. The indexes came back to close mixed.
The market crisis started weeks ago with problems in troubled
securities, especially those backed by subprime mortages,
which allowed the use of lots of leverage. It is now spreading
to less-risky investments, as the liquidity dry-up in many
corners of the market unexpectedly hurts some of the safer
havens.
1
AP
A trader watches the numbers from the floor of the
New York Stock Exchange on Thursday.
"I think we're at a critical level, and it's important that the
market holds" at or above the 10% correction level, said Ted
Weisberg, floor trader at Seaport Securities -- as it did today.
"If it trades below this, you're going to start to get rhetoric that
we're in a bear market."
Global markets reeled overnight. South Korea's Kospi
Composite tumbled 6.9%, while the FTSE-100 in London declined nearly 4%. Almost every significant
index in the world was lower, adding to big declines in recent days. "The effects from U.S. credit on
global markets remains consistent with a textbook case…of financial contagion," said Lena Komileva, an
economist at Tullet Prebon.
The dollar touched a 13-month low against the yen as the carry trade -- in which investors borrow in
8/16/2007 4:52 PM
Today's Markets - WSJ.com
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low-yielding currencies to invest in higher-yielding environments -- unwound.
"We think the yen's rally is really scaring people" because it's taking money out of the markets, said Ryan
Detrick, chief technical strategist at Schaeffer's Investment Research.
Investors have been sacrificing some of their safer and better-performing assets to meet redemptions and
to build reserves. For example, money-market funds, which are generally seen as less-risky investments,
were taking a hit.
Greg Collins, chief operating officer at Tuttle Asset Management, said the fear is that if those
money-market funds hold asset-backed commercial paper, demand for which has suddenly dried up, they
will get hurt. So, he said, "people…are preferring to put money into [Treasury] bills," which in recent
days have seen a surge in demand. Brisk trade in Treasurys continued today, and the 10-year note's yield
plummeted to less than 4.60%.
Metals and other commodities were also victims of the phenomenon. Gold was down 2.6%, while metals
such as silver, copper and palladium sold off, too. Mr. Collins pointed out that the metals had enjoyed
price-boosting speculation during the liquidity boom, which is now being removed. Even Dow
component Alcoa, an aluminum company, dropped 5.8%.
Crude-oil futures fell $2.33 to $71 a barrel, reacting to the drop in global stock markets, which could
stymie demand, and expectations that a tropical storm would miss key oil and gas infrastructure in the
Gulf of Mexico.
Earlier Thursday, the New York Fed said in a statement that it expects to provide reserves through
repurchase agreements, or repo operations, "on most days." The Fed injected about $17 billion more in
liquidity into the system, briefly giving stocks an early-morning lift before they sank into the red.
MARKETS ON THE MOVE
2
Track indexes and hot stocks3, with
roll over charting and headlines. Plus,
comprehensive coverage of bonds,
commodities and forex. Markets Data Center
highlights:
Most Actives4, Gainers5, Losers6
New Highs and Lows7, Money Flows8
Intraday Futures9 and Currencies10
MARKET WRAP
• European Stocks Move Lower11
• Asian Indexes Fall Sharply12
• Stocks Drop on Credit, Retail Woes13
Still, there were voices of bullishness amid the downturn. U.S.
Treasury Secretary Henry Paulson said the recent turmoil and
downturn in the financial markets will hurt U.S. growth, but
won't prompt a recession, as the U.S. economy is "strong
enough to absorb the losses." (See related article14.)
The storm in the markets comes when the global economy is
"very healthy" with "strong fundamentals," Mr. Paulson said,
adding that the recent "reassessment or repricing of risk" -- his
term for the reluctance to make loans to riskier home buyers
and firms and to hold securities backed by such loans -- was
"inevitable" and "shouldn't surprise anyone."
He wasn't the only one seeing a glass half full. Jason Goepfert,
chief executive at Sundial Capital Research, said, "I absolutely think we're getting close to the bottom."
He said the market's current behavior is "extremely rarely seen, and almost exclusively at or near market
lows."
But many market watchers might have found it hard to echo that optimism Thursday. "People are running
to the exits. The selling is basically across the board," Mr. Weisberg said. Even Dow components, which
are traditionally seen as safe harbors during downturns, were suffering. Though the Dow has
outperformed the other indexes, its weakness was a sign that more solid investments were being sold in
attempts to satisfy redemptions and meet any margin calls.
8/16/2007 4:52 PM
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Thursday's economic data didn't help, either. Before the opening bell, the Commerce Department said
July housing starts decreased to the lowest rate in 10 years, throwing more cold water on the idea that the
sector might be emerging from its lows. Meanwhile, the Labor Department said jobless claims were up in
the week ended Aug. 11, which could signify even broader troubles for the consumer. To top it all off,
the Philadelphia Fed's manufacturing activity index came in basically stagnant in August.
Countrywide Financial, which contributed to negative sentiment in the morning, saw shares tumble
5.2% after the company announced it drew down15 an $11.5 billion credit facility to boost its liquidity.
The nation's largest mortgage lender is dealing with slack demand for mortgage-related investments and
commercial paper.
As the markets came off their lows in the midafternoon, the financials rebounded. Bear Stearns, which
has been at the center of subprime woes after two hedge funds blew up, rose 13%, J.P. Morgan Chase
added 5.7% and Lehman Brothers added 6.7%.
Amid the volatility, some online brokerages had problems giving customers access and executing orders.
In major market action:
Stocks fell. On the New York Stock Exchange Thursday, 1,313 stocks rose and 2,104 declined, on
volume of 2.84 billion shares traded on the exchange.
Bonds gained. The benchmark 10-year note was up 16/32, or $5.00 for every $1,000 invested, yielding
4.667% Thursday. The 30-year bond rose 1-2/32, to yield 4.960%.
The dollar was uneven. The dollar was at 113.77 yen from 116.69 yen late Wednesday. The euro traded
at $1.3413 from $1.3450 late Wednesday.
Write to Joanna L. Ossinger at Joanna.Ossinger@wsj.com16
URL for this article:
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8/16/2007 4:52 PM
Fed Cuts Discount Rate to 5.75%, Citing Raised Economic Uncertainty ...
1 of 2
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August 17, 2007 9:47 a.m. EDT
Fed Cuts Discount Rate to 5.75%,
Citing Raised Economic Uncertainty
By GREG IP and BRIAN BLACKSTONE
August 17, 2007 9:47 a.m.
With risks to the economy from financial market turbulence rising "appreciably," the Federal Reserve on Friday lowered the
rate it charges banks on loans they receive from the Fed's discount window, though it opted not to cut its primary policy tool,
the federal funds rate.
DEBT DILEMMA
• Credit Notebook: Latest
Developments1
• Primer: How the Fed Keeps Actual
Rates Near Its Target2
• Map: Credit Blowups Around the Globe (Daily
updates)3
• Scorecard: Deals Affected by Credit Tremors
(Daily updates)4
• Subprime Shakeout: Stricken Lenders5
• Complete Coverage: Debt Dilemma6
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The Fed's decision to lower the discount rate and ease the terms of discount
borrowing but not to cut the fed funds target suggests that for now it believes the problems in the markets are
mostly related to the availability of cash, not the price of cash. (Read the Fed's statement7.)
Importantly, the dual actions demonstrate to the market the Fed is aware of the macroeconomc consequences of
the rapidly tightening supply of credit and is ready to cut interest rates in response if needed. Some in the markets
had perceived the Fed to be taking a hard line on the current turmoil as a way of teaching investors to live with
the consequences of unwise decisions. For now, the Fed will likely monitor the consequences of today's actions
before taking that additional step.
It's possible that with these additional steps, enough order and confidence will be restored to markets that a fed
funds rate cut will ultimately prove unnecessary. Indeed, after the announcement, futures markets indicated a sharp gain in stocks at the opening of trading
today, led by financial issues.
But the odds have clearly risen that the Fed will deliver such a rate cut when it meets Sept. 18, if not sooner. The decision to release the statement was made
Thursday evening in a hastily called videoconference of the Federal Open Market Committee, comprising the currently five sitting governors in Washington
(two seats are vacant), five presidents of the regional banks who vote, and the remaining seven presidents who don't vote.
Six Days Since Fed's Last Meeting
As a sign of how rapidly the Fed's view of the outlook has changed, the meeting came just six days after the committee met last Friday and didn't discuss a
rate cut, but merely agreed to a statement explaining the Fed's more aggressive open market operations.
While today's statement affirms the Fed's view that growth will remain "moderate", the Fed sees that outlook in jeopardy. It makes no mention of inflation,
the primary focus of the Fed's concern for the last year, implying that it now considers a rate cut more likely than a rate increase.
The nature of the release of the intermeeting statement altering its perception of risks was unprecedented. Since the Fed began releasing statements in 1994,
it has only issued one between meetings when it also changed interest rates.
Besides the half-percentage-point discount rate cut to 5.75%, the Fed announced a change in the Reserve Banks' practice "to allow term financing for as
long as 30 days, renewable by the borrower."
The Fed said the changes will remain in place until the Fed "determines that market liquidity has improved materially."
Providing 'Psychological Impact'
Softening its stance on intermeeting action, along with the cut in discount rates and the statement about growth risks, the Fed is aiming "to provide as much
psychological impact as possible," said Lou Crandall, chief economist at Wrightson Associates, the research arm of money market broker ICAP. "Without
backing away from the principles they've outlined, they want to show as much support as possible."
Banks have resisted borrowing at the discount window because its rate, generally a percentage point above the federal funds rate, "smacks of desperation,"
Mr. Crandall said. "The discount window has a tremendous stigma. [The Fed] hopes to chip away at that" and make borrowing there seem like a more
reasonable business decision.
Though the discount rate is often seen as symbolic, it can be a precursor of the Fed's intentions for its primary vehicle, the federal funds target, which has
stood at 5.25% for more than one year. However, economists said Friday's discount move probably means no intermeeting cut in the federal funds rate in
the near term.
"The discount rate cut also means no funds rate cut today, very near term, and the market had been looking for that," wrote David Ader, economist at RBS
Greenwich Capital.
Still, given that until now the Fed has maintained an official anti-inflation bias, Friday's action increases the odds of a fed funds rate cut soon. The Fed's
next scheduled rate-setting meeting is Sept. 18.
First Intermeeting Move Since 9/11
"Although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside
risks to growth have increased appreciably," the Fed said in a statement.
8/17/2007 10:12 AM
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"This is effectively a move from a tightening bias to an easing bias," said economists at ING Bank.
The surprise move, the first intermeeting rate cut since the days following the Sept. 11, 2001 attacks, comes at a time when a credit crunch threatens global
financial markets and, in turn, the economy. Six years ago, however, the Fed lowered both the fed funds and discount rate targets.
"It's a good first step," said Lehman Brothers economist Drew Matus. "This is much more effective in the short term than fixing the federal funds rate," he
added. Still, Lehman now expects the Fed to lower the fed funds rate by a half percentage point by the end of the year. Prior to Friday it had expected no
change.
The Fed reiterated Friday that economic fundamentals remain sound. Recent data suggest the economy grew in excess of 4% in the second quarter and
should expand around 2.5% in the third.
Still, the Fed did not address the question of whether risks to growth now matched or exceeded inflation risks. "I don't think they're downgrading inflation,"
Mr. Crandall said. "I think they didn't want to commit themselves."
--Sudeep Reddy contributed to this article.
Write to Greg Ip at greg.ip@wsj.com8 and Brian Blackstone at brian.blackstone@dowjones.com9
URL for this article:
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8/17/2007 10:12 AM
Economics Blog > Print > Economists React: ‘Lifting the Wizard’s Curtain’
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Economists React: ‘Lifting the Wizard’s Curtain’
Posted By topeditor On 17th August 2007 @ 10:31 In Global | 60 Comments
Economists weigh in on the [1] Fed’s surprise decision to cut its discount rate to 5.75%, while leaving the more important
federal funds rate unchanged.
At the risk of lifting the wizard’s curtain and ruining this gesture, I need to point out that a cut in the discount rate is
not an ease, and in fact from the standpoint of mechanics is barely relevant, as borrowing at the window was minimal
through Wednesday. The Fed is no doubt hoping to capitalize on the past. Prior to 2003, when the discount rate was lower
than the funds rate, cutting the discount rate was the most powerful tool in the monetary policy toolbelt. Indeed, prior to
1994, when the Fed began announcing changes in the funds rate target, a discount rate move was the ONLY move that
was explicitly announced. Many market participants will think of the discount rate cut in those terms, which is not the
correct way to consider it. Instead, this should be thought of as another (indeed, probably the last) intermediate step
short of an ease. –Stephen Stanley, RBS Greenwich Capital
[The Fed] cut a symbolic rate that no one uses and the stock market is
predicted to have its biggest up-day in history. This underscores how psychological
this selloff has been. Sometimes it is better to make statements than to actually
do anything. –Bianco Research
The Fed’s discount rate cut this morning was a meaningless gesture. The
discount rate was at one time the means by which the Fed set policy, but those
days are long gone. Today it is little more than an emergency funding mechanism
for banks that due to weakened condition, do not have access to the Fed Funds
market, which by the way traded at 5% last night. So the discount rate “cut”
keeps the discount window .75% above the current market. Big freaking deal,
huh? … All in all, the Fed’s action this morning seems like a mean, stupid, and
futile gesture, worthy of Animal House for its humor and theatrical impact. –Lee
Adler, Wall Street Examiner
They took a three-pronged approach to provide as much psychological impact
as possible [through a statement on growth, changing the discount rate and
softening its stance on intermeeting action]. Without backing away from the
principles they’ve outlined, they want to show as much support as possible. –Lou
Crandall, Wrightson Associates
We can only speculate about this, but the decision to move the primary discount rate rather than the Fed funds rate
may indicate that the Fed anticipates some institutional failure as soon as today, probably not a bank, but rather an
institution that has substantial bank liabilities that may not be able to clear. Markets should not be calmed by this tactic.
Unlike the Fed funds rate — which affects all banks’ cost of funds — a discount rate cut only lowers the cost of emergency
borrowing by institutions in distress. This move is not going to provide any relief to the overall economy. However, we
believe that the Fed’s action and statement today raise the odds of a reduction in the Fed funds rate at the September
FOMC meeting, or perhaps even before.. –High Frequency Economics
This essentially removes the stigma of accessing the discount window as well as providing a means of financing a wider
range of collateral (collateral eligible for the discount window was unchanged) via the Federal Reserve including
commercial paper and mortgage loans (not just securities) as well as municipal securities and foreign government
securities… We expect the Fed will follow up on this action with a rate cut at the September FOMC meeting. –Drew Matus,
Lehman Brothers
This step shows a commitment to restoring liquidity rather than broadly reflating the economy. Rate cuts will be
considered, but this step is a considerable move to inject liquidity into the system well beyond the previous liquidity
injections. The Fed has time to consider the repercussions of this recent liquidity crisis on the economy before adjusting
rates on September 18th.–Societe Generale
It’s conceivable that the Fed’s actions today could go a long way toward restoring liquidity to the markets… In sum,
today’s actions signal a very high degree of concern at the Fed, coupled with an ongoing reluctance to announce an
intermeeting cut in official target. However, in expressing newfound concern about the outlook for economic growth, the
Fed is clearly leaving the door open for a formal cut in the target rate — either at or before the Sept meeting — if the
measures announced today are not successful in forestalling the credit crunch. –Morgan Stanley Researc
It is interesting to note that the vote was unanimous among voting members of the FOMC but that Richard Fisher voted
as an alternate for Bill Poole. The request for the discount window change came from the New York and San Francisco Fed.
(Only the board needs to vote on a discount window change. The committee vote was on the statement). –Bruce Kasman,
J.P. Morgan
Compiled by [2] Phil Izzo
Offer your reactions in the [3] comments section.
8/20/2007 9:57 AM
Economics Blog > Print > Using Discount Window Is Sign of Strength, ...
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Using Discount Window Is Sign of Strength, Fed Says
Posted By topeditor On 17th August 2007 @ 14:44 In Global | 1 Comment
As part of dramatic moves this morning to contain the financial market crisis, the Federal Reserve [1] held a
conference call with major banks to encourage them to consider borrowing from the central bank’s discount
window.
After the Fed this morning said it was lowering its discount rate, officials took action to make that change more effective,
asking the Clearing House, which represents major banks, to host a conference call this morning with major market
participants to discuss the latest changes. Fed Vice Chairman Donald Kohn and New York Fed President Timothy
Geithner participated in the call. Their main message was that the Fed would view use of the discount window as a sign of
strength, not weakness.
Banks have traditionally been reluctant to borrow from the discount window as it is often seen as a sign of weakness. The
Fed has tried to reduce that stigma in recent years but discount window borrowing still remains miniscule. The morning
meeting was designed to eradicate that stigma. Fed officials know the discount window action will only be effective if banks
either use it, or the knowledge of its availability, to expand their own lending to high-quality counterparties such as high
quality mortgage borrowers.
The participants from the banking world included ABN AMRO; Bank of America; The Bank of New York Mellon; The
Bank of Tokyo-Mitsubishi UFJ, Ltd.; The Bear Stearns Companies Inc.; Citigroup; Deutsche Bank Group;
Goldman Sachs; JPMorgan Chase & Co.; Lehman Brothers; Merrill Lynch; Morgan Stanley; UBS; U.S. Bank;
Wachovia; and Wells Fargo. –Greg Ip and Sudeep Reddy
Article printed from Economics Blog: http://blogs.wsj.com/economics
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back | Click here to print.
8/17/2007 4:23 PM
Fed Offers Banks Loans Amid Crisis - WSJ.com
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August 18, 2007
PAGE ONE
EXTENDING CREDIT
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By GREG IP, ROBIN SIDEL and RANDALL SMITH
August 18, 2007; Page A1
The Federal Reserve took highly unusual steps Friday to open up the supply of cash to the nation's banks and signaled a
willingness to cut interest rates if necessary, at a time when some of the safest financial markets are seizing up and threatening
the broader economic outlook.
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Specifically, the central bank lowered the discount rate, charged on direct Fed loans to banks, to 5.75% from 6.25%, and took
steps to encourage banks to borrow from what is known as its discount window, such as lengthening the term of such loans to as long as 30 days from the
current one day. Fed officials also joined a conference call with leading financial executives, aiming to ensure the Fed's moves have maximum impact by
making clear that officials are actively inviting more borrowing from the Fed.
DEBT DILEMMA
• Economist's React: 'Lifting the
Wizard's Curtain'1
• Credit Notebook: Latest
Developments2
• Primer: How the Fed Keeps Actual Rates Near Its
Target3
4
• Primer: Explaining the Discount Window
• Map: Credit Blowups Around the Globe (Daily
updates)5
• Scorecard: Deals Affected by Credit Tremors
(Daily updates)6
• Subprime Shakeout: Stricken Lenders7
• Complete Coverage: Debt Dilemma
8
The central bank has now used most of the tools at its disposal for restoring normalcy to the markets. If these
steps fail, its only major weapon left is a cut in the federal-funds rate target -- perhaps even on or before its next
meeting on Sept. 18. The futures market indicated traders expect the Fed to cut rates at least a quarter point at its
September and October meetings, and down a full point from the current 5.25% to 4.25% by the end of the year.
"The downside risks to growth have increased appreciably," the central bank said in a statement before markets
opened in the U.S. -- and after another day of drastic declines in Asia and Europe. The Fed said it would "act as
needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets." It made
no mention of inflation, the principal concern of Fed policy makers for at least the last two years.
The discount window was originally established as a way for the Fed to lend to banks having difficulty raising
funds elsewhere. But this option is little used because it generally carries a stigma, since it is seen as a struggling
bank's last resort. Officials are hoping their latest moves will encourage more borrowing, injecting more liquidity
into the system.
Markets reacted euphorically to the Fed intervention. The Dow Jones Industrial Average soared more than 300 points at the market's open, then eased a bit
to close at 13079.08, up 233.30 points, or 1.82%. But Fed officials consider that widely watched benchmark a poor barometer of financial conditions, and
have focused more on the trading in debt securities such as commercial paper, interest-rate swaps and Treasury bills and bonds, which in recent days
signaled deepening financial distress.
Trading in those notes had become difficult because investors were seeking the safest, most readily traded
investments and don't want to let them go. Officials were relieved to see some signs of improvement
Friday. But the gains were tentative, and officials believe it could be some time before they know if their
steps have worked.
Amid a growing clamor from battered traders and money managers, as well as some economists, for
central banks to go beyond their massive liquidity injections of the past week, Fed Chairman Ben
Bernanke continued to resist calls for an immediate interest-rate cut. But he showed some creativity and
flexibility by altering the prices and policies surrounding the discount-window.
Top Fed officials decided to lower the discount rate -- the interest charged on direct Fed loans to banks -during an emergency hour-long videoconference Thursday evening. To encourage banks to borrow from
this source, the Fed lengthened the term of such loans to as long as 30 days from the usual one day.
Then, in a move reminiscent of the Fed's crisis management during the 1998 market meltdown prompted
by woes at the Long Term Capital Management hedge fund, a consortium of banks got together with Fed
Yale economist Robert Shiller explains why the Fed's move won't officials to discuss the central bank's plans. At the request of the New York Fed, the Clearing House
cure the credit woes of subprime mortgage holders.
Payments Co. -- a 154-year-old bank-owned group that operates much of the nation's payment systems by
clearing checks, wire transfers and other forms of payments -- hosted a conference call at 10 a.m. Friday. Financial leaders such as as James Dimon of J.P.
Morgan Chase & Co., Charles Prince of Citigroup Inc., Kenneth Lewis of Bank of America Corp., Lloyd Blankfein of Goldman Sachs Group Inc. talked
with Fed officials who explained their crisis response and subtly sought some help in boosting the impact of their action.
Officials believe that getting banks to borrow from the window requires overcoming the reluctance of any individual bank to borrow, for fear of showing
weakness, unless other banks do, too.
The call was led by New York Fed president Tim Geithner and Fed vice-chairman Donald Kohn and they emphasized they would see discount window
borrowing as a sign of strength. "The objective is to encourage a broad range of financial institutions to feel more comfortable providing term financing that
will facilitate orderly functioning of funding and credit markets," Mr. Geithner said, according to a participant. The steps, he said, will "help facilitate a
collective response by financial institutions to these exceptional conditions.
Officials believe that getting banks to borrow from the discount window requires overcoming the reluctance of any individual banks to do so, for fear of
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showing weakness unless other banks borrow from it too. So, Fed officials said they would regard participation as a sign of strength, not weakness.
Bank executives said the moves would likely bring some confidence to markets, although they stopped short of saying they would follow the Fed's guidance
and tap funds from the discount window. That is particularly the case for banks that can borrow at more attractive rates elsewhere even in light of the
reduced discount rate. Still, the Fed move does give banks access to cash they wouldn't otherwise have, because the discount window will accept as
collateral the mortgage-related securities that have been shunned by creditors amid the turmoil.
Lori Appelbaum, a bank analyst at Goldman, said access to the discount window could help specialty mortgage-finance companies such Countrywide
Financial Corp. On Thursday, Countrywide drew down an $11.5 billion credit line to bolster its short-term finances.
"This is not a panacea in any way, but I do think people will use the discount window in the coming days and weeks,"
said an executive who was on the call.
Morgan Stanley economist David Greenlaw said that in theory, banks could use the discount window to make
relatively low-risk loans such as jumbo mortgages -- as those over $417,000 are known -- or purchases of commercial
paper and be assured a profit for 30 days. Moreover, he noted that many investment dealers and finance companies
have bank subsidiaries or affiliates that they may be able to use to access the discount window. For example, some
investment dealers own industrial loan companies, and Countrywide owns a thrift, all of which have access to the
discount window.
For months, Fed officials believed the financial market's problems were generally limited to borrowers of subprime
mortgages -- those issued to more-risky homebuyers and firms -- and investors who held those mortgages. But the
credit crunch has spread as hedge funds, banks and others from around the world reported unexpected exposure to
defaulting subprime loans. The breadth, suddenness and opacity of this exposure have rattled investors and triggered a
broadbased reluctance to lend to any but the most creditworthy borrower.
That skittishness spread first to the market for loans to heavily indebted companies, such as those undergoing a
leveraged buyout. Next it hit "jumbo" size mortgage borrowers, and then some issuers of asset-backed commercial paper -- short-term corporate IOUs
backed by other assets such as subprime mortgages, which are often sold to money-market funds.
While the Fed acknowledged at its Aug. 7 policy meeting that the risks to growth had grown, it kept its principal concern on inflation. A scramble for cash a
few days later triggered by new revelations of subprime exposure sent short-term rates spiking in Europe and the U.S., prompting the European Central
Bank and the Fed to pump billions of dollars into overnight money markets through open-market operations. Markets calmed down initially.
But this week, the situation steadily worsened. The commercial-paper market, a critical source of short-term funding for an array of companies, was
becoming inaccessible for a growing number of companies. There were signs of trouble in parts of the currency market. The announcement by
Countrywide, the nation's largest mortgage lender, that it was facing funding difficulties also weighed on officials' minds.
In the past week, top Fed officials have explored what other options they had to restore market confidence. As they dusted off operating procedures for the
discount window, Mr. Bernanke and others concluded they had a potentially powerful tool at their disposal. The Fed could lengthen the term of
discount-window loans, accept virtually any collateral -- including unimpaired subprime loans -- and could set the rate at whatever level Fed officials
deemed necessary.
Mr. Bernanke convened a videoconference of the Federal Open Market Committee, comprising the Fed's governors in Washington and presidents of its
regional banks or their stand-ins, at a little after 6 p.m. Thursday. After about an hour, the panel agreed to the unprecedented step of releasing a statement
with a revised assessment of the outlook. (Such a statement has never been released outside a regular meeting, except when rates were also changed.)
Officials knew one of the biggest risks facing their new strategy was that banks wouldn't borrow at the discount window. In attempt to prevent that, officials
went on the offensive. Their formal announcement was released shortly before 8:30 a.m. Friday; soon after, Mr. Geithner asked the Clearing House
Payments Company -- a 154-year-old bank-owned group that operates much of the nation's payment systems by clearing checks, wire transfers and other
forms of payments -- to organize the 10 a.m. conference call.
Mr. Bernanke wasn't on the call. But Mr. Geithner and Fed Vice-Chairman Donald Kohn were, and they emphasized to participants they would see
discount-window borrowing as a sign of strength. A number of executives countered that they could borrow more cheaply than at the Fed window, said
people who participated in the call. Mr. Geithner made it clear the banks weren't being told they must participate, but should keep it in mind as an
alternative when they are making judgments about credit.
The discount window can be particularly helpful to the nation's smaller institutions, which have less access to financing mechanisms than their larger
brethren and are likely reining in their lending due to concerns about deteriorating credit markets. Although smaller firms didn't participate in the call, a
person familiar with the matter said the Fed is reaching out to those institutions as well.
Goldman's Mr. Blankfein said he applauded the moves because accessing the window would not only provide liquidity -- that is, extra buying power -- but
more importantly, would add more stability to the system.
Participants in the call said they found it very productive, according to someone who was briefed on the discussion, and were especially gratified to be told
by Fed officials that there would be no negative ramifications to accessing the window.
Even so, the discount window's reach in the current crisis is limited by the fact that only banks can use it, and they aren't the ones facing the greatest strains.
Fed officials categorically rejected suggestions by some analysts that they were acting on signs of distress among banks, saying banks are in good shape.
Rather, the strains are being felt by nonbanks such as unregulated mortgage lenders, issuers of commercial paper, hedge funds, and the market for
securitized loans such as mortgage-backed securities and collateralized debt obligations.
Still, the Fed hopes banks that take advantage of the discount window's easier loan terms will in turn be more willing in turn to finance the positions of
others.
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"It's conceivable that the Fed's actions today could go a long way toward restoring liquidity to the markets," said Mr. Greenlaw, the Morgan Stanley
economist.
Yet the risk for the Fed is that, like its other steps so far, it will prove too little and require even more aggressive action later. Its decision to acknowledge
downside risks to growth on Aug. 7, then its aggressive open-market operations last week, both briefly sent stocks soaring. But the debt markets have only
tightened since.
"They're kind of running out of options," said J.P. Morgan economist Michael Feroli. "Beyond this, the only option that's going to give them a lot of traction
is to cut rates."
--Craig Karmin, Joanna Slater, Serena Ng, Kate Kelly and Sudeep Reddy contributed to this article.
Write to Greg Ip at greg.ip@wsj.com9, Robin Sidel at robin.sidel@wsj.com10 and Randall Smith at randall.smith@wsj.com11
URL for this article:
http://online.wsj.com/article/SB118735319666500894.html
Hyperlinks in this Article:
(1) http://blogs.wsj.com/economics/2007/08/17/economists-react-lifting-the-wizards-curtain/
(2) http://online.wsj.com/article/SB118718233403998411.html
(3) http://blogs.wsj.com/economics/2007/08/16/how-does-the-fed-keep-rates-near-its-target-a-primer/
(4) http://blogs.wsj.com/economics/2007/08/17/explaining-the-discount-window/
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August 20, 2007
PAGE ONE
LOOSENING UP
DOW JONES REPRINTS
How a Panicky Day
Led the Fed to Act
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Freezing of Credit
Drives Sudden Shift;
Shoving to Make Trades
By RANDALL SMITH in New York, CARRICK MOLLENKAMP in London, JOELLEN
PERRY in Frankfurt and GREG IP in Washington
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August 20, 2007; Page A1
Strains in financial markets had been evident for weeks, but Thursday, Aug. 16, was different.
As the day dawned in London, $45.5 billion in short-term IOUs issued outside the U.S. by corporations
and others were maturing and had to be rolled over. Traders usually have buyers for such paper by
lunchtime in London, around 7 a.m. in New York. On this morning, demand had dried up, and it would
take the whole day to sell less than half of it, said a person familiar with the market.
At 7:30 a.m. in New York, the largest maker of mortgages in the
U.S., Countrywide Financial Corp., said it was tapping $11.5
billion in bank credit lines, a sign that it was unable to raise
money in financial markets as it had been.
This was a development more serious than another hedge fund
running into trouble. "When you start talking about
Countrywide," said one senior Wall Street executive, "that's kind
of America. At the end of the day, we're talking about Mom and
Pop and the right to own a home."
The floor of the NYSE shows heavy activity after
the ringing of the opening bell on Aug. 17.
Just before noon New York time, near the end of the London
trading day, the yen suddenly surged against the dollar, rising 2% in just minutes and crushing
currency-market players who hadn't anticipated such a sharp move. On the London trading floor of
Goldman Sachs Group Inc., phone lines lit up in unison, and some salesmen wielded two phones at the
same time. They were shoving and grabbing each other to get in front of traders, and shouting orders to
execute trades, according to eyewitnesses.
Shortly afterwards, investors began piling into the shortest-term U.S. Treasury securities, which are
considered safe because they're backed by the U.S. government. The yield on three-month bills, which
had been around 4%, dropped as low as 3.4%, and the gap between yields on T-bills and corporate
commercial paper widened sharply. "It was an extraordinarily violent move," said Jason Evans, head of
government-bond trading at Deutsche Bank. "It became clear that the market was at a point of distress
and expected a response" from the U.S. Federal Reserve.
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These shocks reflected one of the most perilous days for global credit markets, the circulatory system of
the international economy, since the 1997-98 crisis that began in Asia, spread to Russia and Brazil and
eventually to the U.S.-based hedge fund Long-Term Capital Management.
On Friday morning, following a conference call the previous evening convened by Chairman Ben
Bernanke, the Fed blinked. Just 10 days after declaring that inflation was still its predominant worry, the
Fed declared "downside risks to growth have increased appreciably" and hinted that it may soon cut its
target for short-term rates. In an unusual move, it also encouraged banks to borrow directly from the Fed
and made such loans more attractive.
In essence, the Fed is following advice that British journalist Walter Bagehot offered in his 1873 book,
"Lombard Street," a copy of which Mr. Bernanke kept on a shelf when he was Princeton professor. In
times of "internal discredit" -- when uncertainty leads private players to pull back -- the prescription to
the central bank is: Lend freely.
"A panic...is a species of neuralgia, and according to the rules of
science you must not starve it," Bagehot wrote. "The holders of the
cash reserve" -- today's central banks -- "must be ready...to advance
it most freely for the liabilities of others. They must lend to
merchants, to minor bankers, to 'this man and that man,' whenever
the security is good."
Bolstering Confidence
This week, the Fed will find out if it did enough to bolster the
confidence that was in such short supply last week, when investors
refused to buy or accept as collateral securities that in normal times
would be of unquestioned worth. Its critics, including those who say
it is too quick to rescue imprudent lenders and borrowers, will be
watching for evidence that the Fed went too far.
The initial reaction of U.S. stock and credit markets to Friday's Fed
move was favorable. The interest-rate spread between U.S. government bonds and some riskier bonds
shrank slightly, while the Dow Jones Industrial Average rose 1.8%. In early Tokyo trading today, stocks
surged more than 3%.
It isn't clear yet how many big banks responded to the Fed's encouragement to borrow at what is known
as the Fed's discount window. Hard data won't come until the Fed releases its routine tally on Thursday -unless the Fed or the banks volunteer information. One big bank told the Fed that, though it doesn't need
the money and could get it more cheaply, it will borrow $100 million today as a gesture, according to a
person familiar with the bank's plans. And one Wall Street firm said it planned to offer collateral to its
bank, assuming the bank in turn would offer it to the Fed as collateral for a discount-window loan.
The latest chapter in the credit crisis of 2007, rooted in the deterioration of the market for U.S. subprime
mortgages and securities linked to them, represents a new test of the savvy of central banks from
Frankfurt to London to Washington to Tokyo. These are the institutions in modern capitalist economies
that regulate the supply of credit with the goal of keeping prices from rising too fast and preventing
economic downturns from deteriorating into repeats of the Great Depression.
It began on Tuesday, Aug. 7, in Europe. Shortly after 9 a.m., on the second floor of the European Central
Bank's 37-story glass and metal office tower in Frankfurt, the bank doled out €292.5 billion in its regular
weekly financing operation. Commercial banks were flush with cash, yet money-market rates -- the
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interest charged by banks when lending to one another -- were rising. Something was eroding the banks'
willingness to lend.
On Wednesday, the ECB noticed volatility increasing and credit spreads rising. More money was flowing
into safe havens such as two-year German government bonds, and reports of tensions in the
commercial-paper market were circulating. By evening, it was clear the ECB had to intervene to keep
market rates from rising well above the central bank's previously set target of 4%. President Jean-Claude
Trichet and Vice President Lucas Papademos were in touch with Fed officials.
With market rates nearly three-quarters of a percentage point above the target, ECB staffers charged with
monitoring liquidity met at 8:45 the next morning, about 90 minutes earlier than usual, says a person
familiar with the matter. They recommended that the central bank take the biggest move in its nine-year
history -- an unlimited offer of funds to the banking system at its 4% target rate. Members of the
Executive Board approved the decision.
At 10:26 Frankfurt time, screens across the world flashed the message: "The ECB notes that there are
tensions in the euro money market notwithstanding the normal supply of aggregate euro liquidity. The
ECB is closely monitoring the situation and stands ready to act to assure orderly conditions in the euro
money market." At 12:32 p.m., the ECB announced that it would accept all bids to borrow money made
by 1:05 pm.
The announcement sent shock waves through the market. At 2 pm, the ECB said it was lending €94.8
billion in one-day funds, bigger even than its initial reaction to the Sept. 11, 2001, terrorist attacks. That
night, JP Morgan's senior European economist, David Mackie, said, "For the last few days, people have
been worried that [the subprime crisis] would translate to a broader liquidity issue. I think the surprise is
that it happened in Europe, rather than in the U.S."
In the days that followed, the ECB repeatedly put money into the markets. To a lesser degree, so did the
Fed and other central banks. On Friday, Aug. 10, following an early-morning conference call among Fed
policy makers, the Fed assured the markets that it would do what was necessary to keep the economy
lubricated with cash. By Tuesday, Aug. 14, Mr. Trichet, who was in and out of Frankfurt while trying to
take a vacation, issued a statement saying that conditions in the euro zone had gone "progressively back
to normal."
But that would prove overly optimistic.
On Wednesday, a real-estate affiliate of Wall Street buyout titan Kohlberg Kravis Roberts & Co. asked
investors to accept a six-month delay in repayment on $5 billion in commercial paper.
That night, Countrywide notified banks that it was going to draw on its prearranged credit lines, a move
hastened by a Merrill Lynch analyst's warning that Countrywide could face bankruptcy. Countrywide
bonds plunged, and the price of insurance against a default soared. At one point Thursday morning, it
cost $1.1 million per year to buy protection for every $10 million in Countrywide debt.
Countrywide's woes posed a particularly severe risk to the economy, officials in Washington realized. It
is a major force in the market for jumbo mortgages, those greater than $417,000. By law, the
government-sponsored mortgage investors Fannie Mae and Freddie Mac cannot buy these big mortgages.
Markets overseas were going haywire too. Until the credit crunch, many investors had engaged in the
so-called carry trade, borrowing money in Japanese yen, a low-yielding currency, and converting the yen
to higher-yielding currencies such as the U.S. dollar and the Australian dollar. Now, facing big losses,
some investors needed to unwind these trades, and the yen shot up in value. So many traders were trying
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to unload the Australian currency that Australia's central bank intervened to restore order for the first
time in six years.
In Canada, a group of banks and investors had to rescue faltering issuers of 130 billion Canadian dollars
(US$121 billion) in commercial paper.
On Thursday, a top Wall Street executive telephoned Rob Nichols, a former Treasury official who is now
president of the Financial Services Forum, a Washington trade group, asking for help in conveying to the
Fed the urgency of the deteriorating situation. "It is time for us to act," he said. Mr. Nichols passed on the
information, but found the Fed already knew it.
Fed Chairman Bernanke, sometimes derided on Wall Street for being an academic rather than a market
veteran, had long studied episodes like this. In a January speech, he noted that the Fed was founded "in
response to the periodic episodes of banking panics and other forms of financial instability that had
plagued the U.S. economy during the 19th and early 20th centuries." These panics typically started when
banks faced a sudden drain on their deposits and called in loans to meet those demands, fueling a
self-reinforcing constriction of credit.
Discount Window
In the Panic of 1907, the stock market crashed, the U.S. slid into recession and bank runs broke out
across the country. Famed financier J.P. Morgan organized other bankers to direct credit to troubled
banks, secure international lines of credit and buy stock, and calm was restored. After the Federal
Reserve was founded in 1913, banks were able to access the discount window, the same mechanism the
Fed is now using to stimulate a willingness to lend.
Over the past few weeks, Wall Street executives peppered Fed officials in New York and Washington
with suggestions for easing the logjam in credit markets. One idea was for the Fed to widen the type of
assets it accepts in its "open-market operations," when it pumps cash into the economy by buying U.S.
government bonds and the like. Some thought the Fed should buy lower-quality mortgages.
At one point on Thursday, three big banks -- J.P. Morgan Chase & Co., Citigroup Inc. and Bank of
America Corp. -- discussed with the Fed the possibility of borrowing a total of $75 billion to be used to
buy asset-backed commercial paper, mortgage-backed securities and other instruments.
Fed officials say they welcomed the creativity. They listened to some ideas without comment, and in
some cases explained that the suggestions were outside the Fed's normal legal authority.
For several days, Mr. Bernanke pondered options with his confidants. They included the Fed's vice
chairman, Donald Kohn, an economist who was one of former Chairman Alan Greenspan's closest aides;
and Timothy Geithner, president of the New York Federal Reserve Bank and a protégé of former
Treasury secretaries Robert Rubin and Lawrence Summers. The officials were looking for a maneuver
dramatic enough to shore up confidence, while avoiding a cut in the Fed's main interest rate, the
federal-funds rate. Mr. Bernanke was still not convinced the economy needed a cut, and some Fed
officials feared it might encourage more of the sloppy lending that led to the crisis.
They began to look more closely at the discount window. Banks remain well-capitalized and profitable.
But they appeared reluctant to provide credit to companies, issuers of commercial paper and even each
other, perhaps out of uncertainty over the safety of their customers or their collateral.
Eventually, Fed officials agreed to reduce the rate charged on loans from the discount window (to 5.75%
from 6.25%) and try to reduce the usual stigma associated with such loans. By making these direct loans
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without the usual penalty to their bottom line or to their reputation -- and thus make them a bit more
willing to lend in normal fashion.
In addition, in its public statement Friday morning, the Fed made what amounts to a vow to cut its target
on the federal-funds interest rate if normalcy fails to return. That is the key rate that the Fed normally
lowers when it wants to loosen monetary policy. The Fed believed this combination of moves would
assure everyone that it was aware of risks to the U.S. economy posed by the market turmoil.
Particularly at times of stress, what the Fed says can be almost as powerful a weapon as what the Fed
does. So Mr. Geithner, whose job makes him the traditional liaison to Wall Street, turned to a convenient
forum, the Clearing House Payments Co., which is owned by a group of banks and operates much of the
plumbing of the nation's financial system. To avoid the inevitable headlines -- and comparisons to the
1998 rescue of Long-Term Capital Management, when financial executives were summoned to the New
York Fed's fortress-like headquarters -- Mr. Geithner sought a 15-minute telephone conference call.
On the call were commercial bankers who work with Clearing House as well as several top investment
bankers, among them Zoe Cruz, co-president of Morgan Stanley; James Cayne, chief executive of Bear
Stearns Cos.; Joseph Gregory, president of Lehman Brothers Holdings Inc.; and Stan O'Neal, chief
executive of Merrill Lynch & Co.
Sign of Strength
Joined by Mr. Kohn, but not Mr. Bernanke, Mr. Geithner told banks about the discount-rate cut and said
they could wait up to 30 days, instead of just a day, to pay back their discount-window loans. "We will
consider appropriate use of the discount window...a sign of strength," said Mr. Geithner, according to a
participant.
Seth Waugh, chief executive of Deutsche Bank AG's Americas unit, told those on the call that it was
important for discount-window borrowing not to be seen as a sign of financial weakness. "You need
some safety in numbers," Mr. Waugh said, according to a person who was listening. He said the Fed
needed to make clear it "will be there for as long as it takes to restore liquidity."
Another banker participating in the call said of the Fed, "What they came up with is pretty ingenious."
Investment banks or hedge funds that hold mortgage-backed securities can't borrow from the Fed
directly, but they can bring those securities to banks. In turn, the banks can offer the paper as collateral to
the Fed for a 30-day loan.
The Fed "really wanted to drive home the point that if [bankers] were complaining about not being able
to borrow money against liquid, high-quality securities -- mortgages -- we have no more basis for
complaint. We were all given a clear message," says this banker.
Bond markets on Friday were calmer, although not completely won over by the Fed's move. The price of
two-year and 10-year Treasury bonds fell slightly, suggesting demand for these safe investments wasn't
as great as before, although the price of three-month Treasury bills rose. The difference between yields
on junk bonds and Treasury bonds slipped to 4.48 percentage points, from 4.59 percentage points on
Thursday, according to a Merrill Lynch index, in a hint that tolerance for risk was recovering somewhat.
These are the kinds of measures that will be watched closely this week, to see whether the destructive
cycle of declining confidence and illiquid debt markets has halted.
If it doesn't, the Fed will likely cut interest rates on or before Sept. 18, the date of its next scheduled
policy meeting.
8/20/2007 9:43 AM
How a Panicky Day Led the Fed to Act - WSJ.com
6 of 6
http://online.wsj.com/article_print/SB118755980713302186.html
--Serena Ng and Robin Sidel in New York, Iain McDonald in Sydney, Jason Singer in London and Andrew Morse in Tokyo
contributed to this article.
Write to Randall Smith at randall.smith@wsj.com1, Carrick Mollenkamp at
carrick.mollenkamp@wsj.com2, Joellen Perry at joellen.perry@wsj.com3 and Greg Ip at
greg.ip@wsj.com4
URL for this article:
http://online.wsj.com/article/SB118755980713302186.html
Hyperlinks in this Article:
(1) mailto:randall.smith@wsj.com
(2) mailto:carrick.mollenkamp@wsj.com
(3) mailto:joellen.perry@wsj.com
(4) mailto:greg.ip@wsj.com
Copyright 2007 Dow Jones & Company, Inc. All Rights Reserved
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8/20/2007 9:43 AM
Barclays Capital Executive Resigns as Investments Slip - WSJ.com
1 of 2
http://online.wsj.com/article_print/SB118788415393806665.html
August 24, 2007
Barclays Capital Executive
Resigns as Investments Slip
By MARGOT PATRICK and CARRICK MOLLENKAMP
August 24, 2007; Page C2
Edward Cahill, a senior structured-finance executive at Barclays Capital,
resigned this week, people familiar with the situation said, as investment
structures that Barclays helped arrange for outside clients lost value
because of the global credit-markets crisis.
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Mr. Cahill had been European head of collateralized debt obligations. These CDOs are pools of debt that
investors buy in pieces based on the risk and return of assets in the structures.
Barclays Capital, part of British bank Barclays PLC, has helped fuel Barclays's growth and accounts for
40% of the company's profit before taxes.
Mr. Cahill's group developed cousins of CDOs known as structured investment vehicles. Barclays
specialized in a subset called SIV-lite, which relies on short-term commercial paper to buy portfolios of
securities with longer-term returns. The structures, in normal times, borrow the commercial paper and
earn money on the higher-yielding returns from the assets, including securities underpinned by U.S.
mortgage loans.
Mr. Cahill couldn't be reached to comment.
SIVs have been a booming business for banks. The total value of SIV portfolios increased to $370 billion
in June from $205 billion in December 2005, according to Citigroup Inc. research. SIV-lites have
emerged in the past 18 months and have a total portfolio volume of about $13.5 billion, Citigroup said in
an Aug. 3 report.
The big problem for SIVs and other bank affiliates that rely on the commercial-paper market for funding:
In the past few weeks, investors have stopped buying commercial paper sold by these structures because
they are concerned that the vehicles are exposed to U.S. subprime mortgages. The banks are left without
funding for the structures and are having trouble selling assets because many have significantly decreased
in value.
This week, for example, British bank HBOS PLC said it would step in to cover the maturing commercial
paper of one of its affiliates.
Barclays helped arrange three SIV-lites called Golden Key, Sachsen Funding I and Cairn High Grade
Funding I. The vehicles invested mainly in top-rated U.S. prime and subprime
residential-mortgage-backed securities.
A Barclays Capital spokesman said he couldn't comment on the bank's exposure to the vehicles.
8/24/2007 1:43 AM
Barclays Capital Executive Resigns as Investments Slip - WSJ.com
2 of 2
http://online.wsj.com/article_print/SB118788415393806665.html
Write to Margot Patrick at margot.patrick@dowjones.com1 and Carrick Mollenkamp at
carrick.mollenkamp@wsj.com2
URL for this article:
http://online.wsj.com/article/SB118788415393806665.html
Hyperlinks in this Article:
(1) mailto:margot.patrick@dowjones.com
(2) mailto:carrick.mollenkamp@wsj.com
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8/24/2007 1:43 AM
Deal Journal - WSJ.com > Print > Wall Street Braces For “Writedown ...
1 of 1
http://blogs.wsj.com/deals/wp-print.php?year=2007&monthnum=08&d...
Wall Street Braces For “Writedown Wednesday”
Posted By Dennis K. Berman On 24th August 2007 @ 16:12 In Investment Banks | 9 Comments
Okay, we just kind of like the term as a counterpunch to the juvenile “Merger Monday.”
And from a news perspective, we’re paying much more attention to writedown news in the days ahead. A number of banks
close their third quarter books on August 31. Soon after, we might finally get a sense of the carnage created by the
overzealous lending committees and real estate desks up and down the Street.
That’s because the banks’ outside auditors and own accountants are going to have to establish and reveal “marks” for
their current positions, which are larded with LBO loans, mortgage-backed securities, and derivatives. From what Deal
Journal is hearing, some banks have been trying to mitigate the damage, classifying certain securities as part of their bank
lending books — rather than securities held in their securities arms.
However it’s done, expect a torrent of bad news releases to pop after the Labor Day holiday. If you thought CNBC droned
on about the mortgage news too much, wait til Goldman, Lehman, or Merrill owns up to a big charge.
Of course, the Street houses will cluster their news within days of one another. The idea is to create the perception of an
“industry-wide issue” that would somehow absolve individual firms of responsibility. Funny how that works, isn’t it?
In case you forgot, here’s where stocks of the leading players stand year-to-date:
Credit Suisse: -4.33%
Deutsche Bank: -6.24%
JPMorgan: -6.63%
Goldman Sachs: -10.05%
UBS: -12.3%
Citigroup: -13.26%
Merrill Lynch: -18.57%
Greenhill: -20.5%
Morgan Stanley: -21.05% (includes the spin-off of Discover)
Lehman Brothers: -23.6%
Blackstone: -30.01%
Article printed from Deal Journal - WSJ.com: http://blogs.wsj.com/deals
URL to article: http://blogs.wsj.com/deals/2007/08/24/wall-street-braces-for-writedown-wednesday/
back | Click here to print.
8/27/2007 10:46 PM
file:///C:/Documents%20and%20Settings/HP_Administrator/Desktop/D...
August 27, 2007, 10:00 am
Goldman, Bear Insiders: Where Are You?
Posted by Dana Cimilluca
Financial-firm executives of all stripes are snapping up their own companies’ shares like nobody’s business. All
executives, that is, except those at the center of the financial world.
According to this Bloomberg article, August was the heaviest month for insider buying at financial firms since
1995. Driving all the buying were executives at firms including Wachovia, American Express, CIT Group and
American Capital Strategies, according to the article. They aren’t the only insiders buying these days, as this
recent post points out.
Notably absent from the bargain-hunting bonanza — which should be a bullish signal for stocks — were
honchos at Wall Street’s biggest securities firms: Goldman Sachs Group, Morgan Stanley, Merrill Lynch,
Lehman Brothers Holdings and Bear Stearns. (No mention in the story of what executives at Citigroup and J.P.
Morgan have been doing, but presumably they have been at least cautious buyers, too.)
The big securities firms, of course, have more to fear from the market storm than some of their more narrowly
focused counterparts. Their exposure to all corners of the credit markets have been in sharp relief as Goldman
and Bear were forced to rescue in-house hedge funds. The fierce behind-the-scenes jockeying to save the Home
Depot Supply deal shows how much Lehman, Merrill and J.P. Morgan apparently feel they have riding on that
leveraged buyout.
It may not be safe to go back into the water until the ultimate Wall Street insiders take the plunge themselves.
1 of 1
8/28/2007 3:36 PM
Deal Journal - WSJ.com > Print > Goldman, Bear Insiders: Where Are You? http://blogs.wsj.com/deals/wp-print.php?year=2007&monthnum=08&d...
1 of 1
Goldman, Bear Insiders: Where Are You?
Posted By Dana Cimilluca On 27th August 2007 @ 10:00 In Investment Banks | 11 Comments
Financial-firm executives of all stripes are snapping up their own companies’ shares like nobody’s business. All executives, that is, except those at t
the financial world.
According to this [1] Bloomberg article, August was the heaviest month for insider buying at financial firms since 1995. Driving all the buying were
firms including Wachovia, American Express, CIT Group and American Capital Strategies, according to the article. They aren’t the only insiders buyi
as [2] this recent post points out.
Notably absent from the bargain-hunting bonanza — which should be a bullish s
stocks — were honchos at Wall Street’s biggest securities firms: Goldman Sachs
Morgan Stanley, Merrill Lynch, Lehman Brothers Holdings and Bear Stearns. (No
the story of what executives at Citigroup and J.P. Morgan have been doing, but
they have been at least cautious buyers, too.)
The big securities firms, of course, have more to fear from the market storm th
their more narrowly focused counterparts. Their exposure to all corners of the c
have been in sharp relief as Goldman and Bear were forced to rescue in-house h
The [3] fierce behind-the-scenes jockeying to save the Home Depot Supply dea
much Lehman, Merrill and J.P. Morgan apparently feel they have riding on that
buyout.
It may not be safe to go back into the water until the ultimate Wall Street inside
plunge themselves.
[4] Sign up for our new roundup of the day’s Deal Journal posts, along
deal news, columns, videos and more. (WSJ.com subscription required
Article printed from Deal Journal - WSJ.com: http://blogs.wsj.com/deals
URL to article: http://blogs.wsj.com/deals/2007/08/27/goldman-bear-insiders-where-are-you/
URLs in this post:
[1] Bloomberg article: http://www.bloomberg.com/apps/news?pid=20601109&sid=a7RnWkCC979M&refer=home
[2] this recent post: http://blogs.wsj.com/deals/index.php?s=avaya
[3] fierce: http://online.wsj.com/article/SB118817084895809294.html
[4] Sign up :
http://blogs.wsj.com/dealsJAVASCRIPT:OpenWin('http://wsj.com/email/outset_subscribe?checklist=138','','500','250','off',true,0,0
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8/27/2007 10:51 PM
Economics Blog > Print > Parallels to the Crisis of 1907
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Parallels to the Crisis of 1907
Posted By topeditor On 28th August 2007 @ 10:00 In Global | 48 Comments
Since the current credit crisis began, economists have been looking for historical parallels. [1] Steve Quinn, Associate
Professor of Economics, Texas Christian University Fort Worth, TX, sees a connection to a situation in the early 20th
century. ([2] Read a related Deal Journal post.) Here are his thoughts:
The crisis of 1907 as an apt analogy to the current situation.
1. In 1907, trusts had developed to circumvent the regulatory restrictions on banks. In this, trusts paralleled hedge funds.
2. When panic hit, no one knew where the risk was, so a general credit crunch followed. As today, live by asymmetric
information, die by asymmetric information.
3. The trusts outside the lender of last resort system of 1907 (clearinghouses) had a terrible time of it. Today hedge funds
are outside the Federal Reserve System.
4. The crisis subsided after J.P. Morgan felt sure enough to step in with his own capital. Bank of America jumping into
Countrywide is similar.
5. The 1907 crisis scared enough people to generate substantial new regulatory initiatives. At first, the old system of
emergency lending was extended in the Aldrich-Vreeland Act. Later, the Federal Reserve was created to replace the
clearinghouse system and separate the supply of ultimate reserves from banks. The parallel here is extending Fed
discounting to instruments like CDOs and institutions like hedge funds.
6. Finally, how can one resist the 100 year gap?
The best source on this is [3] “Liquidity Creation without a Lender of Last Resort: Clearinghouse Loan Certificates in the
Banking Panic of 1907″ by Ellis W. Tallman and Jon R. Moen, Federal Reserve Bank of Atlanta Working Paper 2006-23
(November 2006). Of course, I am biased because they are my friends.
See also: [4] “Why Didn’t the United States Establish a Central Bank until after the Panic of 1907?”
Article printed from Economics Blog: http://blogs.wsj.com/economics
URL to article: http://blogs.wsj.com/economics/2007/08/28/parallels-to-the-crisis-of-1907/
URLs in this post:
[1] Steve Quinn: http://www.econ.tcu.edu/quinn/quinn.html
[2] Read a related Deal Journal post:
http://blogs.wsj.com/deals/2007/08/06/breaking-credit-market-newsfrom-1907/
[3] “Liquidity Creation without a Lender of Last Resort: Clearinghouse Loan Certificates in the Banking Panic of 1907″:
http://www.frbatlanta.org/filelegacydocs/wp0623.pdf
[4] “Why Didn’t the United States Establish a Central Bank until after the Panic of 1907?”:
http://www.frbatlanta.org/filelegacydocs/wp9916.pdf
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8/28/2007 11:08 PM
MarketBeat Blog - WSJ.com > Print > Safety in the World’s Dark Corners
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Safety in the World’s Dark Corners
Posted By David Gaffen On 29th August 2007 @ 10:43 In Global, Emerging Markets | 3 Comments
Globe With all the volatility in the world markets, some are looking to a surprising place as the safe haven — emerging
markets. In the past, emerging-market indexes were the first to be dumped, as they were often the most likely to
suffer from global financial crises (or were the catalysts for it, as it was in 1998 when Russia defaulted on its debt).
“I don’t know that I would go so far as to call it a ’safe haven,’” says Marc Pado, chief strategist at Cantor Fitzgerald.
“Global markets, maybe not global banks, probably don’t care too much about our sub-prime woes. Their economies are
growing faster and better than ours. Seems reasonable to put some money to work in those markets.”
According to MSCI Barra, the world index of developed countries is down 5.94% over the last three months, including a
2.87% decline in August. For the year, the index has gained just 2.51%. The world emerging markets index, meanwhile,
has gained 3.51% in the last three months despite a more volatile 5.6% decline in August. For the year, the index is up
15.09%.
The extra returns — and the added volatility — aren’t
surprising, as growth stories tend to be subject to wilder
fluctuations in short-term periods. But what’s surprising
is that commentators aren’t looking at emerging
markets as the first item to toss in favor of safer
plays, particularly because the greater turmoil currently
appears to be in the U.S., Europe and Japan.
“It’s essentially 1998 in reverse: the credit problem is
now in the US rather than EM,” writes Michael Hartnett,
global emerging markets equity strategist at Merrill Lynch.
“Liquidity to ease the US credit problem will be redirected Vanguard Emerging Markets ETF vs. S&P 500, last 3 months
toward EM just as liquidity to ease the Asia/Russia/LTCM
problem was redirected toward tech.”
While those countries — particularly smaller ones — are still more vulnerable to a global downturn, dependent upon
exports as they are, other risks aren’t as great. “Drying up of liquidity in the global financial markets is the next crucial
factor, and here too EM is much less vulnerable than in the past,” writes Marc Chandler, head of currency strategy at
Brown Brothers Harriman. “Most are running current account surpluses, making them less dependent on capital
inflows.”
The real problem, however, is growth — if the global economy were to go into a recession, or even just a sharp
slowing, emerging markets would be at greater risk.
“What has contributed to the abundance in current account surpluses, fiscal surpluses and massive reserve accumulation
has been a remarkable bout of above-trend growth with particular emphasis on demand for commodities found in many
emerging economies,” writes Gray Newman and Luis Arcentales at Morgan Stanley, [1] in commentary. “It may indeed
be true that emerging economies will ultimately prove more resilient — I certainly suspect that their growth track records
will continue to beat that of the developed world — but that doesn’t mean that they are immune from the global business
cycle.”
Article printed from MarketBeat Blog - WSJ.com: http://blogs.wsj.com/marketbeat
URL to article: http://blogs.wsj.com/marketbeat/2007/08/29/safety-in-the-worlds-dark-corners/
URLs in this post:
[1] in commentary: http://www.morganstanley.com/views/gef/archive/2007/20070828-Tue.html#anchor5427
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8/29/2007 2:05 PM
MarketBeat Blog - WSJ.com > Print > Midday Tidbits — Financials Flushed
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Midday Tidbits — Financials Flushed
Posted By David Gaffen On 29th August 2007 @ 12:50 In Midday Tidbits | 2 Comments
A predictable rebound, and a few thoughts on the markets:
The losses in the stock market haven’t been broad, notes Michael Panzner. With the S&P 500 down
7.46% since July 19, the biggest drag has been the financial sector, off 9.09%, accounting for about
one-quarter of the move. Materials and consumer discretionary stocks have done even worse, but represent less
of the index than financials.
Bob Doll, global chief investment officer at BlackRock, and Rob Kapito, head of portfolio management, see no
reason to flee equities as a result of market turmoil. But they do have preferences within the stock market. “In general,
we have been favoring large-cap over smaller-cap companies, multinational companies in favor of those with a
predominantly U.S. focus, and growth companies over value,” they say in a special commentary.
Even though it missed the boat on certain bond ratings, Moody’s sees no reason to downgrade U.S. investment
banks based on their exposure to LBO loans. The majority of investment banks’ leveraged loan commitments are “under
water” and are being spurned by investors who aren’t willing to pay up for them, but investment banks “have sufficient
liquidity to fund their commitments, while continuing to maintain strong liquidity profiles,” the ratings agency said today.
We’ll see if this pans out better. (With reporting from Dow Jones Newswires)
Article printed from MarketBeat Blog - WSJ.com: http://blogs.wsj.com/marketbeat
URL to article: http://blogs.wsj.com/marketbeat/2007/08/29/midday-tidbits-financials-flushed/
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8/29/2007 2:02 PM
MarketBeat Blog - WSJ.com > Print > Fiddling with Fed Funds
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Fiddling with Fed Funds
Posted By David Gaffen On 29th August 2007 @ 14:01 In Federal Reserve, Economics | 14 Comments
With each piece of depressing economic data — much of it anecdotal, mind you (such as the consumer confidence survey)
— market participants become more confident that the Federal Reserve will be cutting rates come September
18.
And yet, just a short time ago, it seemed like the Fed was going to avoid needing to reduce its targeted rate of
5.25%, on expectations that worsening financial conditions were just that — financial, specifically related to
esoteric structures dreamed up by market participants guzzling too much Jolt cola.
Now a rate cut in a few weeks seems inevitable, barring a boost in inflation. And with that comes the hand-wringing
over the “moral hazard” of “bailing out” Wall Street, or whether this reduction in rates will have the effect of
reinflating an asset bubble built on cheap credit over the last several years. It makes some wonder whether the bigger
error would be to lower rates and risk such a situation, or to stand pat despite the public calls for rate cuts from market
types and rich CEOs.
Ethan Harris, chief economist at Lehman Brothers, says such concerns are overdone. “Yes, the
Fed is coming to the rescue, but only after major pain in the markets and with a
legitimate concern about a significant shock to growth,” he writes. “To ignore the risks to
growth because you don’t want to help financial markets amounts to throwing the baby out with
the bath water.”
He expects, as a result, two interest-rate cuts by the end of the year – a bit less dramatic
than current market expectations, which implies a better-than-average chance that the Fed cuts
to 4.50% by its December meeting.
What was notable about yesterday’s release of minutes from its August 7 meeting was not that
the Fed was seemingly reserved about rate cuts, but that it did [1] reduce its economic
expectations, implying concern about the economy. If that continues — and current expectations are for an OK third
quarter and unsteady fourth quarter — it stands to reason the Fed would cut expectations further, which also
suggests they’ll cut rates too.
“The policy measures taken to date do not adequately address the deterioration in the economic outlook,” wrote
economists at Nomura Securities. “To do so will require one or more cuts in the federal funds rate target.The
FOMC can only hope that it market conditions will not force it to act before its September 18 policy meeting.”
Herein lies the rub, though — the Fed’s actions work with a significant lag, estimated from 12 to 18 months or more. If
there is more pain in the financial sector — and today’s story on rising credit-card defaults, along with expectations for
$120 billion in ARM re-sets, suggests there will be — how far will the Fed go? How many cuts will the market clamor for?
The last time this occurred, the Fed cut rates to 1%. That helped foster this situation — will it repeat itself?
What do you think? Where will the funds rate be at the end of the year? Let us know.
Article printed from MarketBeat Blog - WSJ.com: http://blogs.wsj.com/marketbeat
URL to article: http://blogs.wsj.com/marketbeat/2007/08/29/fiddling-with-fed-funds/
URLs in this post:
[1] reduce its economic expectations: http://www.federalreserve.gov/fomc/minutes/20070807.htm
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8/29/2007 10:18 PM
Capital - WSJ.com
1 of 3
http://online.wsj.com/article_print/SB118842768442912725.html
August 30, 2007
CAPITAL
By DAVID WESSEL
Revised Bank Rules Helped Spread Woes
August 30, 2007
Even before the current financial firestorm passes, the search for people
and institutions to blame has begun: Greed and hubris overtook common
sense and propriety. Excessively easy credit overwhelmed good judgment
and fueled a housing bubble. Profit-grubbing crooks took advantage of
unsophisticated home buyers. Rating services blew it. Government
overseers couldn't keep up with financial innovation. U.S. regulators let
shady subprime lenders slip through cracks in archaic rules. European bank
regulators were blind.
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The right answer will prove to be some combination of
the above. One culprit, however, has gone unnoticed: A
sweeping change in international rules governing the
capital banks must hold. By requiring banks to boost
the capital held in reserve against the loans carried on
their books, the rules encouraged banks to get rid of
those loans by turning them into securities to be sold to
investors. Banks took the hint.
That's complicating the Federal Reserve's efforts to put
out the current fire.
For more than 20 years, a club of central bankers has
been tinkering with rules -- known as Basel, for the
Swiss city in which officials meet -- to get banks to
hold more capital so they can absorb major losses
WSJ's David Wessel discusses a somewhat arcane contributor to without threatening the financial system. Details are so
the credit meltdown: Basil bank capital standards, he says, may
have had unintended and widespread consequences for markets technical that only insiders pay attention. Most of the
that the Fed can't address.
time that's just fine. The battles over the rules typically
have had more to do with banks and countries
jockeying for advantage than anything that mattered to borrowers in Boise or Bremen.
The rules are rooted in the worries of wise men like Paul Volcker, the former Fed chairman, that banks
didn't have enough capital, an especially acute concern after Germany's Herstatt Bank defaulted on
obligations to foreign banks in 1974 and the U.S. government rescue of big Continental Illinois National
Bank & Trust in 1984.
The solution: A 1988 international accord required banks (in countries where national authorities adopted
the rules) to hold more capital if they make riskier loans and investments. A bank that loans $100 million
8/29/2007 10:23 PM
Capital - WSJ.com
2 of 3
http://online.wsj.com/article_print/SB118842768442912725.html
to other solid banks needs only $1.6 million in capital; a bank that loans $100 million to ordinary
companies needs $8 million capital.
Banks are a special case. They're traditionally at the center of the financial system; bank panics led
Congress to create the Fed in 1913. And government insurance of bank deposits means most depositors
needn't worry if their banks make foolish loans. That can give bankers a heads-we-win/tails-you-lose
incentive to gamble that regulators must monitor.
MORE
1
• Discuss: Is regulation partly
responsible for the market mess?2
The original Basel rules were crude, overwhelmed when
banks figured out how to game them and were recently
revised. The rules did succeed in getting banks to strengthen
their financial footing. They did reduce the risks most banks
take. Was that the intention? Yes. Is that always a good
outcome? Well, maybe not.
Among other things, the rules required banks to hold more capital against an ordinary mortgage than
against pools of mortgages turned into securities. So banks sold off individual mortgages and many
replaced them with securities comprising pools of mortgages. Between 1988 and 1993, these
mortgage-backed securities rose to more than 9% of bank assets from 2.9%.
This huge change in finance has advantages. Banks still make loans and hold them, but are more likely to
originate and distribute loans. As a result, much of the risk of delinquencies on mortgages in inner-city
Detroit isn't shouldered by local banks but has been shifted to investors all over the world. (How many of
these hot potatoes may actually return to bank balance sheets is a question for another column. Short
answer: More than some bankers would like.)
It turns out, the folks who hold mortgage-backed securities are forced to be much quicker than banks are
to acknowledge reality when the value of the collateral for loans drops. And banks now behave more like
securities firms, more likely to mark down the value of assets when market prices fall -- even to
distressed levels -- rather than sitting on bad loans for a decade and pretending they'll be paid back.
It's a huge contrast to the bad old days of the early 1980s when big New York banks found themselves
holding lots of bad loans to Latin American governments and took years to write them down -- or when
Japanese banks' reluctance to admit the size of their bad-loans problem paralyzed Japan's economy.
But it may have some unwelcome effects: Banks aren't the shock absorbers they once were at a moment
of market panic. Because they hold fewer loans on their books, banks don't have the ability to say, "These
mortgages are more likely to be paid off than the market thinks today, and we'll just hold on until the
market comes to its senses." Instead, the holders of mortgage-backed securities are dumping them,
pushing down the price. This forces other leveraged players -- those backed by borrowed money -- to sell
their holdings and, if not interrupted, an economically devastating downward spiral can take hold.
The Fed is now laboring to prevent such an outcome. But its tools are designed with banks in mind, not
for a world in which banks have shifted risks to all sorts of other leveraged investors who are now forced
to be obsessed with the value of their collateral.
The Fed, which was an enthusiastic proponent of these risk-based capital standards and securitization, is
trying to prime the banking pump to put out the fire. Ironically, it's discovering that's harder because of
unappreciated consequences of the Basel rules that were intended to make the banking system more
fire-resistant.
Write to David Wessel at capital@wsj.com3
8/29/2007 10:23 PM
Capital - WSJ.com
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August 27, 2007
While you were away - fear and loathing in
the markets
For those who have been soaking up the sun on foreign beaches, a guide to the
storms that have been rocking the markets at home
Patrick Hosking, Banking and Finance Editor
I’ve been away for six weeks. Much been happening?
EXPLORE BANKING &
FINANCE
BANKING & FINANCE
You could say that. Financial markets have been in turmoil.
Central banks have had to extend emergency lines of credit to
cash-strapped banks. Hedge funds have collapsed. Institutions
have been bailed out using taxpayers money. Scores of planned
mergers and acquisitions have been cancelled. Normal service
in the City has, for the present, been abandoned.
Hold on a moment. When I left the country in mid-July, the
FTSE 100 was at 6,700 and things seemed reasonably rosy.
CONSTRUCTION &
PROPERTY
CONSUMER GOODS
ENGINEERING
HEALTH
INDUSTRIALS
LEISURE
MEDIA
You’ve missed a roller-coaster. From that high point for the year,
the index of blue chips slumped by as much as 12 per cent to a
nadir below 5,900 and, after huge spikes up and down, stands at
just over 6,200. That pattern was replicated in share markets
worldwide. But the real fear and loathing has been in the credit
markets.
The credit markets?
NATURAL RESOURCES
RETAILING
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TECHNOLOGY
TELECOMS
TRANSPORT
UTILITIES
The markets for corporate and packaged-up consumer debt.
There has been a sea-change in attitudes to risk. Investors in
bonds and many other forms of debt suddenly became much
more risk-averse. That translated into higher prices: they
demanded a much higher yield. But also into supply shortages:
many just wouldn’t lend at any price. Suddenly the entire banking
system, built on borrowing short-term and lending long-term,
looked precarious.
What brought this on?
Two words: American sub-prime. Investors came to a
shuddering realisation that much of the $300 billion (£150 billion)
in home loans to America’s poor and others with patchy credit
histories wasn’t going to be paid back. Enticed into home loans
with attractive “teaser” initial terms, many were unable to meet
monthly interest bills once the loans had reverted to normal
money market rates. The rising interest-rate environment added
to the pain. And falling house prices in the United States meant
that lenders were left nursing losses even when properties were
repossessed.
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Early in the year, HSBC sent the first tremors through the
financial markets when it wrote off £5 billion of these loans.
Since then a steady trickle of other sub-prime lenders and
brokers announced difficulties. In June, Bear Stearns revealed
that two of its hedge funds were in trouble because of
investments in securities backed by sub-prime mortgages – but it
wasn’t until mid-July that the full horror of the fallout became
apparent. It took a forecast from Ben Bernanke, Chairman of the
Federal Reserve, that $100 billion or more could be lost for the
unease to curdle into outright fear. A few days later another
consultancy predicted that banks would foreclose on 1.8 million
American home-owners this year.
8/31/2007 9:32 AM
While you were away - fear and loathing in the markets - Times Online
2 of 5
Collateralised Debt Obligations, Collateralised Loan Obligations.
At their most simple, these are packages of mortgages parcelled
up and sold on to pension funds, hedge funds, special
investment vehicls and other investors enticed by the promise of
a decent yield and – with hindsight – not concerned enough
about the credit-worthiness of the end borrower. Investors have
been just as likely to be German banks and French insurers as
US-based. Many UK banks, including HBOS, Lloyds TSB and
HSBC, have created special purpose vehicles investing in tens
of billions of dollars of them. And then there are jitters over
SIV-lites, too, similar special-purpose vehicles with the same
weakness – a reliance on constant replenishment of their coffers
by short-term lenders.
And the other reason?
The realisation by investors that they had misjudged the risk of
US sub-prime borrowers led to a wholesale rethink of other risks.
The conclusion was that risk had been mispriced in all kinds of
debt markets, in particular leveraged buyouts, or LBOs. Banks
happily lent money to LBOs confident that the loans could be
sold on or syndicated to other investors. When the mood swung
abruptly last month, banks were left holding huge amounts of
unsellable debt. In Britain the institutions that bankrolled the £9
billion sale of Alliance Boots, the high street chemist, have been
unable to sell on this debt.
http://business.timesonline.co.uk/tol/business/industry_sectors/banking_...
WORLD MARKETS
Europe
America
Asia
FTSE 100
FTSE 100
6,295.70
+1.35%
DAX
7,621.81
+1.35%
CAC 40
5,680.78
+1.58%
More market data
BANKING & FINANCE
Why were these sub-prime home loans made in the first
place?
A combination of sheer greed and a profound change over the
past few years in the way that banks do business. Bank
employees and mortgage brokers were paid and received
bonuses according to how much money was lent. The quality of
the borrower and their ability to meet interest payments was
regarded as secondary. Institutions that originated the loans
weren’t so bothered, either, because they held them on their own
balance sheets for only a few months before selling them on in
CDOs and CLOs.
So who, exactly, bought this stuff?
We don’t know yet, because the holders are anomymous. So far
the casualties range from hedge funds to sovereign states. And,
anyway, it is infinitely more complicated than that. More often
than not, the mortgages were sliced and diced. One CDO might
hold the riskiest portion of thousands of individual mortgages,
another might hold the safest portion. Moreover, many
institutions bought insurance policies against defaults – known
as credit default swaps – in the derivatives market. Identifying
who actually holds the “toxic waste” is almost impossible until
they admit to it themselves.
Bill Gross, managing director of Pimco, the huge bond investing
institution, likens it to the “ Where’s Wally?” puzzle books –
Where’s Waldo? in America – in which readers have to find the
cartoon character amid crowds of other people. The Waldos are
bad loans and defaulting sub-prime paper. “While market
analysts can guesstimate how many Waldos might actually show
their face over the next few years – $100 to 200 billion-worth is a
reasonable estimate – no one really knows where they are
hidden.”
So what happened next?
The machinery started to seize up. Banks were in a funk. There
was a mad dash for cash and the safest securities, such as UK
Government gilts and US Treasury bills. Loans were called in.
Margin calls were made. Even strong banks needing overnight
loans to balance the books suddenly found that none of their
peers was prepared to lend to them. That was when central
banks started to step in. Both the US Fed and the European
Central Bank have been making credit available to inject some
much-needed liquidity into the system. The Bank of England has
also made credit available, albeit at a punitive rate of interest.
Some of the biggest banks in the world, including Citigroup and
Barclays, have taken advantage of this credit. The impact has
been felt in many corners of the financial markets. Northern
Rock, the Tyneside-based bank, has been a particular casualty.
It relies on the wholesale money markets rather than small
savers to finance its mortgages. That source of finance has dried
up. Rock shares have fallen by around half from their highs at
the start of the year.
While you were away fear and loathing in
the markets
For those who've been
soaking up the sun on the
beach, a guide to the storms
that have been rocking the
markets at home
RICH LIST 2007
Britain's most wealthy
Find out who made it into the
club with the £70 million
entrance fee this year
THE
ANDREW DAVIDSON
INTERVIEW
Boss with the most
bottle
Diageo, the world's biggest
drinks company, is growing
fast in emerging markets - but
not fast enough for its chief
The carnage extended even into the currency markets as
MOST READ
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MOST CURIOUS
8/31/2007 9:32 AM
While you were away - fear and loathing in the markets - Times Online
3 of 5
investors scrambled to unwind their favourite bet – the yen carry
trade. By borrowing in Japanese yen at ultra-low interest rates,
converting the money into US dollars, Australian dollars, euros
and pounds and investing the money in higher-yielding
securities, it came to be seen as the perfect arbitrage. The only
possible risk was a bounce in the yen. Cue . . . a bounce in the
yen.
Ouch! Still, presumably all these hedge funds that promised
absolute returns regardless of lurches in any particular asset
class will have been safe from the carnage? Er, no. Some of the
biggest casualties of the market upheaval have been quantitative
hedge funds. These beasts, known as black-box investors,
simply trade according to preset computer programs designed to
be proof against anything the markets can throw at them. Global
Equity Opportunities, a $5 billion black-box fund managed by
Goldman Sachs, lost $1.3 billion in the space of a few days. Man
Group’s black-box investment fund AHL also posted big losses.
So have there been any winners?
Yes. Some hedge funds have made good money “shorting”
sub-prime securities and vulnerable-looking organisations –
betting that their prices would go lower. Traders who got in
ahead of the herd have done well as the flight to safety pushed
up prices of blue-chip government securities. Anyone loaded up
with cash is in a strong position to buy assets cheaply.
Insolvency firms and lawyers will do well dismantling and picking
over the corpses of failed investment vehicles. The lesson that
leverage is a two-edged sword has been usefully relearnt
without, so far, cataclysmic damage to the financial system.
http://business.timesonline.co.uk/tol/business/industry_sectors/banking_...
executive Paul Walsh
MEDIA
David Kershaw: The
death of advertising? I
totally disagree
The head of M&C Saatchi
says that losing the BA
account two years ago
galvanised the agency to work
even harder
CONSTRUCTION &
PROPERTY
How the sub-prime squeeze has spread
Hedge funds
Hedge funds have been at the centre of the credit market rout.
Investors on both sides of the Atlantic became alarmed in late
June when it emerged that Bear Stearns, the Wall Street bank,
planned to bail out two of its struggling credit hedge funds, both
heavily invested in American sub-prime mortgage assets.
Between them, the two funds had racked up about $1.5 billion of
losses after defaulting borrowers sent the value of
mortgage-backed securities sliding. Bear offered to take on $3.2
billion of liabilities, eventually extending a $1.6 billion line of
credit so that the funds could meet margin calls. Despite the
bailout, less than a month later Bear had to tell investors that
their assets were, in effect, worthless. One fund lost all its equity,
the other had investments worth just nine cents in the dollar.
Lords, lions & lolly
The Marquess of Bath is just
one member of the gentry
safeguarding his fortune
through the imaginative use of
a country estate
Fears of credit contagion spread. Hedge funds were exposed
and their investments lost value. In the last week of July, the
sector suffered its worst returns in four years. Inevitably,
individual firms suffered. Man Group’s closely watched AHL
Diversified Futures Fund fell 6.7 per cent that week. Over the
next ten days, GLG Partners’ $2.3 billion European equity fund
fell 4.4 per cent during the first ten days of August. Hedge funds
run by banks such as Goldman Sachs and UBS reported falling
asset values. Few trading strategies escaped unscathed. At the
same time, investors rushed to withdraw their hedge fund assets.
Bear Stearns had to cancel redemptions on its $850 million
Asset Backed Securities fund to prevent further withdrawals. The
good news for hedge funds is that they were able to switch
strategies quickly. The bad news is that the market still expects a
collapse. (Miles Costello)
Investment banks
The past six weeks have been agony for the banks – in the main,
American consumer banks – directly exposed to sub-prime
lending. And their pain is getting worse. Last week, First Magnus
Financial became the fourteenth lender since December to seek
bankruptcy protection and Countrywide Financial was forced to
tap a $11.5 billion (£5.7 billion) credit line after failing to raise
short-term debt. British banks have not escaped unscathed.
HSBC shocked investors in February when it set aside $10.6
billion to cover bad debts for 2006, 20 per cent more than
expected. Last week, HSBC shut its home loan office in Indiana,
cutting 600 jobs.
Others hit include banks with direct investments in CDOs or
structured investment vehicles (SIVs). Like other equity
investors, banks’ proprietary trading desks saw the value of their
assets fall as markets around the world plunged. Those with
in-house hedge funds have been damaged by both bad
BUSINESS EXTRAS
8/31/2007 9:32 AM
While you were away - fear and loathing in the markets - Times Online
4 of 5
http://business.timesonline.co.uk/tol/business/industry_sectors/banking_...
sub-prime investments and the subsequent fall in equities.
Goldman Sachs pumped $2 billion of its own cash into its Global
Equity Opportunity fund after the investor failed to cope with wild
market fluctuations. Two funds controlled by Bear Stearns went
bust and UBS is expected to book a $300 million loss on
troubles at Dillon Read Capital Management, its defunct hedge
fund business. The banks’ leveraged finance operations are
sitting on as much as $400 billion in unsyndicated, highly
leveraged lending. It is expected to take them months to parcel
out the loans and only after improving terms for investors at the
expense of their fees. (Christine Seib)
Stock markets
For music fans, August 16, 2007, was significant for being the
thirtieth anniversary of the death of Elvis Presley. For equity
investors, it will be remembered as the day on which the full
force of the summer’s sub-prime credit crunch was most keenly
felt. Unsettled by comments from Hank Paulson, the US
Treasury Secretary, that financial turmoil would “extract a
penalty” on US growth, stock markets worldwide lurched
simultaneously downwards, leaving the FTSE 100 more than
250 points lower: its biggest one-day percentage loss in more
than four years and its fourth-biggest points fall ever. In the
space of five weeks, the benchmark index dropped nearly 13 per
cent and that day alone saw £60 billion wiped from its value.
Every one of its constituents fell – even those, such as ICI,
where the backing of an agreed cash offer should have kept
them in check. Falling equity prices had created margin calls,
where investors who have borrowed cash against the value of
their equity portfolios were forced to sell equities to satisy their
lenders – serving only to drive down the value of their remaining
holdings and forcing them to sell again. This meant that the
shares that suffered most were those that had attracted the
heaviest weight of short-term money. Yet even supposed
“safe-haven” stocks suffered in the rout. With fund managers
seeking to take profits wherever they lay, that often meant the
selling of the more liquid stocks in their portfolios, in which it is
easier to deal. So it was that the likes of Tesco, down 16 per
cent from its peak, suffered even worse than the wider stock
market. (Nick Hasell)
Central banks
Central banks have been working overtime to restore
confidence, but their biggest challenge lies ahead: working out
whether to put aside moves for tighter policy and start cutting
rates. With banks refusing to lend to each other, the European
Central Bank (ECB) started to inject billions of euros of liquidity
into the market, lending directly to institutions to ease the
pressure on overnight lending rates. Despite the global turmoil,
the ECB has hinted that it may still press ahead with a
September rise in interest rates, to 4.25 per cent, clearly
signalled before the squeeze began. In contrast, the Bank of
Japan has already shelved a planned rate rise.
The US Federal Reserve has also been enhancing liquidity. On
August 17, it cut its discount rate for emergency bank lending
from 6.25 per cent to 5.75 per cent and extended the term of the
loans to 30 days. Yet stigma surrounds borrowing at the discount
window, which is priced above the Fed funds target rate, the
Fed’s main instrument of policy. The four biggest American
banks borrowed $2 billion last week from the discount window to
encourage others to do so. The Fed also indicated that it is now
more concerned about growth than inflation, a change of
position. Ben Bernanke, its Chairman, is under considerable
pressure to lower rates from 5.25 per cent. Analysts expect two
cuts by Christmas.
By contrast, the Bank of England has refused to cut its penalty
rate for direct lending to institutions and has taken no steps to
increase liquidity. However, the chances of rates going to 6 per
cent now look much fainter than they did a month ago. (Gabriel
Rozenberg)
Private equity
It was June and the masters of the universe were busy scooping
up public companies and taking them private on an almost daily
basis. They had multibillion-dollar funds to spend and the market
had never been so good – but little did they know that the party
was just about to end. News that thousands of cash-strapped
American families had started to default on their mortgages did
8/31/2007 9:32 AM
While you were away - fear and loathing in the markets - Times Online
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http://business.timesonline.co.uk/tol/business/industry_sectors/banking_...
not trigger panic immediately, but when two American hedge
funds went bust as a result, nerves started to fray. After all,
wasn’t it the same people who invested in the sub-prime
mortgage market in the United States who also bought up
private equity’s leveraged loans? It turns out it was. The result
was devastating. Overnight, the market for cheap credit totally
dried up and, with it, billions of dollars of deals were put on hold.
Yet it was the banks that felt the real pain. After years of frenzied
lending, their excesses came home to roost. JPMorgan,
Citigroup, Deutsche Bank, RBS and Barclays had aggressively
undercut each other to underwrite massive buyouts, including
the €13.5 billion acquisition of Alliance Boots and the €7.57
merger of Saga and the AA. As investors fled, so banks got
stuck with the debt on their books. More than €80 billion of
unsyndicated loans were left hanging in Europe and $280 billion
in the United States. Amid that backdrop, The Blackstone Group,
an American buyout firm, brought forward its initial public offering
(IPO), but the stock took a hammering and lost about 17 per cent
of its value. Kohlberg Kravis Roberts, its rival, put its IPO on hold
for fear that investors would snub it, too. (Siobhan Kennedy)
CONTACT US
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HAVE YOUR SAY
When I was starting my banking career more than 50 years ago,
there was a yardstick called the risk/reward ratio. It would appear
that today's decision takers are either dealing with financial
instuments that are so opaque that they cannot be properly
assessed or are guilty of mere greed driven by potential bonuses
(based on volume of business at the expense of quality).
It will be interesting to see whether many heads will roll or whether
bank charges will simply increase to cover losses.
Geoff Clayton, Marlow, UK
Very full, lucid account of the crisis, which, amazingly, appears
very poorly understood by the great majority of so-called
professionals, calling for rate cuts. Cheap money caused this crisis!
John Appleton, Ipswich, UK
Our Great Grandchildren will because we are the Great
Grandchildren of the Depression and here we are, at it again.
AK, Brighton,
Read all 13 comments
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8/31/2007 9:32 AM
Today's Markets - WSJ.com
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http://online.wsj.com/article_print/SB118890568283616740.html
September 4, 2007 11:57 a.m. EDT
TODAY'S MARKETS
Stocks Gain Ground After ISM
By ANNELENA LOBB
September 4, 2007 11:57 a.m.
Stocks moved higher on Tuesday after the release of data showing a slight
manufacturing slowdown in August.
The Dow Jones Industrial Average added 37.71 to 13395.45, after wavering
between positive and negative territory at the open, while the S&P 500 rose
9.97 to 1483.96. The Nasdaq Composite Index gained 27.74, or 1.1%, to
2624.10.
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The Institute for Supply Management's manufacturing survey for August slid to a reading of 52.9, from
53.8 in July. Any reading above 50 indicates expansion.
Wall Street cheered the numbers because they supported the case for a fed-funds rate cut -- without
coming across as evidence of an economy in rapid decline. For the past couple of weeks, market
participants have pushed for the Fed to cut its target for the federal-funds rate, a key overnight bank
lending rate, now at 5.25%.
The ISM report's prices index moved to 63.0 in August from 65.0 in July. "If pricing went down, the Fed
has more wiggle room -- it ratifies the data we got last week that showed inflation seemed to be
receding," says Jim Awad, of W.P. Asset Management. Inflation has long been cited as the main barrier
to a rate cut and the Fed's main concern.
MARKETS ON THE MOVE
1
2
Track indexes and hot stocks , with
roll over charting and headlines. Plus,
comprehensive coverage of bonds,
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MARKET WRAP
• European Shares Are Slightly Higher10
• Asian Markets Close Lower11
Stocks gained sharply on Friday after Fed Chairman Ben
Bernanke12 said the central bank wouldn't rely as much as
usual on economic data in determining rate policy and as the
Bush administration announced a plan to offer more federal
insurance to stem an expected wave of mortgage defaults.
"The view appears to be that the Fed cannot afford not to cut
rates, given that markets are clearly looking to it to do so -- the
7% bounce in U.S. equities over the past three weeks, for
example, must owe something to the prospect of the Fed
cutting rates," said Michael Crowley, an analyst for Bank of
Ireland Global Markets. He expects a half-point rate cut at its
next meeting and another quarter-point cut by year's end.
In the housing sector, lender Countrywide Financial and home builder Lennar both slipped in morning
trade. NovaStar Financial dove, falling 17.6% to $7, after announcing more restructuring, including job
cuts, tighter lending, and the cancellation of a $101.2 million sale of convertible preferred stock. But
9/4/2007 1:17 PM
Today's Markets - WSJ.com
2 of 3
http://online.wsj.com/article_print/SB118890568283616740.html
Thornburg Mortgage added 4.3% to $12.29, after news that it completed a securitization of $1.44
billion in prime hybrid adjustable-rate mortgage loans.
Among other stocks to watch, CBS inched up after an announcement that its quarterly dividend would
increase 14%, to 25 cents a share from 22 cents. The board also approved a $1.6 billion stock buyback
plan.
Auto makers will be reporting U.S. sales for August throughout the day. Analysts are expecting the
lowest levels of sales since a strike at General Motors nearly a decade ago. (See related article13.)
U.S.-listed shares of Deutsche Bank rose 3.2% to $127.92 after Chief Executive Josef Ackermann said
recent market turmoil had hit the bank's mark-to-market valuations, but that the bank hasn't suffered
problems with funding availability. His remarks helped European stocks reverse early losses, with the
German DAX 30 up 0.1%. The Nikkei 225 lost 0.6% in Tokyo. Peers including Goldman Sachs,
Morgan Stanley, Lehman Brothers and J.P. Morgan Chase all posted gains.
Shares of Local.com rose 7.9% to $6.40 after the search-engine operator renewed a multiyear marketing
distribution agreement with Yahoo. Yahoo rose 5.5% to $23.99.
MEMC Electronic Materials fell 3.6% to $59.19 after the company said it expects third-quarter revenue
to come in about 5% below its previous forecast of $500 million and sees margins roughly flat
sequentially.
Crude-oil futures added 72 cents to $74.76 a barrel. Investors are concentrating on the damage that
Hurricane Felix produces -- and whether it will affect production out of the Gulf of Mexico.
In major market action:
Stocks advanced. On the New York Stock Exchange Tuesday, 2,056 stocks rose and 1,105 declined, on
volume of 447.2 million shares traded in stocks listed on the exchange.
Bonds fell. The benchmark 10-year note fell 10/32, or $3.125 for every $1,000 invested, yielding 4.568%
Tuesday. The 30-year bond was down 13/32 to yield 4.854%.
The dollar strengthened. The dollar was at 116.32 yen from 115.89 yen late Monday. The euro traded at
$1.3606 from $1.3626 late Monday.
Write to Annelena Lobb at annelena.lobb@wsj.com14
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9/4/2007 1:17 PM
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9/4/2007 1:17 PM
Why Libor Defies Gravity - WSJ.com
1 of 4
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September 5, 2007
CREDIT MARKETS
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Why Libor Defies Gravity
Divergence of a Key Global Rate Points to Strain
By IAN MCDONALD and ALISTAIR MACDONALD
September 5, 2007; Page C1
The Federal Reserve could cut short-term interest rates in the weeks ahead,
but right now one key rate is going in exactly the opposite direction,
something that could have a big impact on markets and the economy.
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That rate is the London interbank offered rate, or Libor. It is an important
benchmark for everything from adjustable-rate mortgages in the U.S. to giant floating-rate bank loans
taken out by global corporations.
Credit-market turmoil has pushed the Libor higher, even as other short-term interest rates, such as the
interest rate on Treasury bills, are falling.
"Higher Libor rates affect the whole economy by tightening the budgets of borrowers large and small,"
says Lou Crandall, chief economist with Wrightson ICAP in New York. " It hurts corporate profits and
tightens household budgets, too."
The disjointed movement in Libor and other short-term interest rates underscores the turmoil that persists
in money markets more than two weeks after central banks in the U.S., Europe and Asia sought to settle
short-term lending by injecting massive amounts of cash into the global financial system. (How small
investors are easing back into bonds. See related article1.)
2
DEBT DILEMMAS
• See complete coverage3 of the troubles
in the credit markets.
It also shows how financial trouble now ricochets around the
world. Many European banks have been stung by exposure to
U.S. subprime mortgages; some U.S. borrowers, in turn, could
get stung by upward pressure on Libor rates set in Europe.
Libor is an interest rate charged by banks for short-term loans to each other. It is set daily by a bank trade
association in London. The loans can be in U.S. dollars, euros, British pounds or other currencies.
U.S.-dollar Libor rates usually closely track the federal-funds rate, which is the overnight lending rate
managed by the Federal Reserve. But the two rates are now parting ways, complicating matters for the
Fed as it tries to manage the global credit crisis and pushing up many short-term interest rates for
borrowers.
For the first eight months of this year, the U.S.-dollar Libor rate for three-month loans between banks
nudged between 5.34% and 5.36%. Yesterday, the rate hit 5.7%, marking the rate's fastest rise in several
years. The Libor hasn't been this far above the base short-term rates set by central banks since the Enron
and WorldCom collapses in 2001, according to the British Bankers' Association, which sets the rate.
9/5/2007 9:54 AM
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One reason the Libor is trading so high: Banks, many of them in Europe, have heavy commitments tied
to struggling commercial-paper markets. They are reluctant to lend out dollars, and that is driving up
short-term borrowing rates. Some are also worried that their counterparties in these trades, other banks,
might be too weak to pay back the loans.
The Libor could well settle in the weeks ahead, limiting the impact
of the recent moves. Moreover, the impact is muted because other
short-term interest rates, such as the interest rate on Treasurys, are
falling. Treasurys are also used as a benchmark for many forms of
borrowing. But if Libor rates don't settle down, it could have a large
impact.
When Chrysler and its finance unit borrowed $20 billion from banks
in July as part of the auto maker's acquisition by Cerberus Capital
Management, its loans were indexed to Libor interest rates. That
means its interest costs go up and down as the Libor rises and falls,
though some of the exposure could be hedged.
Lou Barnes, partner of Boulder West Financial Services, a Colorado
mortgage bank, has three Libor-linked mortgages of his own, valued
at more than $800,000 in all. Because his own loans don't reset for
several years, he isn't worried about being hit. But he says he does worry that many other U.S. consumers
have fortunes tied to this interest rate that few understand.
"They don't know how to pronounce it. They don't know what it means," Mr. Barnes says.
According to HSH Associates, a New Jersey mortgage-information company, the interest rate on a
three-year adjustable-rate mortgage taken out in 2004 and tied to the Libor could be more than a
half-percentage point higher than a similar mortgage tied to U.S. Treasurys, whose yields have been
falling. On a $200,000 mortgage, that is a difference of about $1,000 a year in interest payments, though
many adjustable-rate mortgages include caps that limit how much interest payments can go up in any
single year, softening the pain.
A host of credit derivatives are also pegged to the Libor, as are many short-term commercial-paper loans
used by banks -- $3 trillion globally. Financial contracts with values of about $150 trillion are indexed to
the Libor, according to a paper published in May last year by Donald MacKenzie, a sociology professor
at the University of Edinburgh.
"There is no two ways about it, this is bad news for economic growth and for confidence in the financial
system," said Teun Draaisma, head of European equity strategy at Morgan Stanley.
The Libor became popular because in the 1980s the world needed a short-term rate on which to
benchmark the costs for loans between banks. At the time, the interest rates banks charged other banks
and big companies lacked a universally accepted basis. British bankers' stab at one took hold faster than
others, and it is now a benchmark for many globally traded debt securities.
--Cynthia Koons and Jon E. Hilsenrath contributed to this article.
Treasury Prices Decline; 10-Year Yield at 4.558%
Treasury-bond prices gave up most of their early gains yesterday, with longer-dated notes finishing
lower, amid gains in stocks as data on manufacturing activity and auto sales last month beat expectations.
9/5/2007 9:54 AM
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The benchmark 10-year note fell 3/32 point, or $0.9375 per $1,000 face value, to 101 17/32. Bond
markets were closed Monday for Labor Day. Its yield rose to 4.558% from 4.547% Friday, as yields
move inversely to prices. The two-year note was up 1/32 point to yield 4.14%, while the bond equivalent
yield on the three-month Treasury bill rose to 4.568%.
In the absence of anything alarming in the most up-to-date economic reports, investors remain driven by
the mood elsewhere in financial markets, said Scott Gewirtz, head of Treasury trading at Lehman
Brothers in New York. "The market is thin, and people are trying to trawl through a lot of information, so
they're taking their cue" from stocks, he said.
--Emily Barrett
Commercial Paper Hits a Volume Record
Daily issuance volumes of asset-backed commercial paper hit a new high in the week to Friday,
according to Federal Reserve data, a sign that the rush to sell ever-shorter-term-maturity debt amid the
current credit crisis has yet to diminish.
In the week to Friday, asset-backed commercial paper averaged a daily $90.6 billion, up from $88.6
billion the prior week. By comparison, average daily issuance last year was $51.2 billion.
More than three-quarters of last week's issuance matures in one to four days, and only $938 million was
issued in the 81-plus-days category. Last week's numbers were the highest since the Fed started keeping
records on commercial paper in 2000.
The rise in very short-term paper is a direct result of the current credit crunch, as investors have become
reluctant to lend for longer periods because of concerns over issuers' exposure to the U.S. mortgage
market.
The asset-backed commercial-paper market has been widely used to fund purchases of higher-yielding,
longer-term mortgage products.
As a result, there is a pileup in commercial paper that matures over a short period.
The most recent Fed data on this show that as of Aug. 24, there was $936 billion in commercial paper
coming due by Sept. 14. There was also $509 billion in asset-backed commercial paper due by that date.
--Laurence Norman
Write to Ian McDonald at ian.mcdonald@wsj.com4 and Alistair MacDonald at
alistair.macdonald@wsj.com5
URL for this article:
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(4) mailto:ian.mcdonald@wsj.com
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9/5/2007 9:54 AM
Steel Says Uncertainty Has Spread Beyond Subprime-Mortgage Sector ...
1 of 3
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September 5, 2007 11:47 a.m. EDT
Steel Says Uncertainty Has Spread
Beyond Subprime-Mortgage Sector
By DAMIAN PALETTA
September 5, 2007 11:47 a.m.
WASHINGTON -- Uncertainty in how credit markets appraise risk has
spread from the isolated subprime mortgage sector into much broader
segments of the economy, such as securitized products and buy-out
transactions, Treasury Department Under Secretary for Domestic Finance
Robert K. Steel said Wednesday.
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"Valuation became extremely difficult as a no-bid environment seized certain segments of the market,"
Mr. Steel said in testimony to the House Financial Services Committee, according to prepared marks.
"This reappraisal has spread across the credit market spectrum, first affecting residential-mortgage
backed securities and then spreading to other asset classes and, particularly, securitized products."
Mr. Steel called the risk reappraisal "normal" and said it "typically follows periods of widely available
credit when markets have undervalued risk."
This summer, credit markets froze in certain sectors as concerns grew about credit performance,
exacerbated by growing problems in the performance of both subprime- and jumbo-mortgage products.
Several large lenders scrambled to find liquidity. Federal Reserve, White House and Treasury
Department officials have worked to calm the jittery markets with limited impact.
"I do want to caution policy-makers that this process is far from over," Mr. Steel said. "It will take more
time to play out and certain segments of the capital markets are stressed."
Mr. Steel's appearance at Wednesday's hearing, alongside federal bank and securities officials, marked
the first Congressional hearing on the matter since Congress returned from its August recess. He said the
"ultimate impact of these events on the economy has yet to play out."
Erik Sirri, director of market regulation at the Securities and Exchange Commission, said questions about
credit and risk appraisal have had a broad impact on a wide range of participants.
"As liquidity for structured products diminished, market participants needing to raise funds to meet
margin calls and investor redemptions sold less complex financial instruments such as equities and
municipal securities, placing downward pressure on prices in those markets," Mr. Sirri said. "Overall,
these dynamics have significantly impacted a wide range of market participants, from individual
investors to systemically important financial institutions."
Mr. Steel, Federal Deposit Insurance Corp. Chairman Sheila Bair and Comptroller of the Currency John
Dugan all said weakened underwriting standards fueled problems in mortgage markets as liquidity
prompted lenders to develop new products.
9/5/2007 12:11 PM
Steel Says Uncertainty Has Spread Beyond Subprime-Mortgage Sector ...
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"To satisfy...demand and their excess capacity, some mortgage originators relaxed their underwriting
standards, lending to individuals with a lower standard of documentation and selling mortgage products,
which for some borrowers would become unaffordable," Mr. Steel said.
Mr. Dugan, whose agency supervises national banks, said the most severe credit market issues have
occurred outside of the commercial banking sector.
"The national banking system remains safe and sound," he said.
Mr. Dugan also said that the current strain on the banking system could end up having a positive impact
as the industry reprices and reevaluates risk.
"While recent market conditions have certainly been painful, and may continue to be so for some time,
we believe they are likely to cause some positive changes in the longer term as markets reevaluate and
re-price risk," he said.
Ms. Bair said the uneven mortgage industry standards created a dangerous backdrop that is now having a
widespread impact.
The mortgage industry is overseen by a patchwork of state and federal regulators, which some Democrats
in Congress are trying to overhaul this year.
"Failure to uphold uniform high standards in these areas across our increasingly diverse mortgage lending
industry has resulted in serious adverse consequences for consumers, lenders, and, potentially, the U.S.
economy," Ms. Bair said. She said credit concerns have now extended to leveraged commercial lending.
Mr. Steel said Treasury officials shared the Fed's view that "recent market developments pose downside
risks to economic growth." Still, he said the "underlying strength of the economy" should fuel further
growth.
He said the President's Working Group on Financial Markets planned to study the broad market issues
related to recent market events, including the roles of securitization and the credit rating agencies.
Mr. Steel said the U.S. Department of Housing and Urban Development planned to propose new
settlement procedures this fall, a process that the agency has long struggled to finalize because of harsh
turf battles between different industries involved in the mortgage closing process.
Mr. Sirri said issues in the subprime and credit markets have prompted the SEC to begin a review of the
credit rating agencies services, potential conflicts of interests, disclosures, and rating performance,
among other things.
Write to Damian Paletta at damian.paletta@dowjones.com1
URL for this article:
http://online.wsj.com/article/SB118900451928218127.html
Hyperlinks in this Article:
(1) mailto:damian.paletta@dowjones.com
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9/5/2007 12:11 PM
Beige Book Sees Little Impact Of Market Distress on Economy - WSJ.com
1 of 2
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September 5, 2007 2:43 p.m. EDT
Beige Book Sees Little Impact
Of Market Distress on Economy
By BRIAN BLACKSTONE
September 5, 2007 2:43 p.m.
WASHINGTON -- Though recent distress in financial markets has
"deepened" the housing slump, the overall economy has seen little impact
so far, the U.S. Federal Reserve said Wednesday.
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REAL TIME ECONOMICS
1
• Read the latest news and analysis
on the economy at WSJ.com's Real
Time Economics blog.2
That assessment, contained in the latest beige book, suggests
that while a rate cut in two weeks may still be likely, officials
may not see the same need for aggressive easing that financial
markets expect.
"Outside of real estate, reports that the turmoil in financial
markets had affected economic activity during the survey period were limited," according to the beige
book -- a summary of economic activity prepared for the Sept. 18 Federal Open Market Committee
meeting. The survey period ended Aug. 27. (Read the full report.3)
The Fed is widely expected to lower the federal-funds rate for the first time in more than four years at
this month's meeting, by a quarter percentage point to 5%. Last month, it cut the discount rate it charges
banks that borrow directly from the Fed by 50 basis points to 5.75%.
But what happens after this month remains a question mark. Financial markets expect one percentage
point in fed-funds rate cuts by year end, and prominent economists including Harvard Professor Martin
Feldstein have argued for that type of aggressive response to the housing slump.
Tighter lending standards as a result of financial strains were "having a noticeable effect on housing
activity," which "added to uncertainty about when the housing market might turn around," according to
the beige book, which was prepared by the Cleveland Fed.
Most Fed banks report sales activity and prices as either flat or falling.
Still, "a number [of district Fed banks] commented that credit availability and credit quality remained
good for most consumer and business borrowers," the Fed said, and commercial real estate "was
generally stable to expanding."
The beige book isn't usually considered among the highest tier of economic indicators. But it has taken
on heightened importance after Fed Chairman Ben Bernanke's speech in Jackson Hole, Wyo., on Friday
in which he said, "we will pay particularly close attention to the timeliest indicators, as well as
information gleaned from our business and banking contacts."
9/5/2007 3:48 PM
Beige Book Sees Little Impact Of Market Distress on Economy - WSJ.com
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Other economic numbers that probably fall in the "timeliest" category do suggest downside economic
risks have intensified somewhat.
The National Association of Realtors' pending home sales index, a leading indicator of sales, plunged
12.2% in July. Meanwhile, jobless claims have risen in recent weeks, and a report Wednesday from
Automatic Data Processing Inc. and Macroeconomic Advisers estimated that only 38,000 private-sector
jobs were created last month.
Other reports on manufacturing sentiment and automobile sales for August suggest, however, that there is
some measure of support for the economy despite the housing slump, so it doesn't appear to be headed
toward recession.
According to the beige book, consumer spending saw "modest to moderate increases," while automobile
sales were "slow or subdued" in most regions.
Most Fed district banks reported "at least modest" gains in employment, the beige book said, while wage
increases remained "moderate or steady." There was "little change" in overall price pressures, the Fed
said.
Write to Brian Blackstone at brian.blackstone@dowjones.com4
URL for this article:
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Hyperlinks in this Article:
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(4) mailto:brian.blackstone@dowjones.com
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9/5/2007 3:48 PM
In Tight Market, Banks Woo Buyers For Commercial Paper - WSJ.com
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September 10, 2007
In Tight Market,
Banks Woo Buyers
For Commercial Paper
DOW JONES REPRINTS
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LONDON -- It is crunch time for many of the world's biggest banks
grappling with one of the tightest credit markets of recent memory.
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By CARRICK MOLLENKAMP
About $120 billion of commercial paper outside the U.S. is due for renewal
in the next week, including $56.5 billion of asset-backed paper, which has met the stiffest resistance from
investors. Issuers need to find buyers in order to roll over these short-term funding mechanisms or pay
off the loans. So banks and other issuers are pulling out all stops to lure investors back. In the meantime,
they are using short-term moves to raise cash to keep them going.
While there is little sign the market is opening up, a few rays of hope are emerging. In Australia, the
central bank has broadened the definition of assets it would accept as collateral for short-term funding it
supplies to domestic banks. In the U.S., money-market funds haven't suffered big redemptions and thus
still have money to put to work. Investors in these funds also are willing to hold commercial paper for
slightly longer time frames, suggesting some stability may be returning, though the funds may find their
investors want a limited diet of short-term paper.
It is a crucial time. Volume in this market tends to ramp up midmonth, and September is shaping up to be
a busy time. In mid-August, $100 billion in euro commercial paper matured, according to Lehman
Brothers Holdings Inc. and research firm Dealogic.
Adding to the challenge, commercial-paper sellers increasingly are turning to shorter maturities, adding
to the amount of debt to be rolled over on a daily or weekly basis and to the frequency of issuers
returning to the market.
Commercial paper is a $3 trillion market of loans issued to raise money for short periods of time.
Asset-backed commercial paper is a large and growing segment of this market, used by banks, hedge
funds and other financial institutions to raise money to fund various investments. Billions of dollars of
these asset-backed loans have been tainted because some proceeds were used to buy investments tied to
U.S. subprime mortgages.
Because of limited investor demand, the U.S. and euro commercial-paper markets have been shrinking in
terms of outstanding debt. The asset-backed commercial-paper market shrank by $195 billion from July
to $980 billion at the end of August, according to Federal Reserve data.
Here is how commercial-paper issuers are stepping up efforts to woo money-market investors or find
other funding:
9/10/2007 11:56 AM
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Bank affiliates, known as conduits and structured investment vehicles, as well as independent paper
issuers managed by money managers are seeking to calm investor unease by disclosing an unusual level
of information about their holdings, especially their exposure to subprime loan assets.
Structured investment vehicles, known as SIVs, are in talks with banks to borrow against their own assets
to obtain funding pacts known as repurchase agreements. These so-called repo pacts could help pay
maturing paper and avoid fire sales of their assets, which include securities tied to U.S. mortgage loans.
Many commercial-paper sellers also have been reducing their issuance and choosing to sell assets to raise
money.
Sellers that are coming to market are paying higher yields -- in the range of 0.5 percentage point more
than the London interbank offered rate. That in turn is helping drive up interest rates broadly, as Libor is
benchmark for many other kinds of short-term lending.
In Europe, bankers recently met with the European Central Bank to discuss the possibility of more cash
injections into the financial system.
Banks that may be forced to assume assets from the conduits that have financing coming due could
themselves face shortages of capital.
To head off such a problem, Australia's central bank, the Reserve Bank of Australia, has relaxed rules on
collateral it will accept for short-term funding. This would enable banks to take more time to evaluate
which portions of the asset-backed commercial-paper market are most affected by ailing subprime
mortgages.
In doing so the Australians went beyond the Federal Reserve, which doesn't accept such paper as
collateral in repo operations but did recently clarify it was willing to accept a wide variety of such paper
for its lesser-used, and costlier, "discount window" loans to banks.
The Reserve Bank of Australia changes will begin Sept. 17 and in October will include residential
mortgage-backed securities and Australian dollar-denominated asset-backed commercial paper. Bond
yields fell sharply on the news.
London is a global hub for trading the bulk of the $800 billion euro commercial-paper market for 68
countries outside the U.S. "There is so much paper out there," said Neil Hamilton, a lawyer with London
law firm Clifford Chance, which hosted a debt conference in London Thursday and Friday.
One big concern is SIVs set up by banks and other money managers. These affiliates deal heavily in
commercial paper, but their operations often are counted off bank balance sheets. If they can't sell
commercial paper to pay off securities coming due, many may be forced to sell assets to finance their
operations.
"It's going to be difficult for SIVs, especially the nonbank-sponsored SIVs," said Manfred Exenberger, a
managing director at Omicron Investment Management in Vienna. Banks "will have to take the assets on
balance sheet."
Over the next two weeks, trade groups for the securitization industry plan meetings and conference calls
to discuss how to respond to the shutdown of certain parts of the debt markets.
In the end, investors may not wade back into the market until October and November, when big banks
such as Citigroup Inc., Deutsche Bank AG, and Barclays PLC, all major players in the debt markets,
report financial results and provide even more details about their subprime exposure and what is actually
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on their balance sheets.
--Jason Singer contributed to this article.
Write to Carrick Mollenkamp at carrick.mollenkamp@wsj.com1
URL for this article:
http://online.wsj.com/article/SB118938229857522044.html
Hyperlinks in this Article:
(1) mailto:carrick.mollenkamp@wsj.com
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9/10/2007 11:56 AM
Data Suggest Stress Easing In Commercial-Paper Market - WSJ.com
1 of 2
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September 13, 2007 11:28 a.m. EDT
Data Suggest Stress Easing
In Commercial-Paper Market
Outstanding Paper Falls $8.2 Billion
By ANUSHA SHRIVASTAVA
September 13, 2007 11:28 a.m.
NEW YORK -- The outstanding level of U.S. commercial paper fell by a
much smaller amount this week compared with the previous four weeks,
signaling that the stress in the short-term borrowing markets could be
easing.
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The asset-backed commercial paper segment accounted for the entire decline this week. If that part of the
market were stripped out, the outstanding level would have increased, according to data released
Thursday by the Federal Reserve.
The total outstanding amount of commercial paper fell $8.2 billion on a seasonally adjusted basis -- the
smallest decline since the current credit crunch began a month ago -- to $1.917 trillion in the week ended
Wednesday, according to the Fed. Last week, the decline was $54.1 billion. At the height of the credit
crunch the weekly declines were slightly more than $90 billion.
Asset-backed commercial paper outstanding declined $21.6 billion to $945.1 billion in the week ended
Wednesday. Last week, the decline was $31.3 billion.
The commercial paper market is where companies commonly fund their short-term capital needs.
Investors have been shifting funds out of the asset-backed CP sector over the last month due to fears that
this part of the market had been infected by problem subprime loans.
The smaller shrinkage in outstanding volume this week suggests that the commercial paper market is
"stabilizing," said Tony Crescenzi, market strategist at Miller Tabak & Co. "The decline is far smaller
than the roughly $70 billion in weekly declines seen over the previous four weeks."
Domestic non-financial firms issued a net $2.2 billion in commercial paper, the first increase in two
weeks. Foreign financial firms issued another $13.9 billion commercial paper after issuing $3.1 billion
last week.
"We are not saying that the crisis is passed," said Marc Chandler, currency strategist at Brown Brothers
Harriman in a note to clients. Rather, this CP report points to "some relaxation of tensions," aided by the
"firmer tone in equities, the easing of volatility in the equity market and the Japanese yen," as well as the
easing of some money market rates such as the 20 basis point drop in asset-backed CP rates.
The somewhat looser conditions in the commercial paper market could also help bring down what has
become an elevated London interbank offered rate -- a benchmark short-term rate that banks charge each
other and that debt such as company loans and asset-backed securities are valued against.
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"If issuers are having an easier time obtaining funding in the commercial paper markets, they won't have
to depend upon bank credit for funds," said Mr. Crescenzi. "With funding pressures on banks reduced,
Libor will fall, because banks won't need to borrow as much money from each other as before in order to
fund their lending operations."
On Thursday, three-month Libor stood at 5.694%, down only slightly from the 5.70% on Wednesday.
Before the credit crisis, Libor stood at 5.36% for much of the year.
For Libor to fall significantly, the commercial paper market to needs to remain stable for many weeks,
said Mr. Crescenzi.
To be sure, the data released Thursday only represents one week, leading analysts to be cautious about
calling the end of a credit crunch that has caused some, such as the nation's largest home lender
Countrywide Financial Corp., to scramble to find funds elsewhere.
But the numbers do suggest that the panic seen last month is behind financial markets.
"While some of this may be a function of expectations of a decisive move by the Fed next week," Mr.
Chandler wrote, "it may also be partly a reflection of simply improved sentiment and suspicions that the
blowout was excessive."
The Federal Reserve's policy makers meet next Tuesday to decide on interest rates. Market participants
expect the central bank to cut the fed funds target rate by at least a quarter-percentage point.
Write to Anusha Shrivastava at anusha.shrivastava@dowjones.com1
URL for this article:
http://online.wsj.com/article/SB118969431668226418.html
Hyperlinks in this Article:
(1) mailto:anusha.shrivastava@dowjones.com
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9/14/2007 12:35 PM
Latest Cash Infusion May Calm Europe's Banks - WSJ.com
1 of 2
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September 13, 2007
Latest Cash Infusion May Calm Europe's
Banks
By JOELLEN PERRY in Frankfurt and CARRICK MOLLENKAMP in London
September 13, 2007; Page A2
With European banks stockpiling cash and wary of lending to each other
for periods longer than a week, the European Central Bank pumped €75
billion, or about $104 billion, in three-month credit into money markets
yesterday in another effort to bring dealings back to normal.
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The extra longer-term funding, the second such maneuver in nearly three weeks, was in addition to the
ECB's routine injections of three-month funds and contrasted with the shorter-term funds the ECB has
also been providing to the market.
The operation was exactly what European commercial banks say they have been seeking in discussions
with the ECB over the past week or so. Like most central banks, the ECB is in constant contact with
commercial banks.
Still, three-month euro interbank offered interest rates continue hovering around 4.75%, their highest
levels since May 2001 and well above the ECB's target lending rate for overnight funds of 4%. Usually,
the gap is smaller.
The tensions in European money markets reflect a confluence of forces. One is
concern among European banks that other banks still have undisclosed exposure
to the U.S. subprime-mortgage market. Another is the eagerness of European
banks to hoard cash for various reasons.
ECB policy makers have been laboring to help unnerved money markets function
normally. ECB President Jean-Claude Trichet last Thursday said the bank would
make additional three-month money available, just as it did on Aug. 23 when it
injected an extra €40 billion. But the ECB didn't indicate an amount until it acted
yesterday.
The ECB's action comes at a crucial time. Corporate IOUs called commercial
paper have been central to the credit turmoil. Some $139 billion in euro
commercial paper started maturing earlier this week and will continue to do so in coming days, so banks
have been scrambling for cash and pushing up rates in the interbank-lending market. Banks told the ECB
that three-month funds would enable them to put the money to use for a longer period of time, according
to a person familiar with the situation.
Commercial-paper traders believe it will be another four to six weeks before investors reappear at full
strength. But there already are some signs of a modest recovery. Yesterday, $24.85 billion of euro
commercial paper was issued, more than offsetting the $21 billion that matured. There also are
9/14/2007 12:27 PM
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indications that money-market investors have forsaken some overnight deposits for higher-yielding
one-month and three-month paper.
Adding to the crunch, banks have been stockpiling cash to cover financial backstops required by affiliates
known as conduits that haven't been able to renew maturing commercial paper. These conduits typically
issue short-term commercial paper to buy higher-yielding, longer-maturing assets such as securities
backed by U.S. mortgages. Another factor sapping cash are moves by banks to step in and pay off large
chunks of the maturing commercial paper issued by their affiliates.
Many believe the ECB's ability to resolve the fundamental distrust infecting European markets is limited.
The perception, right or not, is that the finances of European banks are less sound than those of their U.S.
counterparts and that the unregulated European vehicles affiliated with banks that have undisclosed
exposure to U.S. subprime mortgages are less well-managed than those in the U.S.
Many of the complex securities at the heart of the current crisis aren't traded on exchanges. That makes
them difficult to value and -- policy makers say -- is helping spur a broader-based risk aversion.
Some banks have begun giving some indications of the impact the credit turmoil has had on business.
Deutsche Bank AG last week said it affected its leveraged-loan business, but said the bank isn't likely to
take further hits from the U.S. subprime market.
--Ragnhild Kjetland in Frankfurt and Mark Brown in London contributed to this article.
Write to Joellen Perry at joellen.perry@wsj.com1 and Carrick Mollenkamp at
carrick.mollenkamp@wsj.com2
URL for this article:
http://online.wsj.com/article/SB118959708398625021.html
Hyperlinks in this Article:
(1) mailto:joellen.perry@wsj.com
(2) mailto:carrick.mollenkamp@wsj.com
Copyright 2007 Dow Jones & Company, Inc. All Rights Reserved
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9/14/2007 12:27 PM
The Greenspan Myth - WSJ.com
1 of 3
http://online.wsj.com/article_print/SB118964506628925912.html
September 13, 2007
COMMENTARY
The Greenspan Myth
By DONALD L. LUSKIN
September 13, 2007; Page A17
"What would the Maestro do?" As nervous markets hang on every word of
Federal Reserve Chairman Ben Bernanke, trying to divine whether he will
lower interest rates in response to the current turmoil in credit markets,
comparisons to his illustrious predecessor Alan Greenspan are inevitable.
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Such comparisons can also be invidious, and
shouldn't influence what Mr. Bernanke does now.
Mr. Greenspan is fondly remembered for his role in stewarding markets through
the stock crash of 1987, the Long Term Capital Management crisis of 1998, the
collapse of the tech bubble in early 2001, and the aftermath of the terrorist
attacks of September 2001. Today he enjoys a reputation for having moved
swiftly and decisively -- "pre-emptively" it is often said now -- to help the
markets out of those crises.
But the truth is quite different. Mr. Greenspan is fortunate indeed to be
remembered as such a decisive leader, because in fact his reactions to some of
those crises were quite tardy, and were seen by most market participants at the
time as being too little, too late.
Former Federal Reserve
Chairman Alan Greenspan.
Let's look at the Long Term Capital Management crisis of 1998, an event in
many ways analogous to today's situation. Then the markets were thrown into
turmoil by emerging market currency devaluations and Russia's default on its sovereign debt, much as
markets have recently been rocked by defaults in subprime mortgages. As a consequence, then as now,
the solvency of hedge funds and the investment banks that sponsored them were threatened.
By the time LTCM had collapsed -- and had to be bailed out by a private consortium of banks brought
together by the New York Fed's William McDonough, not Mr. Greenspan -- the S&P 500 had already
fallen by almost 20%, and staged a modest recovery from there. Mr. Greenspan had done precisely
nothing with interest rates.
The Federal Open Market Committee made a 25 basis-point rate cut the day after the LTCM bailout was
announced in late September. Markets were not impressed. Credit markets remained frozen much as they
have been in the current crisis, and stocks fell to new lows over the first 10 days of October.
Laurence Meyer, a Federal Reserve Board governor at the time, recalls in his 2004 book, "A Term at the
Fed," that "Rather than calming the markets, the small size of the rate cut raised doubts that the Fed
appreciated the severity of the problem . . . Greenspan was now under attack."
In mid-October, Mr. Greenspan cut rates another 25 basis points in a surprise inter-meeting move.
9/20/2007 9:24 AM
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According to Bob Woodward in his Greenspan biography "Maestro," Mr. Greenspan was reluctant to
make that move but was pressured by Mr. McDonough and then Fed Vice Chairman Alice Rivlin.
By the end of 1998 there was another 25 basis-point cut at a regular FOMC meeting, the market turmoil
passed and Mr. Greenspan ended up on the cover of Time as chairman of the "Committee to Save the
World." That's how he's remembered today.
Mr. Greenspan is also remembered for cutting interest rates aggressively as the tech bubble burst in early
2001, starting on Jan. 3 with a surprise inter-meeting cut of 50 basis points. In his book, Mr. Meyer
writes that Mr. Greenspan "had decided that the Fed should be seen making a deliberately anticipatory
move -- one that would not be viewed as a late response to a rapidly deteriorating situation."
Alan Greenspan got his wish in terms of how history would remember him, but the reality is that the
economy had already rolled over. By the time Mr. Greenspan made his "anticipatory" cut, the S&P 500
had already fallen almost 16% from its highs the previous September.
And when the cut was announced, the relief in the markets was fleeting. Stocks stabilized for several
weeks, but fell to new lows in mid-February. They were destined to fall nearly an additional 40% from
there, despite no less than 11 more rate cuts -- with even more to come after stocks bottomed in late
2002. So much for "anticipatory."
Mr. Greenspan indeed did cut rates quickly in the aftermath of the stock crash of 1987 and the terrorist
attacks of September 2001. That's because both those extraordinary and highly public events were seen
by the Fed as being very likely to depress overall economic activity, not because distressed markets
themselves needed to be bailed out.
To help the markets in those crises, the Fed opened its checkbook to provide the liquidity necessary for
transactions to clear and credit to endure despite the chaos. That's precisely what Mr. Bernanke has
already done in the present turmoil, both through a very high volume of ordinary open market
transactions and a liberalized discount-window lending policy.
In that sense, Mr. Bernanke has already acted more pre-emptively than Mr. Greenspan did in 1998, and
similarly to the way Mr. Greenspan did in 1987 and September 2001. And he has done so despite the fact
that, judging by the stock market's sturdy performance through the current turmoil -- now down only
about 5% from all-time highs -- today's crisis is less threatening than those earlier ones.
It's noteworthy that the enormous volume of Fed open-market operations in the fed funds markets over
the last month has been completed at the current rate target of 5.25%. This suggests that no lower rate is
required to meet the needs of the banking system. And the discount window has scarcely been used at all,
which suggests that the system is not in quite the state of distress that has been advertised.
So why would Mr. Bernanke cut the fed funds rate, unless he became convinced that the overall economy
was highly likely to be damaged by the present market turmoil? That was the call Mr. Greenspan made
quickly after the 1987 crash and the 2001 attacks, and slowly in 1998 and early 2001. Where's the
evidence to support Mr. Bernanke making such a call today? Almost all the evidence is that the economy
is remarkably robust, credit crisis or no credit crisis, housing slowdown or no housing slowdown.
Yes, we've had one disappointing jobs report. But with jobs at a level historically regarded as "full
employment," must we hurry to cut rates? By historical standards, rates are already low. Since the 1970s,
no easing cycle, and no recession, has ever begun when the real funds rate was as low as it is today.
Yet Mr. Bernanke remains under tremendous pressure from markets to cut rates. The prices observed in
short-term fixed-income and interest-rate futures markets clearly imply that the markets expect a cut -9/20/2007 9:24 AM
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and the balance of pundit commentary is calling for one.
If the principled case can be made that a robust economy is significantly at risk, then Mr. Bernanke
should do what the markets and the pundits demand -- provided that he sees a rate cut as consistent with
his mission to preserve price stability.
But the idea that he must act immediately, in order to be seen as a worthy successor to the "Maestro," is
unfair to Mr. Bernanke and too generous to Mr. Greenspan. The current Fed chief deserves our
admiration for having acted quickly and appropriately so far, and resisted the temptation to over-react.
Mr. Luskin is chief investment officer of Trend Macrolytics LLC.
URL for this article:
http://online.wsj.com/article/SB118964506628925912.html
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9/20/2007 9:24 AM
U.K. Central Bank to Offer Support To Mortgage Lender Northern Rock...
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September 14, 2007 11:50 a.m. EDT
U.K. Central Bank to Offer Support
To Mortgage Lender Northern Rock
By JOELLEN PERRY and HENRY TEITELBAUM
September 14, 2007 11:50 a.m.
In one of the highest-profile instances of a central bank coming directly to
the rescue of a commercial bank in the current credit crisis, the Bank of
England agreed to provide emergency funding to Northern Rock PLC, one
of the United Kingdom's largest mortgage lenders.
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Northern Rock shares plunged at the opening of the trading session, falling 21% after the lender
confirmed it will get a short-term credit line to offset a "severe liquidity squeeze" that cut off its access to
capital. (See related article1.)
If current conditions persist through year-end, "there will clearly be an impact on Northern Rock's 2007
asset growth and, therefore, on profits," the Newcastle, England-based bank said in a statement. Pretax
earnings will be between £500 million ($1.02 billion) and £540 million, missing analysts' estimates of
£647 million.
The Bank of England's move -- the first time it has acted as a lender of last resort in this way since
gaining independence on interest-rate policy in 1997 -- comes two days after its governor, Mervyn King,
condemned some of the liquidity-providing measures other central banks have taken in the last month as
needlessly encouraging risk-taking. In written testimony to the U.K. Parliament's Treasury Committee,
Mr. King said the bank stood ready to take action in case of a severe shock to the banking system, but
also warned that "if risk continues to be underpriced, the next period of turmoil will be on an even bigger
scale."
A three-way statement from the U.K. Treasury and the Financial Services Authority Friday, though,
included a reference to the Bank of England's role as a lender of last resort, saying "the moral hazard of
an increase in risk-taking resulting from the provision of [lender of last resort] lending is reduced by
making liquidity available only at a penalty rate."
The U.K. Treasury said the liquidity made available to Northern Rock was authorized by the Chancellor
of the Exchequer, and said the support was made against appropriate collateral.
On Thursday, the Bank of England confirmed it had provided £4.4 billion in additional reserves to U.K.
financial institutions, and also sharply widened its reserve-requirement range for commercial-bank
accounts with the central banks. The moves, the Bank of England's first to ease U.K. money market
tensions, were limited in comparison to those taken undertaken by banks including the European Central
Bank and U.S. Federal Reserve.
Friday's joint statement also stressed that "Northern Rock is solvent, exceeds its regulatory capital
requirement and has a good quality loan book. The decision to provide a liquidity support facility to
9/14/2007 12:22 PM
U.K. Central Bank to Offer Support To Mortgage Lender Northern Rock...
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Northern Rock reflects the difficulties that is has had in accessing longer term funding and the mortgage
securitization market, on which Northern Rock is particularly reliant."
Early Friday, Northern Rock customers queued outside at least one branch to withdraw their savings after
the mortgage lender was forced to tap the Bank of England for emergency funds. Some savers had been
concerned weeks ago about the possible fallout from the subprime lending crisis on the U.K. lender. In
Kingston, England, a line began to form more than an hour before the Castle Street branch opened as
concerns about the institution's liquidity unnerved savers. A staff meeting appeared to be taking place
before doors were unlocked. Around 9:00 local time, the line outside contained about 30 people, but
swelled to more than 70 within half an hour. Almost all were over 50 years old and retired. All planned to
withdraw their cash.
Northern Rock's business model, in which the bank for several years was able to secure low-cost funding
that reflected investors' high-risk tolerance, is particularly vulnerable to the current credit crunch.
With banks stockpiling cash and nervous to lend to one another for fear of U.S. subprime contagion,
three-month interbank lending rates are hovering at record highs, up to a full percentage point above the
Bank of England's main rate. Northern Rock's low-cost business model has for several years allowed it to
use low interbank lending rates, a reflection investors' tolerance for risk, to gain market share in the U.K.
retail market.
"Northern Rock have for some months been seen by the financial markets as extremely vulnerable to the
liquidity squeeze that we're currently experiencing," said James Nixon, European economist with Societe
Generale in London.
The Bank of England has a standing facility -- similar to the Fed's discount window -- to lend funds to
financial institutions at a penalty rate. In the Bank of England's case, the rate is 6.75%, a percentage point
above its target policy rate. As other central banks have pumped cash into money markets over the past
few weeks, the Bank of England has often stressed that banks could borrow from its standing facility at
any time. British bank Barclays PLC has borrowed from the facility twice recently.
But the standing facility only offers overnight funds, which must be repaid the next day. Northern Rock,
by contrast, can specify to the Bank of England how long it anticipates it will need this emergency
funding. The Bank of England confirmed that its overnight facility was not used last night.
Write to Joellen Perry at joellen.perry@wsj.com4 and Henry Teitelbaum at
henry.teitelbaum@dowjones.com5
URL for this article:
http://online.wsj.com/article/SB118975103917427544.html
Hyperlinks in this Article:
(1) http://online.wsj.com/article/SB118975453028227498.html
(2) http://online.wsj.com/article/SB118977768884027668.html
(3) http://online.wsj.com/public/page/debt.html
(4) mailto:joellen.perry@wsj.com
(5) mailto:henry.teitelbaum@dowjones.com
Copyright 2007 Dow Jones & Company, Inc. All Rights Reserved
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9/14/2007 12:22 PM
Europe's Central Banks on Different Paths - WSJ.com
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http://online.wsj.com/article_print/SB118969167048526406.html
September 14, 2007
Europe's Central Banks on Different Paths
A WSJ NEWS ROUNDUP
September 14, 2007; Page A2
European central banks moved in different directions yesterday amid the
credit crunch. The Swiss National Bank pushed ahead with an interest-rate
increase, while the Bank of England effectively eased conditions in British
money markets and the European Central Bank said it would wait to see
how market conditions develop before making its next interest-rate move.
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After the ECB and the Bank of England left their key interest rates on hold
last week amid uncertainty about the economic fallout of the market turmoil, the Swiss National Bank
surprised many economists by pushing its key interest rate higher. At a regularly scheduled meeting, it
lifted its target for the three-month Swiss franc Libor rate to 2.75% from 2.5%. The central bank said it
now aims at the midpoint of a target band of 2.25% to 3.25%, up from 2% to 3% previously.The increase
was the eighth rise in as many quarters. The central bank also made slight changes to its inflation
forecasts to 2009.
In London, the Bank of England eased conditions in money
markets by providing additional reserves through its weekly
open-market operation and sharply widening its
reserve-requirement range for commercial-bank accounts with the
central bank.
The Bank of England's moves were limited in comparison with the
major cash interventions in recent weeks of other major central
banks, including the ECB and the Federal Reserve. But analysts
said the steps will give financial institutions greater leeway amid
tight liquidity conditions and suggest they shouldn't feel pressured
to borrow at prohibitive market rates to meet their targets.
Sterling London interbank offered rates fixed lower on the news, as
investors judged that the Bank of England's actions would reduce
pressure on banks' short-term funding needs. The overnight rate
dropped to 5.87% from 5.9% Wednesday, while the three-month rate also slipped but remained elevated
at 6.88%, down from 6.9% the day before.
The Bank of England confirmed yesterdaythat it was offering an additional £4.4 billion ($8.94 billion) in
reserves, with a one-week maturity at the 5.75% policy base rate, in response to higher-than-usual
secured overnight interest rates.
The reserve-requirement expansion "is a highly significant development, given that it sends the message
that banks should not fret about meeting their reserve requirements for this maintenance period," said
Marc Ostwald, market analyst at Insinger de Beaufort.
9/14/2007 12:25 PM
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He added that the huge £182.9 billion of bids that the Bank of England received yesterday -- almost five
times the £38.4 billion that the Bank of England actually allocated -- indicated the pressure that market
players are under and "doubtless were one of the prompts for this unusual move."
Separately, the European Central Bank said in its monthly report for September that the recent volatility
in money markets means it is too soon to draw conclusions for monetary policy, even though it sees
upward pressure on prices over the medium term for the 13 countries that use the euro.
"Given this high level of uncertainty, it is appropriate to gather additional information and to examine
new data before drawing further conclusions for monetary policy in the context of our
medium-term-oriented monetary policy strategy aimed at delivering price stability," the ECB said.
In an effort to calm euro-zone money markets, which seized up last month on fears about banks' exposure
to the U.S. subprime-mortgage market, the ECB has injected billions in overnight and longer-term funds
since early August.
The bulletin noted that ECB policy makers will pay "great attention" to financial-market developments.
The economic outlook remains favorable, but market turbulence has increased uncertainty on this view,
the ECB said. In New Zealand, meanwhile,the central bank held interest rates steady at 8.25% yesterday,
as turmoil in the U.S. subprime-mortgage market clouded the country's economic outlook. The decision
by the Reserve Bank of New Zealand effectively called an end to its nearly four-year tightening cycle.
URL for this article:
http://online.wsj.com/article/SB118969167048526406.html
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9/14/2007 12:25 PM
Goldman Hedge Fund Had Worst Month in August - WSJ.com
1 of 3
http://online.wsj.com/article_print/SB118972642347427083.html
September 14, 2007
Goldman Hedge Fund Had
Worst Month in August
By HENNY SENDER
September 14, 2007; Page C2
For years, Goldman Sachs Group Inc.'s flagship Global Alpha hedge fund
could do no wrong. Over the past year, it has been able to do almost
nothing right.
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August was the worst month in the fund's 12-year history; it was down
22.7% last month alone, according to a recent letter to investors. So far this year through the end of
August, it was down 33.4% due to bad bets on everything from the Australian dollar, the Norwegian
stock market and Japanese government bonds. The letter gave no indication about how the fund was
faring this month. Over the past 12 months, the fund has lost 37% of its value.
Two Goldman Stars
That performance is a tough pill for Goldman and the two University of Chicago alumni, Mark Carhart
and Ray Iwanowski, who run the fund. The pair had garnered accolades -- and made Goldman the envy
of other Wall Street firms -- when Global Alpha was one of the best performing of the hedge funds set up
by Wall Street investment banks. Mr. Carhart, an avid cyclist, and Mr. Iwanowski were among
Goldman's highest-paid executives in recent years.
Global Alpha, which has been marketed largely to Goldman partners and wealthy clients, was started in
late 1995 with $10 million. In 1996, its first full year, the fund returned 140%, one former group member
recalls.
Global Alpha trades everything from currencies to stocks and bonds and uses a variety of strategies. It
has been selling some of its investments, according to the letter, a decision that should help stem any
further losses. "We are focused on ensuring that we hold a substantial amount of the portfolio in cash or
available liquidity," the letter says.
August was a difficult month for the overall markets, but even more difficult for a surprising number of
hedge funds. Some funds that use a "quantitative," or "quant," strategy of using models to set strategies
and computers to carry them out got clobbered when many of the funds wound up having to sell similar
investments at the same time, driving prices down.
Where's the Flexibility?
Global Alpha's dismal record this year is especially startling because it is a "multi-strategy fund" and can
engage in an array of strategies. In theory this should give it the flexibility to adapt to volatile and
difficult markets and avoid problems arising from any single strategy. But over the past year practically
everything Global Alpha touched went wrong.
9/14/2007 12:30 PM
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The problems show how one of the key dangers that have tripped up hedge funds in the current turmoil
are strategies touted as unique but which channeled funds into very similar investments. Everyone got
hurt when the investments wound up needing to be sold all at once. One investor in the fund described
the losses as "shocking" that they could have lost money "across so many different strategies."
Last year, the fund did well for the first few months but was down 9% for the year. Assets under
management have slipped from a peak of $10 billion to about $6 billion, according to a person familiar
with the matter, because of a combination of investment declines and withdrawals by investors. A
Goldman Sachs spokeswoman declined to comment.
August was difficult for some of the firm's other hedge funds, as well. Goldman, along with a small
group of investors, stepped in this summer to provide a total cash infusion of $3 billion to its
more-focused computer-driven stock fund, Global Equity Opportunities Fund. A Goldman spokeswoman
declined to comment on the fund's losses.
The letter outlined a litany of bad bets and problems, some of which the fund managers blamed on the
massive selling by other funds as credit suddenly dried up in early August and investors in some funds
started asking for their money to be returned. That forced many funds to sell assets to raise money. Most
of those problems started in the market for subprime mortgages and then spread.
The letter also says that bets that the Japanese yen would fall and the Australian dollar would rise turned
out wrong. Those went badly when the disruptions in markets prompted many investors who had been
borrowing money at low interest rates in Japan to invest elsewhere -- a practice that's known as the "carry
trade" -- to abruptly reverse course and buy the yen while selling other currencies, such as the Australian
dollar.
'Very Poor' Currency Bets
"In particular, we saw very poor performance in our currency selection strategies," the letter said. The
fund also suffered missteps with bullish positions in the Norwegian stock market and bearish positions in
the Finnish market. It lost money on both. Global Alpha's trading in world-wide bond markets didn't fare
much better. It took a negative view on Japanese government bonds; they rallied instead.
Global Alpha has struggled for some time. This time last year, Global Alpha also lost money shorting
Japanese government bonds, or selling the bonds in the hope of buying them back later at a cheaper price.
Earlier in 2007, Alpha was bearish on the Canadian dollar against the U.S. dollar. Yesterday, the
Canadian dollar hit a 30-year high against the U.S. currency.
Write to Henny Sender at henny.sender@wsj.com1
URL for this article:
http://online.wsj.com/article/SB118972642347427083.html
Hyperlinks in this Article:
(1) mailto:henny.sender@wsj.com
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9/14/2007 12:30 PM
Bernanke Says Financial System Remains Strong Despite Turmoil - WS...
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http://online.wsj.com/article_print/SB119029255515833822.html
September 20, 2007 9:19 a.m. EDT
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Bernanke Says Financial System
Remains Strong Despite Turmoil
By LAURENCE NORMAN
September 20, 2007 9:19 a.m.
The financial system remains in a "relatively strong position," despite the
recent turbulence in financial markets, Federal Reserve Chairman Ben
Bernanke said Thursday.
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In the recent "episode, the shift in risk attitudes
combined with greater credit risk and uncertainty about how to value those risks
has created significant market stress," Mr. Bernanke said in prepared testimony to
be delivered before the House Financial Services Committee. (Read the full
remarks.1)
"On the positive side of the ledger, past efforts to strengthen capital positions and
financial market infrastructure places the global financial system in a relatively
strong position to work through this process," he added.
Mr. Bernanke noted however that during the recent turbulence in markets, "global
financial losses have far exceeded even the most pessimistic estimates of the
credit losses on these loans."
Mr. Bernanke listed off the various moves the Fed has taken to relieve the recent strains, including the
reduction in the discount rate, the cut in the fee charged for lending Treasurys securities and this week's
surprise move to cut the benchmark federal funds target rate by 50 basis points.
REAL TIME ECONOMICS
"Recent developments in financial markets have increased the
uncertainty surrounding the economic outlook," he said,
adding that the Federal Open Market Committee "will act as
needed to foster price stability and sustainable economic
growth."
2
• Read the latest news and analysis
on the economy at WSJ.com's Real
Time Economics blog.3
The FOMC met on Tuesday and cut the funds rate by a half percentage point to 4.75%. Most economists
had expected a quarter point cut. In its statement, the Fed said it was acting to "forestall" the economic
impact from the summer's financial turbulence. Mr. Bernanke reiterated that comment in his testimony.
Addressing the subprime mortgage meltdown, Mr. Bernanke said that with "house prices still soft and
many borrowers' facing their first interest rate resets under adjustable rate mortgage deals, "delinquencies
and foreclosure initiations in this class of mortgages are likely to rise further."
Mr. Bernanke said it is "difficult to be precise" about the number of foreclosures to be expected as it will
9/20/2007 9:30 AM
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depend on house price developments, which vary widely.
He said that traditionally, about half of homeowners who get a foreclosure notice are ultimately displaced
from their homes. However, "that ratio may turn out to be higher in coming quarters because the
proportion of subprime borrowers, who have weaker financial conditions than prime borrowers, is higher.
The rise could be tempered somewhat by loan workouts."
Mr. Bernanke will take questions from house members after delivering his testimony at the hearing,
which begins at 10 a.m. EDT.
Write to Laurence Norman at laurence.norman@dowjones.com4
URL for this article:
http://online.wsj.com/article/SB119029255515833822.html
Hyperlinks in this Article:
(1) http://blogs.wsj.com/economics/2007/09/20/bernanke-testimony/
(2) http://blogs.wsj.com/economics/
(3) http://blogs.wsj.com/economics/
(4) mailto:laurence.norman@dowjones.com
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9/20/2007 9:30 AM
The Credit Crunch Continues - WSJ.com
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September 20, 2007
COMMENTARY
The Credit Crunch Continues
By STEVEN RATTNER
September 20, 2007; Page A13
At long last, financial markets have lurched toward higher risk premiums,
the extra interest that lenders receive for eschewing Treasuries in favor of
less-safe loans. As every literate American knows, that adjustment has
come at enormous cost and peril, in the form of oscillating stock prices,
fears of liquidity crises in the banking system and a smattering of blowups
in the shadowy world of hedge funds.
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The pain has been particularly
acute, of course, in housing,
where creditors have lost
massively and the specter of
foreclosure looms over
homeowners unable to cover
escalating mortgage
payments. Nor has the
leveraged lending business
been spared. The spigot of
new commitments has shut
tight. The average risk
premium on high yield bonds
leapt to a recent high of 4.87
percentage points above
Treasuries, compared to
June's record low of 2.63
percentage points, an almost
seismic adjustment for the
tortoise-like debt market.
But unlike the seeming free fall in the mortgage market, the waves of worry in the high-yield arena have
been more episodic, far less fear than is needed to raise risk premiums to sensible levels. Tuesday's
aggressive rate reduction by the Federal Reserve, while perhaps desirable to shore up the economy,
complicates this adjustment process.
Having now eased back to 4.61 percentage points, the high-yield spread above Treasuries remains well
below the 20-year historic average of 5.4 percentage points. Below-average premiums are too slender at a
time of above-average challenges.
How much danger lurks ahead? Like skiers who venture across the ropes into avalanche country,
9/20/2007 9:28 AM
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investors in debt instruments today are dodging an unprecedented overhang of supply. In the so-called
"golden age of private equity" -- wildly shorter than what Pericles enjoyed and now, in just a few short
months, a distant memory -- banks vied to commit to lend massive amounts of capital to private equity
buyouts that would take months to close. Each new promise seemed to bring lower pricing,
ever-loosening strictures ("covenants") on the borrowers, and fewer pre-closing escape hatches for
lenders as banks, thirsty for fees, scrambled for market share. When the music stopped in July, $330
billion or more of these commitments was outstanding. By comparison, that's in the range of the total
annual lending volume to similar borrowers as recently as 2005.
Only a few billion dollars of these commitments have come to market, and lenders have been able to
push them through with relatively modest sweeteners. Now more deals -- including a fistful of
mega-buyouts like First Data and TXU -- are beginning to close.
In a normal world, perhaps the banks would succeed in offloading this paper, as badly structured and
mispriced as it is. But one consequence of the turmoil in the housing-finance market has been the
shriveling up of securitizations, the process by which banks package up loans and sell them in slices to
investors.
In July and August, new collateralized loan obligations (known as CLO's in the parlance) totaled about
$12 billion, half the rate of the previous six months. And with September issuance substantially lower,
much of that constituted offerings long in the pipeline. Meanwhile, the high-yield bond market (the
banks' other major traditional outlet for debt) has shrunk still further. Only $2.5 billion of new paper
emerged from Wall Street in August, compared to more than $100 billion in the previous seven months.
As intimidating as it may seem, the supply overhang is not our biggest worry, which is the prospect of
many of these loans going bad (the seminal reason for the collapse of the mortgage market.) Never before
in the history of capital markets has so much money been lent to so many challenged borrowers.
The statistics are indisputable. In 2007 (until the market effectively shut down), more than 32% of new
lending was to companies planted on the lowest rungs of the credit ladder, compared to 20.9% in 2006,
the previous peak, according to JP Morgan. That brought these borrowers' share of outstanding debt to
above 25%, also a new high. Much of that debt was amassed, of course, by private equity buyers, whose
average leverage ratios for new deals in 2007 reached 6.6 times cash flow, another record.
So why, given such seemingly incontrovertible worries, have interest rates on junk debt stayed
stubbornly low? First, for all the chatter about liquidity crises, vast pools of uninvested capital remain in
place in hedge funds and elsewhere, eager for the next "buying opportunity." Even amid the summer
ugliness, whenever trading values of outstanding debt appeared about to crumble "value" buyers emerged
to prop them back up again. Still more capital is now being raised to invest in this debt, some of it by the
very banks whose imprudent practices helped create the problem.
Debt buyers draw their courage from the solid recent performance of our economy (housing excepted, of
course), which has resulted in record few defaults by corporate issuers (a microscopic seven so far this
year.) Some investors believe that traditional cyclicality has been tamed, a difficult concept even for
those of us confident that our economy is fundamentally strong.
Now, with hints of a softening economy raising the specter of slowdown or perhaps recession, that
courage may be challenged. A Wall Street Journal poll last week found that economists surveyed put the
risk of recession at 36%, up from 28% a month earlier.
For high-yield debt investors, history certainly provides little comfort. Research by Edward Altman of
New York University shows that on average 16% of "B" rated paper (low, but not the lowest, quality)
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defaults within three years of issuance. For the growing amounts of CCC debt, the track record is
dramatically worse: a 37% default rate over three years. To believe that this cycle will be different
requires an ignorance of the past and a vivid imagination.
Investors also take heart from what has been fondly known in financial markets as the "Greenspan put"
(which after Tuesday's rate cut may morph into the "Bernanke put"). Starting with the 1987 stock market
crash just weeks after he became Fed chairman, Mr. Greenspan repeatedly provided massive liquidity
when events like the Asian crisis or the dot-com hangover suggested a possible meltdown. For this, he
has been praised, but also criticized for interfering with the "moral hazard," the notion that investors
should lose money when they are foolish so they don't repeat past mistakes.
Many sages are vigorously (and correctly) defending this concept. Last week, for example, Mervyn King,
the governor of the Bank of England, submitted a paper to Parliament decrying the notion of providing
"ex post insurance to institutions that have engaged in risky or reckless lending." But just one day later,
the bank, operating in concert with the British government, unveiled a bailout of Northern Rock, one of
the country's largest mortgage lenders.
While it's easy to visualize why even a hard-nosed central banker would rescue an institution of such
importance, happily the resolve on this side of the pond has not yet been tested. However, those of us
committed to preventing moral hazard should recognize that devising a means to funnel help to (mostly)
innocent victims, such as subprime borrowers, without rewarding foolish lenders -- itself admittedly no
easy matter -- will be an important ingredient in preventing more widespread rescue missions, with all
the attendant potential such bailouts hold for long-term damage to the future pricing of risk.
So far, in the face of a hopelessly muddled outpouring of exhortations, often cutting across party lines,
the Fed has discharged commendably its responsibility for preventing our financial machinery from
seizing up. A rate reduction was well justified, not as a conduit for channeling relief to nervous investors,
but because recent statistics indicate clear weakness in the economy in the face of the housing collapse
and its collateral damage.
To be sure, maintaining economic growth may have the unintended consequence of keeping some
overleveraged deals from going bad as quickly as they might have. And unfolding events will test the
wisdom of choosing the larger, half-point rate reduction, which at least modestly undermined the goal of
protecting us from moral hazard. But lenders should beware that for all Mr. Greenspan's willingness to
provide liquidity, plenty of money was lost in the high-yield arena in the early 1990s and again in the
post-bubble swoon a decade later. The rerun of that movie has barely begun to play out.
Mr. Rattner is managing principal of the private investment firm Quadrangle Group LLC.
URL for this article:
http://online.wsj.com/article/SB119025366302233430.html
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9/20/2007 9:28 AM
Which Way Is Scarier? - WSJ.com
1 of 3
http://online.wsj.com/article_print/SB119058515796236665.html
September 24, 2007
MARKET MOVERS
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Which Way Is Scarier?
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Fed Move to Steer Away
From Recession Threat
Awakens Inflation Fears
By E.S. BROWNING
September 24, 2007; Page C1
The Federal Reserve cut interest rates last week in order to address a
pressing concern: the risk of recession and of a breakdown in credit
markets.
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By lowering rates before it really wanted to, however, the central bank has revived another fear that had
been dying down: inflation.
That has left the Fed and the investment world in a tight spot.
If the Fed gets it just right, the economy will slip through this crisis and keep expanding with only modest
inflation, making investors happy. If the Fed's rate cuts are too little, too late, recession fears will return,
sending another cold wind through credit markets and the stock market. If the Fed cuts rates too much,
inflation could loom.
What was troubling some investors after the Fed rate cut last week, a reduction in short-term rates by half
a percentage point, to 4.75%, was the latter risk -- the risk of inflation.
QUESTION OF THE DAY
1
• Which problem is most likely:
recession, inflation or stagflation?2
Until the credit crisis struck, the Fed had signaled no intention
of cutting rates so soon. Lower rates typically stimulate the
economy by making it easier for companies, consumers and
investors to borrow. If the Fed continues cutting rates before
inflationary pressures have been stifled, it risks pushing
inflation higher.
The Fed has acknowledged the concern, noting in the statement announcing last week's rate cut that
"some inflation risks remain." Inflation could come from the still-booming global economy and from the
lower rates themselves, which push more money into the economy, making it easier to raise prices.
Some money managers already are warning that inflation may force the Fed to raise rates early next year,
taking back last week's gift. Higher rates would hurt stocks because they stifle the economy and make it
harder for investors to borrow.
Something similar happened in 1999, when the Fed had to raise rates after cutting them during the 1998
financial crisis. The economy ended up in recession in 2001.
Although these worries are spreading in the bond market, stock investors generally are shrugging them
9/24/2007 9:28 AM
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off. There is no technology-stock bubble today, they note, as there was in the late 1990s. Last week, stock
investors were celebrating; the Dow Jones Industrial Average rose 2.8% to 13820.19. It finished just
180.22 points, or 1.3%, short of its record 14000.41, set July 19.
If inflation worries become more widespread, some of that elation could turn to hand-wringing.
Marc Stern, chief investment officer at Bessemer Trust, months ago began cutting his clients' exposure to
risky U.S. and developing-country stocks and bonds, whose prices had soared in recent years. Those were
among the main casualties of the summer's market swoon, and lately they have been recovering. Even so,
Mr. Stern isn't ready to bet that their recovery will be lasting.
Although "buying opportunities
are developing in several
formerly overpriced areas,
including high-yield bonds," he
says, he isn't jumping back in
yet. "Inflationary pressures are
evident in the pricing of many
commodities, such as gold,
agricultural products and
energy," Mr. Stern says. "Our
concerns would grow if the Fed
cut short-term interest rates
from current levels."
Investors who fear inflation
generally are keeping more
money than usual in cash. They
are moving toward bigger, more
stable stocks.
A weakening dollar also adds to inflation. It makes foreign holders of the dollar, such as the Chinese, less
eager to own dollars. Expectations that such investors would shift toward other currencies helped push the
euro sharply higher last week. While a weakening dollar helps U.S. exports, boosting earnings for
companies that compete with foreign multinational companies, it also pushes up import prices, which can
make inflation quicken.
"Who would have thought that the Fed would lower rates by more than investors expected with the dollar
within a breath of an all-time low against all the major currencies? They did, and inflation expectations
are accordingly rising," Richard Bernstein, chief U.S. investment strategist at Merrill Lynch, said in a
report last week.
Benjamin Pace, chief investment officer at Deutsche Bank Private Wealth Management, and many other
money managers don't share that concern. Sure, Mr. Pace says, the textbooks say to fear inflation if the
dollar weakens. But he isn't seeing signs of inflation in import prices, he says, because global competition
is holding prices down.
"I still think we are in a disinflationary environment, where inflation numbers will continue to come
down, at least this year," Mr. Pace says.
Mr. Pace acknowledges that Treasury-bond yields shot up last week, which some took as a sign the bond
market feared inflation. He says yields had gotten abnormally low during the summer's credit-market
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turmoil as investors fled to the Treasury market's safety, and he views last week's surge in Treasury yields
as mainly a return to normal levels.
Last month, anticipating that markets would stabilize, Mr. Pace began buying high-yield, or junk, bonds,
which were beaten down during the credit crunch in July and August.
Corporate profits form one big question mark now. Widely followed companies are just beginning to
report third-quarter earnings, and in about three weeks, the reports will be flooding in. Expectations
generally are low, and companies may not find it hard to exceed forecasts. Profits for companies in the
Standard & Poor's 500-stock index are forecast to rise only about 4%, according to Thomson Financial.
Next quarter, analysts expect a profit increase of almost 11%, and for next year, the expectation is 11.8%,
both well above the average of around 7% or 8% of the past few decades. If interest rates stay down,
companies will find it easier to meet those expectations. If the Fed is forced to raise rates, it will be
harder.
In August, when the Fed started injecting money into the economy in an effort to unfreeze credit markets,
PanAgora Asset Management, which oversees $24 billion, began shifting more money into stocks,
expecting a rebound as the Fed made it easier to borrow money.
"While this continues, it will be good for stocks," says Edgar Peters, PanAgora's chief investment
strategist, "but I am concerned about the longer term. There is an inflation risk here. I think the Fed
realizes that. There is a strong possibility that, when the crisis passes, the Fed will take these rate cuts
back, as they have in the past."
Write to E.S. Browning at jim.browning@wsj.com3
URL for this article:
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Hyperlinks in this Article:
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9/24/2007 9:28 AM
Credit & Collections World Web Site
Page 1 of 2
EXCLUSIVE: Amount of Portfolio Offers Rises Again
The volume of paper posted on public web sites increased
43% in the past week. New listings totaled $547.8 million on
Friday, compared with $381.5 million on Sept. 14 and an
anemic $53.4 million at the end of the Labor Day holiday
week.
Debt broker Garnet Capital Advisors is offering two issuerdirect portfolios from Americredit, consisting of auto
deficiencies, one for approximately $200 million in face value
and the other with $101.5 million face value. Bids for the
smaller package are due Oct. 9, according to managing
partner Sean McVity.
Also new this week, broker National Loan Exchange has a
$114 million face value portfolio of accounts from Aaron’s
Sales & Lease Ownership, a rent-to-own retailer of furniture,
appliances, electronics and computers.
In the resale market, the main product this week is old credit
card paper, with charge-off dates back to 1996. Louise
Epstein, president of Charge-off Clearinghouse, confirmed
what sources told CCR last week: That there is more out-ofstatute paper on the market. Prices, at fractions of a penny on
the dollar, may be attractive to buyers priced out of in-statute
paper, Epstein says.
Charge-off Clearinghouse has a $7.5 million face value
package of credit cards from a major bank. The accounts
have been through one or two agencies.
Credit Card Reseller has four new portfolios this week, two of
them consisting of out-of-statute credit card and mixed
consumer accounts. The company has a $24.3 million
portfolio of out-of-statute GE Capital credit cards and loans
from furniture retailer Levitz; a $3.2 million package of out-ofstatute credit cards and consumer accounts from Home
Federal Bank; a $9.8 million package of Bank of America
credit cards, with accounts both in and out of statute; and a
$7.2 million portfolio of in- and out-of-statute accounts from
Beneficial, a unit of HSBC.
Bid4Assets.com lists two packages from seller Shapiro,
Baines & Associates that together have a face value of more
than $630,000. One consists of credit cards from at least
three major banks; the other contains mixed consumer loans.
Credit card paper available this week totaled $52.1 million, all
of it in the resale market.
http://www.ccrmag.net/article.html?id=20070921H24UD54O
25/09/2007
Credit Turmoil Brings New Caution to Market - WSJ.com
1 of 4
http://online.wsj.com/article_print/SB119092651671541681.html
October 1, 2007
STOCK MARKET QUARTERLY REVIEW
DOW JONES REPRINTS
Credit Turmoil Brings
New Caution to Market
Debt Buyers Adopt 'Foxhole Mentality' as Risk Is Repriced
By MICHAEL HUDSON
October 1, 2007; Page C5
The era of easy money is over, at least for now. Although credit hasn't
disappeared from the financial system, it comes at a stiffer price than a few
months ago.
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Parts of U.S. credit markets froze in July and August as problems with subprime mortgages, loans to less
credit-worthy borrowers, spread to the broader market.
THE JOURNAL REPORT
1
See the 100 best- and worst-performing
public companies2, industry group
rankings3 and leading stock and bond
underwriters4.
• See the complete Quarterly Markets Review5.
Jittery investors showed a sudden reluctance to sink money
into riskier bonds -- not at the low yields they were willing to
take as the credit boom grew to outsize proportions during the
first half.
Things looked better in September, especially after the Federal
Reserve cut its target short-term interest rate Sept. 18. Pain in
the short-term commercial-paper market eased and the
junk-bond market showed tentative signs of life.
But the credit crunch isn't over -- and analysts and investors say it is likely to keep playing out the rest of
this year and into 2008.
"It can't be overstated that there's been a dramatic improvement in tone. But it would [be] naive to think
we're out of the woods here," said Therese Esperdy, who runs global debt capital markets for J.P. Morgan
Chase & Co. in New York.
A big question involves the impact of U.S. central bankers' efforts to soften the nation's credit crunch,
notably their decision to slash their interest-rate target by half a percentage point. It was a bigger move
than many analysts and investors expected and helped make it easier for companies to borrow money in
the capital markets, and helped spark a rally in stocks.
Spurring Inflation?
Some investors worry that the Federal Reserve's rate cutting could overheat the economy and spur
inflation that would eat into their returns.
"This is going to come back to bite the Fed -- and the bond market -- sooner rather than later," said
Richard Yamarone, chief economist at Argus Research in New York.
10/8/2007 12:39 PM
Credit Turmoil Brings New Caution to Market - WSJ.com
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Since the Fed's Sept. 18 rate cut, many inflation-wary investors have sold longer-term Treasury
securities, pushing prices down and their yields up. Prices and yields move inversely.
The benchmark 10-year Treasury note
ended the quarter at 4.579%, up from
4.470% the day before the Fed move. It
is lower than 5.034% at the end of the
second quarter as investors kept prices
high in their quest for safe investments.
Investors shied away from junk bonds,
high-yield, low-rated debt issued by
companies with risky credit profiles.
They continued to buy safer
investment-grade corporate bonds as long
as companies were willing to pay higher
yields than they offered earlier in the
year.
From July through September, U.S.
companies issued more than $215 billion
in new investment-grade bonds,
according to data tracker Thomson
Financial. That is a drop from $283.8 billion issued in the second quarter, the most active quarter on
record, and up from $212.7 billion in the 2006 third quarter.
It is still substantial considering problems in other parts of the credit markets. Issuance rebounded in
August and September after a weak July, when $30.7 billion was issued.
In early September, pharmaceutical maker AstraZeneca PLC sold $6.9 billion in bonds, the biggest
investment-grade deal of the year.
Ms. Esperdy said the hunger for investment-grade bonds was clear in September, as investors who
bought only from the best of investment-grade issuers in August set their sights on bonds from
companies farther down the high-grade scale.
"It's not just the most highly rated issuers that have access to the market now," she said.
Last week, department-store chain Kohl's Corp. sold $1 billion in bonds rated Baa1 by Moody's
Investors Service Inc. and BBB-plus by Standard & Poor's Ratings Services.
The decline in junk issuance was dramatic. According to Thomson Financial, U.S. companies issued just
over $9 billion in junk bonds in the quarter, the worst on record. That is down from $56.5 billion in the
second quarter, the second best on record after $57.5 billion in the fourth quarter of 2006.
High-yield issuance in last year's third quarter was $23.5 billion, according to Thomson Financial.
Signs of Revival
The junk market showed some signs of life after the Fed announced its rate cut. A day later,
telephone-directory company R.H. Donnelley Corp. sold $1 billion in junk bonds, up from $650 million
it had earlier said it would sell. It was the first big U.S. junk-bond deal since late July.
10/8/2007 12:39 PM
Credit Turmoil Brings New Caution to Market - WSJ.com
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At the end of September, investors showed a greater appetite for buying junk bonds on the secondary
market. At the close of the quarter, a KDP Investment Advisors Inc. index of 100 frequently traded junk
bonds showed they were yielding 3.30 percentage points over comparable Treasurys, down from 4.09
percentage points at the end of July. A tighter spread over Treasury yields indicates investors are willing
to take lower returns when they risk their money, which in turn makes it relatively less expensive for
junk-rated companies to borrow money.
Higher Treasury yields at the start of the quarter sent mortgage rates higher, contributing to defaults,
especially on riskier subprime loans. Bonds backed by home loans took a beating, with their values
dropping sharply in July and August. Like junk bonds, they showed signs of recovery in September.
"A lot investors felt reassured once the Fed came in and cut rates," said Derrick Wulf, a portfolio
manager for Dwight Asset Management in Burlington, Vt.
Marilyn Cohen, author of "The Bond Bible" and president of Envision Capital Management, a Los
Angeles investment adviser specializing in fixed income, said the past three months provided a painful
but needed repricing of risk from the carefree levels during the credit boom.
'You Have to Be Nimble'
Now, Ms. Cohen said, investors have embraced a "foxhole mentality" as they try to deal with sometimes
contradictory concerns that will continue to dominate the market the rest of this year.
In addition to the possibility of higher inflation, these concerns include the possibility that the economy
will slump, more hedge funds or banks will stumble because of liquidity problems and the legacy of the
subprime-mortgage mess.
"The lesson for bond investors is you have to be nimble," she said. "If you have bonds that are losing
value, take the loss and move on. You can't hold to maturity anymore when you have so many events out
there that can affect your positions."
Write to Michael Hudson at michael.hudson@wsj.com6
URL for this article:
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10/8/2007 12:39 PM
Today's Markets - WSJ.com
1 of 3
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October 1, 2007 12:33 p.m. EDT
TODAY'S MARKETS
By JOANNA OSSINGER
Stocks Rise as Dow Revisits 14000
October 1, 2007 12:33 p.m.
Stocks advanced Monday, with the Dow trading around its closing record
of 14000, as Wall Street digested new details about the extent of the
credit-market and mortgage crunch from bellwethers including Citigroup.
The Dow Jones Industrial Average rose 149.41 to 14045.04, surpassing its
old intraday record of 14021.95, hit on July 17. Its closing record, set on
July 19, is 14000.41. The S&P 500 climbed 15.60 to 1542.35, and the
Nasdaq Composite Index advanced 28.17 to 2729.67.
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Wall Street has been trying to get a firm grasp on the extent of the recent credit-market turmoil for
months, and as financial companies unveil more information about their balance sheets, investors appear
relieved to have some clarity, even when the news is not necessarily good.
"As the brokers and banks give more transparency about some of these issues, it makes the market feel
more comfortable as it loses fear of the unknown," said Robert Harrington, head of block origination at
UBS. "In the near term, some of the bearish and doomsday scenarios are being abated."
Still, companies are taking large hits. Citigroup warned that it expects1 its third-quarter net income to
slump about 60% from a year earlier due to credit-market problems and "deterioration in the
consumer-credit environment." And Swiss financial-services giant UBS confirmed it will report2 its first
quarterly loss in nine years and revealed sweeping management changes and job cuts. UBS said it would
write down its subprime-mortgage exposure to about $3.4 billion. But shares of Citigroup, a Dow
component gained 2.3%, and UBS rose 3.8%. The Amex Broker/Dealer Index was 2.2% higher.
MARKETS ON THE MOVE
3
Track indexes and hot stocks4, with
roll over charting and headlines. Plus,
comprehensive coverage of bonds,
commodities and forex. Markets Data Center
highlights:
Most Actives5, Gainers6, Losers7
New Highs and Lows8, Money Flows9
Intraday Futures10 and Currencies11
MARKET WRAP
• European Shares End Quarter Mixed12
Also helping stocks Monday was Citigroup's upgrade of home
builders. Among companies Citi moved from "buy" from
"hold" were D.R. Horton, which gained 2.8%; Pulte Homes,
which rose 4.8%; and Lennar, which added 2.3%.
Still, the upgrade didn't mean that the housing industry is
coming back anytime soon. "We do not pretend that any
near-term relief in industry fundamentals is in sight,"
Citigroup's analysts said. But "homebuilding stocks have an
established history of rallying well before industry fears have
finished transitioning into fact."
• Asian Markets Rise Modestly13
In August and early September, stocks were struggling as
investors grappled to understand the extent of the
10/1/2007 12:36 PM
Today's Markets - WSJ.com
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http://online.wsj.com/article_print/SB119123912132444760.html
subprime-mortgage and housing problems. A poor August employment report in the first week of
September shook the markets. But the Federal Reserve stepped in with a half-percentage-point cut in its
target interest rate, which spurred stocks to their current rally and has now brought the major indexes
close to their historical highs. Still, concerns remain.
"I think we've come a little too far too fast, given that the potential for inflation problems has been raised
as a result of the aggressive fed-funds rate cut," said Philip Orlando, chief equity-market strategist at
Federated Investors. "We're concerned about banking earnings" in the third and fourth quarters, "and
we're concerned about big writeoffs."
In addition, "people are grappling with whether the mortgage market is going to hurt the consumer,
which could cause a recession-type slowdown in the U.S.," Mr. Harrington of UBS said. "How deep will
the U.S. slowdown be, and will that affect global activity? If the market is going to pause, that's what it
will be concerned about."
Dominating this week's economic calendar will be data on growth in September nonfarm payrolls, due
out Friday. Jobs reports are usually taken as good indicators of consumer strength, and particularly after
signs of weakness in August, Wall Street will be paying close attention to the data.
In corporate news, Walgreen shares fell 14% after the drugstore chain said its fiscal fourth-quarter net
income fell 3.8%, as higher revenue was squeezed by lower reimbursements on some popular drugs and
higher expenses. And, Acxiom fell 24% following a report saying private-equity buyers are in
negotiations about breaking off14 their proposed $2.25 billion purchase of the data-management
company.
Crude-oil prices fell $1.01 to $80.65 a barrel.
In major market action:
Stocks advanced. On the New York Stock Exchange Monday, 2,387 stocks rose and 788 declined, on
volume of 560.1 million shares traded on the exchange.
Bonds climbed. The benchmark 10-year note added 9/32, or $2.8125 for every $1,000 invested, to yield
4.557% Monday. The 30-year bond added 19/32, yielding 4.804%.
The dollar strengthened. The euro was at $1.4223 from $1.4259 against the dollar late Friday. The
dollar was at 115.91 yen from 114.88 yen late Friday.
Write to Joanna L. Ossinger at Joanna.Ossinger@wsj.com15
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10/1/2007 12:36 PM
Money-Market Rates Show Tumult Hasn't Subsided Yet - WSJ.com
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October 4, 2007
CREDIT MARKETS
Money-Market Rates Show
Tumult Hasn't Subsided Yet
By LAURENCE NORMAN
October 4, 2007; Page C3
Some key money-market rates continued to creep higher in a sign that the
strains from the summer's credit crunch aren't over yet.
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The three-month U.S. dollar London interbank offered rate edged up to
5.244% yesterday from 5.240% a day earlier and 5.23% last week. That
leaves the rate almost 0.50 percentage point above the Federal Reserve's benchmark 4.75% interest rate, a
very wide spread by historic standards.
Libor is a key benchmark for everything from adjustable-rate mortgages in the U.S. to large floating-rate
corporate loans.
"Obviously the liquidity crisis is not necessarily over," said Dominic Konstam, head of interest-rate
strategy at Credit Suisse in New York.
Mr. Konstam said some of the euphoria that fed through to short-term borrowing markets after the
Federal Reserve's surprise half-percentage-point cut last month "has dampened a little bit."
"There's still an awful lot of [bank] balance sheets that are tied up, and the commercial-paper market is
still not as settled" as some have suggested, Mr. Konstam said.
Libor rates started moving sharply higher as the credit crisis intensified in early August, with banks
hesitant about lending to counterparts because of concerns about exposure to subprime-related products.
Libor rates have come off their highs, but even in recent days, interbank-lending volumes remain far
below precrisis highs, analysts say.
The rise in term Libor -- which refers to rates on terms longer than overnight loans -- also raises
questions about some of the upbeat comments from current and former central-bank officials on the
credit crunch.
Former Fed Chairman Alan Greenspan said the worst of the subprime crisis is over, while St. Louis Fed
President William Poole said last week there are "tentative signs" that financial markets are recovering.
Nor is the upward trend in interbank borrowing rates restricted to the U.S. The three-month euro
interbank offered rate, or Euribor, has also ticked higher in recent days, rising to 4.79% yesterday from
4.73% a week ago. That leaves the rate 0.79 percentage point above the European Central Bank's 4.0%
benchmark refinancing rate, despite frequent ECB liquidity injections in recent weeks.
Still, while some borrowing rates suggest money markets are not normalizing, others sent a more upbeat
10/8/2007 12:14 PM
Money-Market Rates Show Tumult Hasn't Subsided Yet - WSJ.com
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signal.
The overnight U.S. dollar Libor declined to 4.975% from 5.038% Tuesday, while the one-week Euribor
fell to 4.09% yesterday from 4.36% a week ago.
Meanwhile, after several days of hovering above the Fed's target, the fed-funds rate -- the rate banks
charge each other to lend from their reserves -- fell to near the 4.75% target rate. Yesterday afternoon, the
funds rate was at 4.8125%.
According to Wrightson ICAP, the Fed has injected slightly more liquidity into the system than expected
so far this week, but "surprisingly strong demand for reserves" kept the funds rate above target.
Yesterday, the Fed's injection consisted of a $2.75 billion overnight repurchase agreement, or repo.
Meanwhile, the shortest term rates in the commercial-paper market also edged down, with overnight
asset-backed CP rates falling to 5.27% from 5.31%, according to Mary Beth Fisher, rates strategist at
UBS. Thirty-day CP rates edged up to 5.31% from 5.28%.
Fisher said the CP market remains stable but "has not made any progress" in recent days.
Treasurys Slip as Economy Shows Some Healthy Signs
The suspicion that the labor market may not be in all that much peril gnawed at Treasurys, as the market
failed to make up the losses sparked by a stronger-than-expected services sector survey.
All maturities finished up a little worse than where they started the session, with the benchmark 10-year
note down 4/32 point, or $1.25 per $1,000 face value, at 101 20/32. Its yield rose to 4.543% from 4.529%
as yields rise when prices fall.
For a market primed for further easing by the Federal Reserve, the non-manufacturing report from the
Institute for Supply Management "further muddies the debate" as to whether weaker growth or rising
inflation is more of a concern, said T.J. Marta, income strategist at RBC Capital Markets in New York.
"The really worrisome subindicator -- employment -- rebounded smartly, and inflation made a
less-than-benign showing," he added.
The employment subindex -- which rose to 52.7 from the prior month's 47.9 reading -- has "a decent
correlation" with the nonfarm-payrolls report to be released by the government tomorrow, said David
Ader, head of government-bond strategy at RBS Greenwich.
--Emily Barrett
Write to Laurence Norman at laurence.norman@dowjones.com1
URL for this article:
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Hyperlinks in this Article:
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10/8/2007 12:14 PM
Employment Rebounded in September As August Decline Was Revised ...
1 of 2
http://online.wsj.com/article_print/SB119158634981050085.html
October 5, 2007 8:41 a.m. EDT
Employment Rebounded in September
As August Decline Was Revised to Gain
By BRIAN BLACKSTONE
October 5, 2007 8:41 a.m.
WASHINGTON -- U.S. employment rebounded last month on robust
public education and other service-sector hiring, and August payrolls were
revised sharply higher, providing further evidence that while the U.S.
economy may slow a bit due to the housing crunch, it is likely to skirt an
outright recession.
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MORE ON THE NUMBERS
Read the complete text of
Friday's economic
reports, and analysis from
Briefing.com:
The figures, which included an acceleration in wage growth, will likely
force investors to rein in hopes for further aggressive easing by the Federal
Reserve.
• Unemployment Rate -- Department
1
2
of Labor ; Briefing.com
Non-farm payrolls rose 110,000 in September, the Labor Department said
Friday. Just as important, August was revised to an 89,000 rise from a
previous estimate of a 4,000 decline. That drop had been seen by Fed watchers as a catalyst in the Fed's
surprisingly aggressive half-point federal funds reduction last month, its first in over four years.
Still, many economists thought that report had overstated employment weakness since it included a big
drop in state and local government education payrolls, which was widely expected to be reversed.
The September report included benchmark revisions for the year ended March 2007. Those revisions
showed that employment was 297,000 less than previously thought.
The unemployment rate rose 0.1 percentage point in September to 4.7%.
Average hourly earnings increased $0.07, or 0.4%, to $17.57. That was up 4.1% from a year earlier,
suggesting tight labor markets are starting to put some upward pressure on wage growth.
September payrolls topped Wall Street expectations of a 100,000 rise. A report Wednesday from
Automatic Data Processing and Macroeconomic Advisers that attempts to track the government figure, as
well as recent jobless claims data, had pointed to modest gains in employment.
Forecasters in the Dow Jones Newswires survey had expected a 4.7% unemployment rate and 0.3% rise
in hourly wages last month.
Despite signs that the economy expanded more than 3% last quarter, financial markets nonetheless have
until Friday expected the Fed to lower the fed funds rate one-quarter point, to 4.5%, when it meets Oct.
30-31, and are pricing in another quarter-point reduction by yearend.
The Fed's rate moves so far have been spurred by the threat posed to the economy by housing and
credit-market difficulties and not current data, which have held relatively firm.
10/5/2007 8:42 AM
Employment Rebounded in September As August Decline Was Revised ...
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The Fed may have cut interest rates in September even if August payrolls had been strong, St. Louis Fed
President William Poole said last week, though he conceded that it "would have increased the
communication challenge." In the Sept. 18 policy statement, officials omitted their longstanding
reference to high resource utilization -- a nod to the tight jobs market -- as an inflation risk.
One bright spot for the Fed in Friday's report was the downward revision to March 2006-March 2007 job
growth. That implies productivity was stronger in 2006 and early 2007 than once thought, suggesting the
economy can grow faster without inflation.
The Labor Department said hiring last month in goods producing industries fell by 33,000. Within this
group, manufacturing firms cut 18,000 jobs. Construction employment was down by 14,000, the fifth
decline in six months.
Service-sector employment jumped 143,000. Retail fell by 5,200. Business and professional services
companies' payrolls rose 21,000. Education and health services employment advanced by 44,000. Leisure
and hospitality rose 35,000, while the government added 37,000 jobs, on top of August's revised 57,000
gain.
The average work week was unchanged at 33.8 hours.
Write to Brian Blackstone at brian.blackstone@dowjones.com3
URL for this article:
http://online.wsj.com/article/SB119158634981050085.html
Hyperlinks in this Article:
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(2) http://online.wsj.com/page/mdc/2_0500-employ-18.html
(3) mailto:brian.blackstone@dowjones.com
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Manufacturing Activity Grows
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10/5/2007 8:42 AM
Big Banks Push $100 Billion Plan To Avert Crunch - WSJ.com
1 of 3
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October 13, 2007
PAGE ONE
Big Banks Push
$100 Billion Plan
To Avert Crunch
Fund Seeks to Prevent
Mortgage-Debt Selloff;
Advice From Treasury
By CARRICK MOLLENKAMP, IAN MCDONALD and DEBORAH SOLOMON
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October 13, 2007; Page A1
In a far-reaching response to the global credit crisis, Citigroup Inc. and other big banks are discussing a
plan to pool together and financially back as much as $100 billion in shaky mortgage securities and other
investments.
The banks met three weeks ago in Washington at the Treasury Department, which convened the talks and
is playing a central advisory role, people familiar with the situation said. The meeting was hosted by
Treasury's undersecretary for domestic finance, Robert Steel, a former Goldman Sachs Group Inc.
official and the top domestic finance adviser to Treasury Secretary Henry Paulson. The Federal Reserve
has been kept informed but has left the active role to the Treasury.
The new fund is designed to stave off what Citigroup and others see as a threat to the financial markets
world-wide: the danger that dozens of huge bank-affiliated funds will be forced to unload billions of
dollars in mortgage-backed securities and other assets, driving down their prices in a fire sale. That could
force big write-offs by banks, brokerages and hedge funds that own similar investments and would have
to mark them down to the new, lower market prices.
The ultimate fear: If banks need to write down more assets or are forced to take assets onto their books,
that could set off a broader credit crunch and hurt the economy. It could make it tough for homeowners
and businesses to get loans. Efforts so far by central banks to alleviate the credit crunch that has been
roiling markets since the summer haven't fully calmed investors, leading to the extraordinary move to
bring together the banks.
In recent weeks, investors have grown concerned about the size of bank-affiliated funds that have
invested huge sums in securities tied to shaky U.S. subprime mortgages and other assets. Citigroup, the
world's biggest bank by market value, has drawn special scrutiny because it is the largest player in this
market.
Citigroup has nearly $100 billion in seven affiliated structured investment vehicles, or SIVs. Globally,
SIVs had $400 billion in assets as of Aug. 28, according to Moody's.
Such vehicles are formally independent of the banks that create them. They issue their own short-term
debt, usually at relatively low interest rates reflecting their high credit rating. The vehicles use the money
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to buy higher-yielding longer-term assets such as securities tied to mortgages or receivables from midsize
businesses seeking to raise cash.
Many SIVs had trouble rolling over their short-term debt in August because of concerns about the quality
of their assets. That contributed to the broader seizing up of credit markets.
The Financial Services Authority, the United Kingdom's markets regulator, has suggested that U.K.
banks consider participating in the plan, a person familiar with the situation said. HSBC Holdings PLC,
the largest U.K. bank, has an affiliate SIV called Cullinan Finance Ltd. with $35 billion in senior debt.
An HSBC representative wasn't immediately available to comment.
If the banks agree, the plan could be announced as early as Monday, people familiar with the matter said.
Citigroup announces third-quarter earnings Monday. The tentative name for the fund is Master-Liquidity
Enhancement Conduit, or M-LEC.
The plan is encountering resistance from some big banks. They argue that Citigroup is asking others to
help bail out its affiliates and an industry-wide bailout isn't needed. Citigroup bankers created the first
SIV in the late 1980s in London.
The new fund represents a way for Citigroup and other banks to "outlast the current market conditions
that are so dry right now," says Jaime Peters, an analyst at Morningstar Inc.
Traditional buyers of debt issued by SIVs include money-market mutual funds, municipalities and other
risk-averse investors attracted by the high credit rating of the vehicles.
By providing a receptacle for assets backed by subprime mortgages and other creations of Wall Street,
the SIVs contributed to the big expansion of credit in recent years whose aftereffects are now roiling the
economy.
The Citigroup plan would create a "superconduit," a fund backed by some of the world's biggest banks
that would issue short-term debt and serve as a buyer of assets currently held by SIVs affiliated with the
participating banks.
According to the people familiar with the plan, these assets include securities tied to U.S. mortgages as
well as debt pools called collateralized debt obligations.
Because the superconduit would be backed by the big banks themselves, it's expected this would reassure
investors and make them more willing to buy its short-term debt, or commercial paper.
The Citigroup proposal recalls the 1998 bailout of huge hedge fund Long Term Capital Management,
which was reeling from bad bets on currencies and other investments. Seven big banks and investment
banks, prodded by the Fed, banded together and prevented LTCM from collapsing.
Two banks in the discussions with Citigroup, Bank of America Corp. and J.P. Morgan Chase & Co.,
would participate not because they have SIVs -- they don't -- but because they would earn fees for
helping arrange the superconduit, according to people briefed on the discussions. The superconduit's debt
would be fully backed by participating banks, they said.
One supporter of the effort is Treasury Secretary Henry Paulson, who decided to assemble the banks after
conversations with businesspeople who expressed concern about SIVs and their impact on the economy,
said a person familiar with the matter.
It's the second time in two months that U.S. authorities helped arrange for financial institutions to discuss
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steps to avert a credit crisis. In mid-August, at the request of the New York Fed, financial leaders met
with Fed officials who explained the Fed's steps to open up the supply of cash to the nation's banks.
The new plan would be challenging to pull off. Bank-affiliated SIVs selling assets into the superconduit
will have to agree on how to price those assets. Some SIVs may value the securities differently. There
have been several meetings since the initial Sunday meeting, both at Treasury and in New York.
For Citigroup Chief Executive Charles Prince, solving the bank's SIV is the latest fire that he needs to put
out. Mr. Prince, under pressure to raise the bank's lagging performance, recently said third-quarter
earnings would fall 60% from year-earlier levels owing to the August meltdown in global credit markets.
Some investors and analysts have called for Mr. Prince's ouster. (See related article1.)
SIVs are purposely kept off the balance sheets of the banks to which they are affiliated. One reason for
this is that banks want to keep down the amount of assets on their balance sheets to reduce the amount of
capital that regulations require them to keep.
Because SIVs are off the balance sheet, it is difficult for investors to size up the financial risks they pose.
Off-balance-sheet liabilities played a major role in the 2001 collapse of Enron Corp., and the makers of
accounting rules have generally sought to get affiliated entities back on the balance sheets of the
companies creating them.
--Robin Sidel and David Reilly contributed to this article.
Write to Carrick Mollenkamp at carrick.mollenkamp@wsj.com2, Ian McDonald at
ian.mcdonald@wsj.com3 and Deborah Solomon at deborah.solomon@wsj.com4
URL for this article:
http://online.wsj.com/article/SB119221840415557568.html
Hyperlinks in this Article:
(1) http://online.wsj.com/article/SB119223341907757962.html
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(3) mailto:ian.mcdonald@wsj.com
(4) mailto:deborah.solomon@wsj.com
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10/14/2007 10:49 AM
Exorcising Ghosts of Octobers Past - WSJ.com
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October 15, 2007
MARKET MOVERS
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Despite Housing Slump,
Crashes Such as in 1987
Likely to Stay Memories
By E.S. BROWNING
October 15, 2007
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With the stock market booming lately, many investors are putting aside worries about the housing
slump and the summer's credit crunch.
At the same time, some are thinking about a looming anniversary.
Twenty years ago this Friday, on Oct. 19, 1987, the stock market crashed, a
memory that still gives veteran stock traders chills. In a single day, the Dow
Jones Industrial Average fell 508 points or 22.6% -- its worst one-day
percentage drop ever (not counting 1914, when the market reopened after being
closed for more than four months during World War I).
For reasons analysts don't fully understand, October has been the month for
market crashes and other sudden drops. It was in October that stocks crashed in
1929, falling 23% over two days. On Oct. 27, 1997, within a day of the
anniversary of the 1929 crash, the Dow Jones Industrial Average fell 7.2%, for
a drop of 13% in two months.
More than 20 years have passed since the market experienced
one of its worst days in history. Veteran-floor broker Ted
Weisberg of Seaport Securities speaks to WSJ.com's David
Gaffen about the infamous day.
But in most years, October has been a fine month for stocks, often marking the
beginning of a fourth-quarter rally. That is what investors are banking on today,
as stocks trade once again near record territory after scary dips in February and
August. After two records this month, the Dow industrials are ahead 13% this
year.
"I think the Fed has taken care of" the summer's harrowing turbulence -- by
cutting short-term interest rates, pumping money into the banking system and
seeming determined to prevent recession, says Janna Sampson, co-chief investment officer at money-management firm OakBrook
Investments in Lisle, Ill..
She was a young money manager in 1987. "I can remember standing in front of a Quotron machine in a crowd of people and
mouths were just hanging open," she says.
Most investors today have little if any memory of the crash. Even many who do believe that, despite surprising similarities
between now and then, there are enough differences to assuage their worries.
Comforting Thought
"The similarities outnumber the differences, but again, that's not to say a crash will
result," Liz Ann Sonders, chief investment strategist at discount brokerage firm Charles
Schwab, wrote in a recent report.
As in 1987, the bull market has been running for five years and is looking somewhat
tired.
The dollar was under attack in 1987, as it has been this year. As autumn began, the
U.S. and its trading partners were bickering about the weak dollar. Then as now, the
U.S. was nervous about its large trade deficit and the inroads of big Asian exporters --
REMEMBERING BLACK MONDAY
1
• Crash Comparison Chartbook2 -- See
how the Black Monday crash of 1987
compares with other dramatic
stock-market drops, including the Great Crash of
1929, the first day of trading after the 9/11 attacks,
and more.
• Q&A: Richard Sylla3 -- What triggered the 1987
crash? Could it happen again? NYU Professor
Richard Sylla places Black Monday in context and
considers the chances of a replay roiling markets in
the future.
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Japan back then, China today. Foreign investors were pouring money into the U.S.
In 1987, big buyout firms dazzled Wall Street by taking major companies private, just
as they did this year. In both years, lending markets faced disruptions.
• Then & Now4 -- What's changed, and what's
stayed the same, on Wall Street and in the rest of
the world since 1987.
Sophistication, '87-Style
This year, as in 1987, sophisticated investors thought they could use computerized techniques to protect themselves from market
drops, and in both years they failed. In 1987, investors planned to sell futures in case of a downdraft -- a technique known as
portfolio insurance. They discovered that, when too many people tried to sell the same futures at the same time, there weren't
enough buyers. This summer, sophisticated hedge funds using mathematical models discovered that, if too many tried to cover
similar bets at the same time, they all could suffer heavy losses.
But some of the root causes of the 1987 crash appear to be missing today. A big problem 20 years ago was that stocks had risen
too far, too fast. At their August high, the Dow industrials were up more than 43% for 1987 alone, a stunning short-term gain.
They slipped after that, falling especially heavily just before the crash.
This year, the stock gains have been more moderate. At their record close of 14164.53 last Tuesday, the Dow industrials were up
14% for the year. The Dow finished on Friday at 14093.08. Instead of declining as October wears on, stocks have rebounded.
Stocks don't look as overpriced today as they did in 1987. Today, the companies in the Standard & Poor's 500-stock index trade
only a little above the historical average of 16 times profits for the past 12 months. In 1987, the S&P 500 was at more than 20
times profits. Interest rates are much lower than they were then and inflation, which was causing the Federal Reserve to fret in
1987, appears to be moderating, at least for now.
Indeed, one of the most
significant differences between
then and now is the Fed's
position. In 1987, to fight
inflation, the Fed was raising
interest rates and tightening
credit conditions, which made
bonds look attractive compared
with stocks and amplified
worries that stocks were
overvalued. Alan Greenspan,
then the Fed chairman, didn't
loosen the credit reins until
after the crash.
Fed's Action
This time, the Fed already has
stepped in, lowering target
short-term interest rates and
pumping money into the
banking system. Frozen credit
markets are a bigger worry
than overvalued stocks, and
the Fed's early action has
helped stocks rebound.
Investors are putting a good
deal of faith in Fed Chairman
Ben Bernanke, who spent
years as an academic studying
the Great Depression and the
role the Fed can play in
preventing a recurrence.
"If anybody in the world
would know the dangers of a
situation like this, it ought to
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be Ben Bernanke, who became quite well known for his studies of it," says Richard Sylla, a financial historian at New York
University's Stern School of Business.
Despite the continuing housing crisis and difficulties that many borrowers still face raising money, many investors believe the
worst of the year's troubles are over. While they wouldn't be surprised to see some stock jitters crop up around the time of the
anniversary, they see stocks continuing their rebound.
"Hardly anyone is thinking about" the 1987 crash, says Phil Roth, chief technical market analyst at New York brokerage firm
Miller Tabak. Mr. Roth thinks U.S. stocks may surprise people by declining further, but he thinks there are bigger risks in foreign
markets, which have risen more rapidly.
"The next crash will probably be where the most speculation is. The most speculation now is not in U.S. stocks (not many of
them, anyway). The speculation is in Asia, primarily China and India," Mr. Roth says.
Another source of reassurance: Frightening though 1987 was, with some stock brokers literally ceasing to answer their phones on
the day of the crash, the worst was over on that day.
The 1987 Snapback
Unlike 1929, when the crash led to the Great Depression, the economy kept growing in 1987. The crash actually marked the
market's low point, and stocks recovered the next day, beginning a new bull market right then. By year's end, stocks had risen
enough that the Dow industrials showed a gain for the year.
Some investors now worry that current economic problems could be worse than in 1987, and could be longer lasting, even without
a crash or a bear market.
The 1987 crash was about overvalued stocks and rising interest rates, and it didn't seriously hamper economic growth. The
troubles this year include the threat to consumer spending from the housing slump and credit problems.
"The disaster in 1987 was different than others, because it happened so fast. It was hard to know how far the tentacles were going
to reach," says Steve Finerty, chairman of Argent Capital Management in St. Louis. "Of course, in 1987, after three or four
months, it was ancient history. I don't think it is going to be that way this time, but you never know. Things can change fast."
Write to E.S. Browning at jim.browning@wsj.com5
URL for this article:
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10/14/2007 11:07 PM
Commercial Paper Outstanding Rises - WSJ.com
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October 18, 2007 10:57 a.m. EDT
Commercial Paper Outstanding Rises
By ANUSHA SHRIVASTAVA
October 18, 2007 10:57 a.m.
NEW YORK -- In a week when a special fund was created to ease the
clogging up of the short-term paper market, the asset-backed commercial
paper outstanding fell by $11 billion.
The U.S. commercial paper market expanded slightly by $1.3 billion on a
seasonally adjusted basis to $1.888 trillion in the week ended Wednesday,
according to the latest data from the Federal Reserve.
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Earlier this week, Citigroup Inc., Bank of America Corp. and J.P. Morgan Chase & Co., as well as
some other financial institutions, confirmed plans to create a special fund to purchase highly rated assets
from existing structured investment vehicles -- or SIVs -- that have been shut out of short-term debt
markets.
These SIVs borrowed in markets such as asset-backed commercial paper to finance their purchases of
longer-dated investments, which have included subprime mortgages.
Commercial paper typically matures in 30 days.
Investors had been refusing to buy short-term debt from SIVs or even investing in paper longer than that
with just overnight maturity during a credit crunch this summer. They feared contamination by the
subprime mortgages that backed some of the issues and became risk averse.
Some market participants have pointed out that the contraction in the ABCP market may actually be
beneficial in the longer term as a balance between supply and demand is achieved.
Last week, commercial paper outstanding rose $4.9 billion on a seasonally adjusted basis to $1.864
trillion, according to data from the Federal Reserve.
The only decline was in the asset-backed commercial paper outstanding sector, which had accounted for
all of the decline for two weeks running. Last week, the decline was $6.8 billion, following a decline of
$6.1 billion in the week prior.
During the credit crunch, the declines had been about $70 billion each week.
Write to Anusha Shrivastava at anusha.shrivastava@dowjones.com1
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10/18/2007 2:17 PM
Print Story - canada.com network
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Friday » October
19 » 2007
Black Monday II unlikely
David Berman
Financial Post
Friday, October 19, 2007
If you are wondering why strategists, economists and journalists are making such
a fuss about the 20th anniversary of the 1987 stock market crash, dubbed "Black
Monday," the answer comes down to one word: nervousness.
Few investors would care about today's anniversary if stocks were mired in a bear
market right now. Indeed, they would probably skip the anniversary altogether
and wait another five years before taking a sober look back.
But with most major stock market indexes at or near record highs amid a slowing
U.S. economy, soaring energy prices and a Chinese investment bubble, 1987
looms large.
Could a crash of that magnitude happen again?
It certainly looks like a hard record to beat. The Dow Jones industrial average
defined the crash with its harrowing 22.6% one-day plunge, taking other world
indexes down with it and creating fears of a global recession and a permanent
change to the way investors look at financial markets.
True, there are a number of similarities between then and now. In 1987 and
today, stock markets had enjoyed about five years of solid gains, the U.S. dollar
was getting whacked, private-equity buyout firms were remarkably active and
sophisticated investors were relying on computer models to give them direction.
However, the world is also a very different place than it was 20 years ago. The
U.S. economy has shrunk in relative importance to the world thanks to the arrival
of China, Russia and India, which means that trouble on Wall Street will not
necessarily translate to trouble around the world. As well, bond yields are
substantially lower, which gives investors a big reason to favour stocks over
bonds. And some stock markets have built-in stabilizers.
But the biggest reason why 1987 will continue to stand as a record-breaking day
is the simple fact that central bankers around the world have a far better
understanding of markets than they did 20 years ago.
"There are a lot of people who believe it was really a function of mistakes made by
the Fed in the summer of '87," said Mark Kamstra, a finance professor at the
Schulich School of Business at York University. He is referring to the fact that the
U.S. Federal Reserve raised rates to head off inflation prior to the crash and did
not lower rates until after the damage had been done. "And I think they have
learned from that."
Today, the Fed -- not to mention many other central banks --are largely on the
side of the investor, quick to free up liquidity in times of trouble and often in
remarkable co-ordination with one another. The response from central banks to
this summer's credit crisis, including the half-percentage-point cut in short-term
interest rates by the Fed, stands as a good example.
"I've never seen a co-ordinated, aggressive central bank action to that
10/19/2007 10:21 AM
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degree--not just by the Fed but by the European Central Bank and other central
banks around the world," said Nick Majendie, strategist at Canaccord Capital,
referring to this summer's actions.
Will stock markets continue to be volatile? You bet, and current concerns such as
the U.S. dollar could easily create big problems in the months ahead. But as for
nightmares like Oct. 19, 1987, the odds of a repeat look very slim.
© National Post 2007
Copyright © 2007 CanWest Interactive, a division of CanWest MediaWorks Publications, Inc.. All rights reserved.
10/19/2007 10:21 AM
When Crash Means 'Buy' - WSJ.com
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October 19, 2007
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After Black Monday,
Advice to Invest on Dips;
'The Great Moderation'
By JUSTIN LAHART
October 19, 2007; Page C1
The 1987 crash -- 20 years ago today -- had investors bracing for the worst.
When the worst didn't come, those who quickly recognized that the economy
and the stock market were far more resilient than they had thought looked smart.
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A little more than a year later, the Dow Jones Industrial Average had made back all the ground it had lost, and
anyone who bought in the aftermath of the crash could feel justifiably pleased.
QUESTION OF THE DAY
1
Vote: How confident are you in
regulators' ability to deal with a market
crash?2
"I put all of my 401(k) in the stock market at that time, and it turned
out to be one of the few really smart things I've ever done," says
ING Investment Management economic adviser James Griffin, who
was then an economist for Aetna Life Insurance.
Even after declines this week, at 13888.96 yesterday, the Dow is up
nearly eightfold from its close of 1738.74 on Black Monday, Oct. 19, 1987.
As the market has rebounded from every downturn in the 20 years since the crash, individual investors
accepted the notion that they should continue to plow money into the stock market even when the picture
looks bleak. "Buy on the dips" has become their creed, and standard-issue investment advice. Many saw this
summer's credit-market turmoil, which sent stocks down sharply in August, as a buying opportunity. The Dow
industrials have rebounded more than 8% since their recent low on Aug. 16 and hit two records just this
month.
REMEMBERING BLACK MONDAY
• Two Terrible Days: 3 A step-by-step interactive
breakdown of Black Monday and Terrible Tuesday.
4
• Video:5 On the 20th anniversary of
Black Monday, Liz Ann Sonders, chief
investment strategist with Charles
Schwab, evaluates whether a similar crash could
occur today.
• Crash Comparison Chartbook:6 See how the
Black Monday crash of 1987 compares with other
dramatic stock-market drops, including the Great
Crash of 1929, the first day of trading after the 9/11
attacks, and more.
• Lessons Learned:7 WSJ editor Dan Hertzberg
remembers the crash he reported on in 1987. Plus,
read Hertzberg's article from Nov. 29, 1987:
It is a testament to the dynamism of the economy and stock market,
and how skillful policy makers have become when faced with a
crisis. At the same time, there is a risk that investors have become
too complacent, and that if the day comes that the economy can't
bounce back, there will be big losses.
"Probably the largest lesson taken away from 1987 was a belief in
the system and the ability of the system to avoid disaster," says
John Bollinger, president of Bollinger Capital Management in
Manhattan Beach, Calif. "In the long haul, that's probably a lousy
lesson for the markets to have learned, because it ultimately sets up
for problems down the road."
Investors were worried when the Dow industrials plummeted 508
points, or 22.6%, on Oct. 19, 1987. The decline dwarfed the
10/19/2007 1:58 PM
When Crash Means 'Buy' - WSJ.com
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"Terrible Tuesday: How the Stock Market Almost
8
Disintegrated a Day After the Crash ."
• WSJ Video:9 More than 20 years have passed
since the market experienced one of its worst days
in history. Veteran-floor broker Ted Weisberg of
Seaport Securities speaks about the infamous day.
10
• Q&A: Richard Sylla:11 What triggered
the 1987 crash? Could it happen again?
NYU Professor Richard Sylla places
Black Monday in context and considers the chances
of a replay roiling markets in the future.
• Then & Now:12 What's changed, and what's
stayed the same, on Wall Street and in the rest of
the world since 1987.
previous record one-day percentage decline of 12.8% on Oct. 28,
1929, which was followed by an 11.7% drop the next day, and
everyone knew what happened after the 1929 crash. The
stock-market crash "clearly has serious recessionary overtones,"
Jon S. Corzine, a partner at Goldman Sachs in 1987, now governor
of New Jersey, told The Wall Street Journal at the time.
Instead of falling into recession, the economy kept growing.
Banking overhauls and securities laws passed after the 1929 crash
helped to reduce financial risk. The Federal Reserve, which
lowered rates in response to the crash, was raising them by the
following April.
• Exorcising Ghosts of Octobers Past13
10/15/2007
"You had an unambiguously spectacular market event, but you
never saw it in the real economy data. That was striking," says
Robert Barbera, economist at New York trading-services firm Investment Technology Group Inc. who was
with brokerage-firm E.F. Hutton in 1987.
Mr. Griffin, now at ING, says what made him bullish in 1987, when many of his colleagues were not, was the
way the Fed, under its newly appointed chairman, Alan Greenspan, responded to the crash. Cutting interest
rates stood in contrast to 1929, when the Fed kept rates high. The Fed lowered rates in 1995 after the Mexican
peso crisis, in 1998 after the Russian debt crisis, in the aftermath of the Sept. 11, 2001, attacks and, most
recently, in response to this summer's turmoil.
Donald Fine, a market analyst at
Chase Manhattan Bank in 1987,
recalls that after the crash "the
recession talk began immediately."
But when the economy shrugged off
the crash "it said that the economy
was considerably more resilient than
people thought," says Mr. Fine.
The next recession didn't begin until
1990, making the economic
expansion begun in 1982 the longest
ever in the U.S. during peacetime.
The expansion that followed, which
didn't end until 2001, was the
longest in history. It's all part of a
damping of economic volatility over
the past 25 years that some
economists dub "The Great
Moderation."
One consequence of the Great Moderation has been that companies no longer get rocked as hard by the forces
of boom and bust as they did before. That, and policy makers' skill at guiding the economy through crises, has
meant buying stocks after selloffs has generally been a good tactic.
Combined with the booming technology industry, this helped to create the tech-stock bubble. The 2½-year
decline that began in 2000 should by all rights have killed the buy-on-the-dips strategy, but because other
parts of the market performed well, investors still dive into the market during nearly every pullback.
10/19/2007 1:58 PM
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It isn't just policy makers who have been on the stock market's side, says Bollinger Capital Management's Mr.
Bollinger, but also the economy at large. In other countries and at other times, that hasn't been the case. The
years of economic stagnation that followed the popping of Japan's bubble in 1990 proved too much for policy
makers, and Japanese stocks are still well below their all-time highs.
The real risk, says Mr. Bollinger, is that someday the U.S. economy will run into trouble that defies the ability
of the Fed to deal with or, to put it another way, that the success of economy's resilience over the past 25 years
has more to do with luck than it does with policy makers' skill.
Write to Justin Lahart at justin.lahart@wsj.com14
URL for this article:
http://online.wsj.com/article/SB119275163589664160.html
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•
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•
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Exorcising Ghosts of Octobers Past
Some Warning Flags Fly As Stocks Continue to Soar
New Rules For Picking A Bottom?
China Regulator Cites Role in Stock Market
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10/19/2007 1:58 PM
Fed Says Its Silence on Super SIV Does Not Reflect Opposition - WSJ.com
1 of 2
http://online.wsj.com/article_print/SB119309437952767673.html
October 23, 2007 12:49 p.m. EDT
Fed Says Its Silence on Super SIV
Does Not Reflect Opposition
By DAVID WESSEL
October 23, 2007 12:49 p.m.
WASHINGTON -- A senior Federal Reserve official said the central bank's
silence on the Master-Liquidity Enhancement Conduit -- or super SIV -has been "misconstrued" as opposition or lack of support for the proposal.
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"The silence has been misconstrued," the official said. "The proposal looks
reasonably well designed and has the potential to contribute -- rather than to impair -- improvements in
these markets and the process of price discovery."
The M-LEC, as it has been dubbed by its creators, was organized by several big banks with the support of
the U.S. Treasury. Fed officials in New York and Washington were briefed on the deliberations, but have
not publicly endorsed it. The megafund, which could be as a large as $100 billion, is intended to address
the weak demand for short-term IOUs issued by certain Structured Investment Vehicles that hold
mortgage-backed securities and is backed by Citigroup Inc., J.P. Morgan Chase and Bank of America
Corp.
One purpose is to reduce anxiety in markets that SIVs and conduits that are unable to finance themselves
will have to sell large amounts of mortgage-backed assets in a hurry, an overhang that backers of the fund
believe is delaying the return of more normal market conditions.
The M-LEC proposal has been criticized on several fronts. Former Federal Reserve Chairman Alan
Greenspan suggested last week that it might impede the resolution of current problems by preventing
prices from being allowed to fall to market levels, an argument the Fed official rejected. Others have
derided it as unworkable, excessively complex or a sophisticated maneuver by Citibank to off load some
of its risks. The Institute for International Finance, a group of large international banks, over the weekend
emphasized the need for more transparency if the proposal is to succeed.
Still others initially read the proposal as a sign that authorities were newly nervous about deteriorating
market conditions, a reaction that the Fed official said was incorrect.
•
•
Bank Overseer Wellink Has 'Mixed Feelings' on Super SIV1
Econ Blog: Poole Unsure if Super SIV Will Work2
Write to David Wessel at capital@wsj.com3
URL for this article:
http://online.wsj.com/article/SB119309437952767673.html
10/23/2007 3:23 PM
Why Rate Cut Isn't a Sure Thing - WSJ.com
1 of 3
http://online.wsj.com/article_print/SB119370194806575651.html
October 30, 2007
Why Rate Cut Isn't a Sure Thing
Bowing to Market Pressure
Could Prolong Dilemma
For Fed's Policy Makers
By GREG IP
October 30, 2007; Page A2
The market is convinced the Federal Reserve will cut interest rates
tomorrow, but for the Fed itself, it is a closer call.
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The behavior of financial markets implies near certainty by
investors of a quarter-point cut in the Fed's key short-term
interest rate. But for policy makers, the decision is between the
quarter-point reduction and no cut at all. A half-point cut is
unlikely to get serious consideration from Fed officials, though
some in the market expect it.
Both courses of action have risks. Perhaps the biggest is that
the market's certainty that rates will be cut creates a burden on
the Fed to deliver. Ordinarily, meeting market expectations
isn't a goal in itself for the Fed.
But the current environment is more fragile than usual, and
thus the consequences of disappointing the market are
potentially more damaging. Against that, the Fed will have to
weigh the risk that a cut will stoke inflationary psychology.
The Fed can mitigate the risks on either front with its
accompanying statement. No rate cut could be accompanied by a statement opening the door to a future
cut. A cut could be accompanied by a statement damping expectations of more reductions.
"I would guess market expectations would be the deciding factor," said Lou Crandall, chief economist at
Wrightson ICAP, a research arm of ICAP, a money-market brokerage. Mr. Crandall doesn't expect a cut,
citing the risk that doing so would prompt investors to expect another in December, putting the Fed in the
same bind. On the other hand, he said if the Fed thinks it will cut eventually, market expectations may
nudge it to do so now rather than later, he said.
On Sept. 18, the Fed cut its target for the federal funds rate, charged on overnight loans between banks, a
larger-than-expected half a percentage point to 4.75%. Since then, market expectations of what the Fed
would do at its two-day meeting that ends tomorrow have swung wildly.
Analysts' views moved in tandem. J.P. Morgan Chase originally called for a quarter-point cut, then
revised that to no cut on Oct. 12 as stocks hit new highs and unemployment-insurance claims remained
10/30/2007 10:44 AM
Why Rate Cut Isn't a Sure Thing - WSJ.com
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low. Then, "everything turned against us," said economist Michael Feroli. Housing data and financial
markets weakened and in speeches Fed officials didn't counter rate-cut expectations. On Oct. 23, the firm
again said the Fed would cut; 17 of 21 dealers surveyed by Dow Jones Newswires agree. Failure to
deliver could cause credit markets to weaken and stocks to dive, Mr. Feroli warned: "I think it will be
ugly."
As of yesterday, the implied probability of no change was 16%, according to options data analyzed by the
Federal Reserve Bank of Cleveland; the probability of a quarter-point cut was 72%, and of half-a-point
cut, 10%.
The case for remaining on hold comes down to the economic forecast. While housing data has
deteriorated further, there is little sign so far that it has spilled over to the broader economy. Fed officials
don't appear to have significantly altered their forecast of a return to moderate growth next year. Helped
by last month's rate cut, many market interest rates have come down. Stocks have recovered from their
swoon two weeks ago. While inflation concerns have receded, they haven't disappeared, especially given
the dollar's drop.
Some officials may argue that, at 4.75%, the federal-funds rate is still high relative to underlying growth
and inflation. But the biggest argument for cutting rates will be market expectations. Fed officials didn't
intend to nudge the market to expect a rate cut, so they will have to weigh the possibility that markets are
signaling a more pessimistic view on growth and credit markets than the Fed sees.
The Fed can use other tools to influence reactions to its rate action. If it cuts, the accompanying statement
could damp expectations for more by suggesting the risks to growth have receded. It could go the added
step of saying the risk of weaker growth equals the risk of higher inflation. If it stands pat, the statement
could keep a later cut on the table by stressing continued risks to growth or market stability. Fed officials
are weighing issuing more forecasts, and could do so at this meeting, perhaps for release with the minutes
three weeks later. A forecast would provide context to the Fed's decision.
•
Econ Blog: Longer Ride Down for Housing1
Write to Greg Ip at greg.ip@wsj.com2
URL for this article:
http://online.wsj.com/article/SB119370194806575651.html
Hyperlinks in this Article:
(1) http://blogs.wsj.com/economics/2007/10/29/longer-ride-down-for-housing/
(2) mailto:greg.ip@wsj.com
Copyright 2007 Dow Jones & Company, Inc. All Rights Reserved
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Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones
Reprints at 1-800-843-0008 or visit www.djreprints.com .
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Which Way Is Scarier?
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10/30/2007 10:44 AM
Merrill's O'Neal Steps Down - WSJ.com
1 of 4
http://online.wsj.com/article_print/SB119375051167876220.html
October 30, 2007 11:12 a.m. EDT
10/30/2007 11:28 AM
Merrill's O'Neal Steps Down - WSJ.com
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Merrill's O'Neal Steps Down
By KEVIN KINGSBURY and JED HOROWITZ
October 30, 2007 11:12 a.m.
Merrill Lynch & Co. ended a firestorm of speculation Tuesday by saying
Chairman and Chief Executive Stan O'Neal, 56, has "retired," effectively
immediately, making him the highest-profile U.S. executive to fall in the
wake of mortgage-related losses on Wall Street.
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Merrill, which runs the world's biggest brokerage network, named board
member Alberto Cribiore as interim nonexecutive chairman and said all
current heads of businesses at the investment banking giant will retain their roles. Mr. Cribiore, a private
equity executive at Brera Capital who was appointed by Mr. O'Neal to the board four years ago, will head
a search committee to replace Mr. O'Neal.
Co-Presidents and Chief Operating Officers Ahmass Fakahany and Gregory
Fleming will continue in their current roles, as will Robert McCann, head of the
firm's retail brokerage unit and Rosemary Berkery, general counsel and vice
chairman.
"The search committee will complete its work as soon as practicable," said
Merrill spokesman Jason Wright.
Shares of Merrill were recently down $1.64, or 2.4%, at $65.78.
Merrill last week reported a third-quarter net loss of $2.3 billion after writing off
$8.4 billion of mortgages, collateralized debt obligations and loans. Only 10 days
earlier, Mr. O'Neal had said the writeoffs would be $5 billion, and earlier in the
summer he and other Merrill executives said the subprime mortgage crisis appeared to be overblown and
ending.
In a statement, Merrill said it and Mr. O'Neal agreed a change in leadership "would best enable Merrill
Lynch to move forward and focus on maintaining the strong operating performance of its businesses."
Mr. O'Neal also reportedly antagonized several board members by approaching commercial bank
Wachovia Corp. about a possible merger without first informing the board. Such a move not only
irritates directors, who have higher fiduciary obligations to shareholders under post-Enron legislation, but
also sent a signal throughout the firm and the investment community that Merrill's situation was even
more dire than its third-quarter numbers revealed.
Several analysts have forecast in recent days that Merrill will write down at least another $4 billion of
subrpime-related CDOs in the current quarter.
RELATED READING
1
• O'Neal's Last Big Deal: His Pay
Package2
10/30/2007
• O'Neal Out as Merrill Reels From Loss3
10/29/2007
• CEO Search File: Merrill4
10/29/2007
Merrill was a latecomer to the structured finance business,
which packages mortgages and other assets into bonds, but in
the last three years under Mr. O'Neal accelerated its
risk-taking to become Wall Street's biggest underwriter of
CDOs. Investors since the summer have refused to buy the
debt instruments, which have been withering along with
underlying mortgages on balance sheets of the firms that
created them.
10/30/2007 11:28 AM
Merrill's O'Neal Steps Down - WSJ.com
3 of 4
• BreakingViews: Merrill Needs an Outsider5
10/29/2007
• Deal Journal: What Merrill Didn't Say6
• MarketBeat: Who is Alberto Cribiore?7
• MarketBeat: Will Replacing O'Neal Matter?8
• Deal Journal: No M&A in Merrill's Future: For
Now9
• MarketBeat: Who Should Be Merrill's Next
http://online.wsj.com/article_print/SB119375051167876220.html
Merrill's search committee will interview outsiders and
insiders, a delicate task at a time when many of the firm's
16,000 brokers in the wealth management division have been
disconcerted by the losses in the company's trading and
institutional sales arm and when some of their very wealthy
clients have lost money in Merrill-sponsored CDOs.
CEO?10
• MarketBeat: O'Neal's Gone; What About These
Mr. McCann, a Merrill veteran, was passed over earlier this
summer by Mr. O'Neal when he named investment banker Mr.
Fleming and former chief financial officer Mr. Fakahany as
co-presidents. Mr. McCann, who had reported to Mr. O'Neal, changed his reporting relationships to the
new presidents.
Guys?11
Messrs. Fleming, McCann and Cribiore were not available for comment, the Merrill spokesman said.
Among the outsiders whose names have been prominently floated by search professionals to replace Mr.
O'Neal is Laurence Fink, CEO of asset management giant BlackRock Inc., who is an acquaintance of
Mr. Cribiore. Merrill owns more than 49% of BlackRock. A BlackRock spokesman said Fink was not
available to comment.
Mr. O'Neal was the first African-American to head a major Wall Street brokerage firm and, unlike past
Merrill CEOs, did not rise through the collegial ranks of the firm's retail brokerage systems.
A native of Alabama, he got his undergraduate degree at a General Motors Corp.-sponsored college in a
work-study program, and went on to earn a Harvard M.B.A. He worked in finance at GM, joined Merrill
in 1986 as a junk-bond banker, was named chief financial officer in 1998, and at various times held
positions leading or co-leading capital markets, banking and retail brokerage.
Mr. O'Neal won credit for steering Merrill through a sluggish economy shortly after taking the top job,
and in recent years building its profits by taking more risks in private equity and credit markets.
However, he also antagonized many insiders by meddling with the firm's paternalistic culture.
In about two years after being named president in 2001, he eliminated more than 20,000 jobs, gaining
credit from investors as a cost-cutter. After taking the CEO post at the end of 2002, fired a cadre of senior
executives who were once seen as his supporters and never groomed a strong line of successors, insiders
say.
Write to Kevin Kingsbury at kevin.kingsbury@dowjones.com12 and Jed Horowitz at
jed.horowitz@dowjones.com13
URL for this article:
http://online.wsj.com/article/SB119375051167876220.html
Hyperlinks in this Article:
(1) http://online.wsj.com/article/SB119361574361074355.html
(2) http://online.wsj.com/article/SB119370189558675646.html
(3) http://online.wsj.com/article/SB119359304744274091.html
(4) http://online.wsj.com/article/SB119361574361074355.html
(5) http://online.wsj.com/article/SB119361407477874268.html
(6) http://blogs.wsj.com/deals/2007/10/30/what-the-merrill-release-didnt-say/
(7) http://blogs.wsj.com/marketbeat/2007/10/30/who-is-alberto-cribiore/
(8) http://blogs.wsj.com/marketbeat/2007/10/29/will-replacing-oneal-matter/
(9) http://blogs.wsj.com/deals/2007/10/29/no-ma-in-merrills-future-for-now/
(10) http://blogs.wsj.com/marketbeat/2007/10/29/who-should-be-merrills-new-ceo/
(11)
http://blogs.wsj.com/marketbeat/2007/10/29/oneal-is-gone-but-what-about-these-guys/
10/30/2007 11:28 AM
Merrill's O'Neal Steps Down - WSJ.com
4 of 4
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(12) mailto:kevin.kingsbury@dowjones.com
(13) mailto:jed.horowitz@dowjones.com
Copyright 2007 Dow Jones & Company, Inc. All Rights Reserved
This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our
Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones
Reprints at 1-800-843-0008 or visit www.djreprints.com .
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Related Articles from the Online Journal
•
•
•
•
Will Replacing O'Neal Matter?
Merrill Board Is Forced To Weigh CEO's Fate
Merrill Weighs Interim Steps as Its Search Goes On
CEO Transforms Merrill, but Shift Comes at a Cost
Blog Posts About This Topic
• Merrill Lynch CEO Close to Exit brusliforex.blogspot.com
• Merrill Lynch, Stanley O'Neal managementaschangeagent.blogspot.com
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10/30/2007 11:28 AM
Fed Injects $41 Billion in Liquidity - WSJ.com
1 of 2
http://online.wsj.com/article_print/SB119393229266979192.html
November 1, 2007 11:55 a.m. EDT
Fed Injects $41 Billion in Liquidity
By EMILY BARRETT
November 1, 2007 11:55 a.m.
NEW YORK -- The Federal Reserve pumped a total $41 billion to the U.S.
financial system in three separate operations Thursday, amounting to the
largest injection of funds since the liquidity crisis took hold this summer.
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The size of the injection may come as a surprise, coming just a day after the
central bank delivered its second consecutive rate cut. Wednesday's 25
basis point cut -- which brings the target rate to 4.5% -- follows a half
percentage-point drop in September, which was intended in part to help ease stubbornly high lending
rates in the interbank market.
The New York Federal Reserve's Web site announced a one-day repurchase of $12 billion, alongside a
$21 billion seven-day, and a $8 billion 14-day operation. The total exceeds the $38 billion injection back
in August that marked the largest contribution to the market in a single day since the World Trade Center
attacks in 2001.
"This morning's combined RP package of $41 billion is significantly larger than we had expected based
on our tentative reserve projections," said Lou Crandall, chief economist with Wrightson ICAP.
It slightly undershoots the $42.5 billion in funds maturing Thursday. But the size of the operation
suggests that the Fed isn't yet prepared to allow its additional liquidity to drain from a financial system
still in recovery mode.
And the sheer volume of bids submitted to the repo market -- a super-safe source of funding for the top
tier of the banking community -- suggests that large institutions are still wary of lending. Banks pledge
collateral to the repo market in the form of government bonds and federal agency-backed bonds in return
for short-term loans. Thursday morning, they submitted collateral totaling $263 billion, of which only
16% were accepted.
The effects of the summer's credit crunch are still keenly felt in the short-term debt markets, in spite of a
gradual easing in interbank lending rates. At 4.60% currently, the Fed funds rate, the benchmark rate for
interbank lending, continues to trades above the new target of 4.5%.
The three-month London interbank offered rate -- a key pricing benchmark for debt issuers -- was fixed
at 4.8775% for the day, only a fraction below Wednesday's 4.89%.
This rate customarily trades only a few basis points above the Fed's target rate. But that gap widened to
as much as 50 basis points last month, as investors insisted on bond premiums in line with what they
considered to be a much riskier market environment.
Libor may still take some time to ease back in line with the new, lower target of 4.5%, said Mary-Beth
11/1/2007 6:32 PM
Fed Injects $41 Billion in Liquidity - WSJ.com
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Fisher, analyst at UBS Financial Services. "I'm going to be patient and say we need a few more days to
let (the cut) filter through" to the interbank market, she said.
--Laurence Norman contributed to this story.
Write to Emily Barrett at emily.barrett@dowjones.com1
URL for this article:
http://online.wsj.com/article/SB119393229266979192.html
Hyperlinks in this Article:
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11/1/2007 6:32 PM
Today's Markets - WSJ.com
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November 1, 2007 6:26 p.m. EDT
TODAY'S MARKETS
Stocks Tumble a Day After Rate Cut
As Financials Strain Dow Industrials
By ANNELENA LOBB
November 1, 2007 6:26 p.m.
Stocks logged painful losses Thursday as investors re-thought yesterday's
Fed rate cut and absorbed a series of shocks, including a downgrade of
Citigroup that helped sink the financial sector.
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All three major indexes lost more than 2% of their value, falling steeply in
late-afternoon trade. The Dow Jones Industrial Average fell 362.14, or 2.6%, to 13567.87. It was the
Dow's fourth-worst performance of the year. The S&P 500 fell 40.94, or 2.6%, to 1508.44, its worst
percentage decline since Aug. 9. The Nasdaq fell 64.29, or 2.3%, to 2794.83. Trading curbs were put in
effect at the New York Stock Exchange shortly after the opening bell, and stayed in place all day.
Thursday's declines vaporized gains, and then some, from a Wednesday rally after Federal Reserve
policy makers1 delivered a highly anticipated quarter-point rate cut. Apparently, after clamoring for the
cut and getting it, despite recent strong economic data, traders somewhat belatedly began to fret about its
implications for the economy's health. The Fed's policy statement, which seemed to forestall future cuts,
also triggered losses.
"Besides the downgrades and credit worries, investors are having second thoughts about the Fed cut,"
said Peter Cardillo, of Avalon Partners. "The market had also been ignoring things like the prices of oil
and gold, and they've been flashing warning signs. The Fed abandoned the fight to contain inflation.
[Now] we might have sluggish growth, but is stagflation around the corner?"
MARKETS ON THE MOVE
2
Track indexes and hot stocks3, with
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highlights:
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MARKET WRAP
Wednesday's cut also led to "nervousness that there's another
shoe to drop in the financial sector," said Matthew Johnson,
head of U.S. stock trading at Lehman Brothers. On Thursday,
the Fed injected $41 billion in liquidity into the financial
system, its largest insertion of funds since the credit crisis
began this summer. But economist Drew Matus, also at
Lehman Brothers, said the size and timing of the shot were
"completely meaningless. The Fed is doing what's needed to
keep the effective [rate] close to 4.5%."
Still, uncomfortable reminders of risks to the financial sector
abounded. CIBC World Markets analyst Meredith Whitney
• Stocks Advance on Fed Rate Cut13
downgraded Citigroup to "sector underperformer," saying the
giant bank needed to raise more than $30 billion in capital
through asset sales, a dividend cut, another stock float, or a
"combination thereof." Citigroup was the worst performer in the Dow, losing 6.9%. American Depositary
• European Shares Close Higher11
• Asian Stocks End Mixed12
11/1/2007 6:30 PM
Today's Markets - WSJ.com
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Shares of Credit Suisse Group fell 5% on news that its quarterly net profit fell 31%14 and that it had
written down 2.2 billion Swiss francs ($1.9 billion) for unsold leveraged loans and structured products.
Other financial stocks followed, including AIG, which dropped 6.1%, Morgan Stanley, which shed
7.2%, and Bank of America, which fell 5.3%. The four financial companies in the Dow -- American
Express, AIG, Citi and J.P. Morgan Chase -- accounted for 27.7% of the drop in the index.
As at other major banks, profits at Citi have been slammed by huge writedowns of mortgage-backed
credit instruments on its balance sheet, after this summer's credit crunch reduced the value of many such
assets or made them impossible to trade. After stabilizing recently, a key measure of such derivatives -the ABX index tracking AAA mortgage bonds -- has fallen to fresh lows, adding to lingering worries
about the credit market.
"These strange instruments don't trade regularly, and maybe [Citi] didn't write off enough," said Alfred
Kugel, of Atlantic Trust. "Merrill Lynch made an estimate weeks ago and…it wasn't really enough. This
is such a complicated situation that it's very difficult to properly evaluate it."
The sense that subprime losses would affect other parts of the financial sector deepened when credit-risk
management and mortgage-insurance firm Radian Group reported a loss in the third quarter, due to
tightening credit markets, writedowns and losses related to a subprime mortgage joint venture. Its shares
tumbled 14%. Bond insurer Ambac plunged 19.7%, and bond insurer MBIA fell 11.6%.
Michael Grasher, who covers Ambac for Piper Jaffray, cited Radian's earnings and concern about the
ABX index as potential sector movers, but added that the index wasn't always indicative of insurers'
underlying portfolios.
Adding to the Dow's woes, Exxon shares fell 3.8% after the oil and gas giant posted a
bigger-than-expected 10% drop in third-quarter net income15 on lower refining and chemical margins,
even as Exxon set a quarterly revenue record.
Crude-oil prices settled down $1.04, or 1.1%, at $93.49, after spiking above $95 in electronic trading and
gyrating all day. "Oil [was] all over the place," said Phil Flynn, of Alaron Trading. Weak earnings and
manufacturing data prompted drops, as other traders tried to buy on dips, he said.
The dollar gained slightly against the euro and fell against the yen. December gold futures also were
down after rising as high as $802.50 an ounce. Overseas, Asian stock markets closed mixed, with the
Nikkei 225 adding 0.8% in Tokyo, while the FTSE 100 lost 2% in London.
In major market action:
Stocks declined. On the New York Stock Exchange Thursday, 2,826 stocks declined and 442 advanced,
on composite volume of 1.7 billion shares traded in stocks listed on the exchange.
The dollar was mixed. The euro was at $1.4435 from $1.4486 late Wednesday, while the dollar was at
114.56 yen from 115.35 yen.
Bonds gained. The benchmark 10-year note added 1, or $10.00 for every $1,000 invested, yielding
4.348% Thursday. The 30-year note gained 1 26/32, yielding 4.635%.
Write to Annelena Lobb at annelena.lobb@wsj.com16
URL for this article:
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11/1/2007 6:30 PM
Banks to Make Another Stab At Selling Chrysler Debt - WSJ.com
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November 5, 2007 4:28 p.m. EST
Banks to Make Another Stab
At Selling Chrysler Debt
By SERENA NG
November 5, 2007 4:28 p.m.
In a sign of the gradual recovery of the corporate loan market, Wall Street
investment banks plan to launch on Wednesday an offering of up to $10
billion in loans for Chrysler LLC's automotive business, according to a
person familiar with the matter.
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The offering amounts to a second try at a debt sale that was postponed in July amid gathering credit
market turmoil at the time. The loans are connected to the recent acquisition of Chrysler by Cerberus
Capital Management LP, the private equity firm.
The banks' renewed efforts to find investors for the Chrysler loans this month come amid a recovery in
the market for risky corporate debt in recent weeks. It also comes shortly after the United Auto Workers
ratified a new four-year contract with the auto maker at the end of October, a development that credit
analysts say is favorable for Chrysler.
Much of the Chrysler auto debt has been on the books of Wall Street underwriters since this summer's
liquidity crunch, which was marked by postponements of dozens of junk debt sales to fund leveraged
buyouts and other acquisitions.
Cerberus acquired Chrysler in August from German auto maker Daimler AG. As part of the deal, Wall
Street banks agreed to raise some $12 billion in high-yield loans for Chrysler's auto business and another
$8 billion in loans for Chrysler's financial arm. The Chrysler Financial loans were mostly sold to
investors in late July at a steep discount to their full value.
But faced with weak investor demand for the $12 billion in auto loans at the time, the underwriters,
which included J.P. Morgan Chase & Co., Citigroup Inc., Goldman Sachs Group Inc., Morgan
Stanley and Bear Stearns & Co., opted to postpone that sale and took $10 billion of the loans onto their
own books. Daimler and Cerberus agreed to commit to the remaining $2 billion of the debt.
It isn't clear how much of the $10 billion in Chrysler auto loans the banks will try to sell this month, and
whether they'll be able to find enough investors to take on the debt.
The market for high-yield corporate loans, which fell sharply in July and August, recouped some losses
in September and October and has seen investor demand return to some extent. In the last two months,
banks have sold investors around $50 billion in junk bonds and loans to finance leveraged buyouts
including that of First Data Corp. and of TXU Corp., according to Standard & Poor's Leveraged
Commentary & Data.
In late September, S&P's rating service said it was reviewing Chrysler's single-B credit rating for an
11/5/2007 5:28 PM
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upgrade. Last week, the rating company noted that the new contract with the UAW is favorable to the
company and will support its turnaround efforts in the U.S.
Chrysler's sales have been falling in recent months amid a broader downturn in the U.S. auto market. The
company is aiming to return to profitability next year, and last week moved to shore up its financial
situation by announcing plans to cut up to 10,000 jobs on top of the 13,000 already slated to go in its
restructuring plan.
In a note to employees last week, Chief Executive Robert Nardelli said the market has "changed
dramatically" as a result of the housing slump and high gasoline prices. Chrysler now expects
"significantly lower" sales volume in 2007 and sees the slowdown dragging on into 2008, Mr. Nardelli
wrote.
In addition to slashing more jobs, Chrysler also announced it will stop producing four slow-selling
models, also in a bid to cut costs.
--Neal E. Boudette contributed to this article.
Write to Serena Ng at serena.ng@wsj.com1
URL for this article:
http://online.wsj.com/article/SB119429740348482994.html
Hyperlinks in this Article:
(1) mailto:serena.ng@wsj.com
Copyright 2007 Dow Jones & Company, Inc. All Rights Reserved
This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our
Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones
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•
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Backlog of Leveraged Loans Still Unnerves Credit Markets
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WSJ.com
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file:///C:/Documents%20and%20Settings/HP_Administrator/Desktop/inf...
Other Issues...
Credipedia: Structured Investment Vehicles
Wednesday, October 17, 2007
Structured Investment Vehicles
(SIVs)and similar instruments called conduits are entities that issue short-term, low-yielding notes called commercial
paper. SIVs use the proceeds from selling such paper to buy longer-term, higher-yielding instruments such as
credit-card debt and mortgage-backed securities. SIVs differ from conduits in that they can also issue longer-dated
notes and use leverage. Though banks typically keep SIVs off their balance sheets, they usually assure that some
or all of the vehicles' IOUs will be repaid.
Seeking Help
The Cons: If the vehicles
The Pros: SIVs are a source
either can't sell commercial
for investors of commercial
paper or suffer losses in the
paper, typically considered a
assets they hold, their affiliated
safe-haven investment. They can be
banks could wind up having to help by
profitable for affiliated banks, while
lending funds to keep the vehicles
generally keeping the risks associated
operating or taking some losses back
with their higher-yielding debt off their
onto their balance sheets, potentially
sponsor banks' balance sheets.
resulting in a massive hit to profits.
The Context: The popularity of SIVs has boomed since the strategy was invented by
two Citigroup bankers in the late 1980s. But they became a source of worry for bankers
and policy makers when a credit crunch that began this summer sapped demand for
both commercial paper and risky asset-backed securities -- a double-whammy for SIVs.
The Treasury Department recently brokered the creation of a $100 billion fund to buy
assets from SIVs in hopes of kick-starting the moribund commercial paper market.
Some critics call the fund a bailout of Citigroup, the largest sponsor of SIVs. The fear i s
that trouble for SIVs could compound problems in the credit market, hurting the broader
economy, while also slamming the balance sheets and reputations of major U.S. banks.
--Compiled by: James Willhite
*Note: As of July 13, 2007
Sources: Citigroup; Standard & Poor's
WSJ Links
• Big Banks Announce Plan to Bolster Credit
Market 10/16/2007
• Plan to Save Banks Depends on Cooperation
of Investors 10/15/2007
• Big Banks Push $100 Billion Plan to Avert
Crunch 10/13/2007
• Debt 'Conduits' Hovering Over Citigroup
9/5/2007
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11/23/2007 1:17 PM
Rising Rates to Worsen Subprime Mess - WSJ.com
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November 24, 2007
PAGE ONE
Rising Rates to Worsen Subprime Mess
Interest Payments Set
To Grow on $362 Billion
In Mortgages in 2008
By RUTH SIMON
November 24, 2007
The subprime mortgage crisis is poised to get much worse.
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Next year, interest rates are set to rise -- or "reset" -- on $362 billion worth
of adjustable-rate subprime mortgages, according to data calculated by Bank of America Corp.
While many accounts portray resetting rates as the big factor
behind the surge in home-loan defaults and foreclosures this
• How to Avoid Reset Grief1
year, that isn't quite the case. Many of the subprime mortgages
• Refinancing May Be Harder to
2
that have driven up the default rate went bad in their first year
Enjoy
or so, well before their interest rate had a chance to go higher.
Some of these mortgages went to speculators who planned to
flip their houses, others to borrowers who had stretched too far to make their payments, and still others
had some element of fraud.
RELATED ARTICLES
Now the real crest of the reset wave is coming, and that promises more pain for borrowers, lenders and
Wall Street. Already, many subprime lenders, who focused on people with poor credit, have gone bust.
Big banks and investors who made subprime loans or bought securities backed by them are reporting
billions of dollars in losses.
The reset peak will likely add to political pressure to help borrowers who can't afford to pay the higher
interest rates. The housing slowdown is emerging as an issue in both the presidential and congressional
races for 2008, and the Bush administration is pushing lenders to loosen terms and keep people from
losing their homes.
Banc of America Securities, a unit of the big Charlotte, N.C., bank, estimates that $85 billion in subprime
mortgages are resetting during the current quarter, and the same amount will reset in the first quarter of
2008. That will rise to a peak of $101 billion in the second quarter. The estimates include loans packaged
into securities and held in bank portfolios.
Larry Litton Jr., chief executive of Litton Loan Servicing, says resetting of adjustable-rate mortgages, or
ARMs, has recently emerged as a bigger driver of defaults. "The initial wave was largely driven by a
higher frequency of fraudulent loans...and loose underwriting," says Mr. Litton, whose company services
340,000 loans nationwide. "A much larger percentage of the defaults we're seeing right now are the result
of ARM resets."
11/23/2007 11:03 PM
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More than half of the subprime delinquencies and foreclosures this year involved loans that hadn't yet
reset, and thus were due to factors such as weak underwriting and falling home prices, according to Rod
Dubitsky, an analyst with Credit Suisse.
The majority of subprime ARMs due to reset next year are so-called 2-28 loans, which carry a fixed rate
for two years, then adjust annually thereafter. In a speech earlier this month, Federal Reserve Governor
Randall Kroszner explained how a typical 2-28 subprime loan issued in early 2007 might work. He said
the interest rate on the loan would start at 7%, then jump to 9.5% after two years. For a typical borrower,
that would add $350 to the monthly payment.
Besides the $362 billion of subprime ARMs that are scheduled to reset during 2008, $152 billion of other
loans with adjustable rates are set to reset, according to Banc of America Securities. The other resetting
loans include "jumbo" mortgages of more than $417,000 and Alt-A loans, a category between prime and
subprime. The latter category is the riskier, in part because it includes borrowers who provided little or
no documentation of their income or assets.
The number of borrowers facing higher payments isn't growing
merely because the amount of loans with resets is higher. Another
factor is that those with a looming reset now have a tougher time
sidestepping it by refinancing or selling their home. "There is a large
amount of borrowers who are in products that either no longer exist
or that they no longer qualify for," says Banc of America Securities
analyst Robert Lacoursiere.
Falling home prices mean that many borrowers have little or no
equity in their home, making it tougher for them to get out from
under their loans.
Treasury Secretary Henry Paulson and the chairman of the Federal
Deposit Insurance Corp., Sheila Bair, have been pressing lenders to
modify terms in a sweeping way, rather than going through a
time-consuming case-by-case evaluation that could end up pushing
many people into foreclosure. Officials at the Federal Reserve and
in the Bush administration have estimated that 150,000 mortgages
are resetting a month.
Ms. Bair has proposed that mortgage companies freeze the interest rates on some two million mortgages
at the rate before the reset to help borrowers avoid trouble. "Keep it at the starter rate," Ms. Bair said at
conference last month. "Convert it into a fixed rate. Make it permanent. And get on with it."
Picking up on that theme, California Governor Arnold Schwarzenegger in the past week announced an
agreement with four major loan servicers, including Countrywide Financial Corp., the nation's biggest
mortgage lender, to freeze the interest rates on certain ARMs that are resetting. The freeze would be
temporary, rather than for the life of the loan. The program is aimed at borrowers who are living in their
homes and making their mortgage payments on time, but aren't expected to be able to make the higher
payments after reset.
The mortgage industry opposes a blanket move to modify loans that are resetting, says Doug Duncan,
chief economist of the Mortgage Bankers Association. While modification may make sense in some
cases, he says, it may also simply postpone the inevitable or reward borrowers who didn't manage their
finances wisely. Mr. Duncan says the industry is working with government officials and consumer
11/23/2007 11:03 PM
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groups to develop principles that could be used to determine quickly who qualifies for a modified loan.
The political efforts are aimed at keeping the U.S. economy out of a housing-triggered recession. The
Mortgage Bankers Association estimates that 1.35 million homes will enter the foreclosure process this
year and another 1.44 million in 2008, up from 705,000 in 2005.
The projected supply of foreclosed homes is equal to about 45% of existing home sales and could add
four months to the supply of existing homes, says Dale Westhoff, a senior managing director at Bear
Stearns. This is a "fundamental shift" in the housing supply, says Mr. Westhoff, who believes that home
prices will drop further as lenders "mark to market" repossessed homes.
Foreclosed homes typically sell at a discount of 20% to 25% compared to the sale of an owner-occupied
home, analysts say. Lenders are eager to unload the properties, and the homes tend to be in poorer
condition.
"People didn't leave the house happily," says Jason Bosch, a broker with Home Center Realty in Norco,
Calif. "There are often signs of that. There's used, dirty carpet. The grass is dead." Mr. Bosch says he
now has about 120 bank-owned properties for sale or in escrow compared with none a year ago.
Federal Reserve Chairman Ben Bernanke told Congress earlier this month, "A sharp increase in
foreclosed properties for sale could...weaken the already struggling housing market and thus, potentially,
the broader economy."
The big concern is a vicious cycle in which foreclosures push down home prices, making it more difficult
for borrowers to refinance and causing more defaults and foreclosures.
Real-estate agents, who look at prices for comparable homes, or comps, say the sale of bank-owned
properties can have a big impact. "One month the comps are showing one price and then a bank comes in
and sells a property for $30,000 less," says Randal Gibson, a real-estate agent in Henderson, Nev. "All of
the sudden, that's the new comp. It hurts everyone in the neighborhood."
Write to Ruth Simon at ruth.simon@wsj.com3
URL for this article:
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•
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The United States of Subprime
In Defense of ARMs
Mortgage Meltdown
Refinancing May Be Harder to Enjoy
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11/23/2007 11:03 PM
Rising Rates to Worsen Subprime Mess - WSJ.com
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11/23/2007 11:03 PM
Some Investors Fault Plan to Aid Home Borrowers - WSJ.com
1 of 4
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December 1, 2007
PAGE ONE
Some Investors
Fault Plan to Aid
Home Borrowers
Critics Say Rate Freeze
May Prolong the Pain;
Lenders' Shares Rise
By DEBORAH SOLOMON, JAMES R. HAGERTY and LINGLING WEI
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December 1, 2007; Page A1
WASHINGTON -- A government-led plan to freeze interest rates on certain troubled subprime home
loans drew criticism both from investors who foresee losses and from some analysts warning that it will
merely prolong the pain of the mortgage crisis.
But others said the Bush administration was making the right move to stave off dangers in the housing
market. Shares of major home lenders moved higher.
As much as $362 billion in U.S. subprime home mortgages with adjustable interest rates are due to reset
at potentially higher rates in the coming year, according to Banc of America Securities, risking a wave of
defaults by borrowers unable to afford the new monthly payments. That in turn could exacerbate a wave
of write-offs by investors who now own those mortgages. Losses related to bad mortgages already have
reached the tens of billions of dollars and have led to turmoil in the world's financial markets.
Fears that the problems could accelerate have led the U.S. Treasury
and the mortgage industry to develop a plan that would postpone
the higher rates for some borrowers.
The success of the plan, details of which are still under discussion,
may hang on the many investors in securities backed by mortgages.
A coalition of lenders negotiating with the administration includes
investor representatives, but the securities are held world-wide and
it would be impossible to get everyone's approval. A deal could also
spark lawsuits from investors who believe they're being cheated out
of their money.
Unlike in years past, when just a bank and a borrower were
involved in a mortgage, today's loans have been bundled together,
sliced into securities and sold to investors. That has created
problems for officials trying to help borrowers, because so many
parties are involved.
Alan Fournier, a fund manager at Pennant Capital Management
12/1/2007 7:24 PM
Some Investors Fault Plan to Aid Home Borrowers - WSJ.com
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LLC, Chatham, N.J., predicted that the plan being pushed by the Treasury Department will prolong the
pain of the housing slump. He said it would merely delay inevitable foreclosures for some people who
can't afford their homes, while allowing holders of mortgage-backed securities to put off marking down
their assets.
"This reduces the pressure short-term to bring everything to a clearing price," Mr. Fournier says. "We
really just need to let it wash through."
Most subprime loans, which go to borrowers with poor credit records, carry an introductory "teaser" rate
for two or three years before moving to a higher rate. The plan would keep the teaser rate temporarily for
some borrowers.
The outline of the Bush administration plan won praise from a diverse spectrum. Paul Krugman, the
liberal New York Times columnist, offered "kudos to the Bush administration" on his blog, saying that
while he needed to see more details, "It seems that [Treasury Secretary] Henry Paulson is being much
more proactive on the housing mess than I expected."
House Financial Services Chairman Barney Frank, a Massachusetts Democrat, offered legislative help
for the large-scale modification of loans, saying he was "encouraged by reports of progress" in efforts to
help borrowers who are in danger of losing their homes.
The plan is being negotiated by the Treasury Department and a coalition of mortgage-industry
participants, including lenders, mortgage counselors and servicers -- the companies that collect mortgage
payments. Many of the particulars need to be worked out, including how long the interest-rate freeze
would last and which subprime borrowers would be eligible for relief.
Interest rates on about two million adjustable mortgages are scheduled to jump over the next two years,
threatening many of those borrowers with foreclosure.
RELATED ARTICLES
• Setting Criteria on Mortgage Aid1
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12/1/07
• U.S., Banks Near A Plan to Freeze Subprime
Andy Chow, who manages a $7 billion portfolio of mortgage
bonds and other fixed-income assets for SCM Advisors in San
Francisco, said the success of the plan will depend on how
many borrowers qualify.
"Given what we know right now, it would benefit a smaller
number of borrowers than the market is assuming," he said.
"But if they expand this notion to include more loans, such as
those that haven't reset but have already been delinquent or
those that have already reset, it could be a big deal for the markets."
Rates3
11/30/07
The stocks of financial institutions involved in the plan rose sharply in Friday trading, in part because of
expectations that the Federal Reserve might cut interest rates but also because of hope that the
government's plan might put a floor under the collapsing value of mortgage debt. At 4 p.m. in New York
Stock Exchange trading, shares in Citigroup Inc. were up 3.1%, Countrywide Financial Corp. rose 16%
and Wells Fargo & Co. was up 6%.
Still, the move is drawing criticism from some on Wall Street, who say the government shouldn't be
meddling in the market.
"There's a part of this that's just morally repugnant. The problem is that the policy makers are talking to
servicers about giving away other people's money," said Mark Adelson, a principal of Adelson & Jacob
Consulting LLC, which consults on securitization and real-estate issues. "It's not the servicers' money,
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but shareholders' and investors' money."
Among those who stand to gain or lose the most in this plan are mortgage giants Fannie Mae and
Freddie Mac. Their support would be crucial to the plan's success, because they are viewed as
standard-setters in the mortgage industry. Both are members of the coalition. If they endorse the Treasury
formula for loan modifications, that would make it easier for servicers to defend themselves from any
challenges by disgruntled holders of securities backed by the loans being modified.
Freddie owns about $105.4 billion of securities backed by subprime mortgage loans, and Fannie holds
about $42.4 billion of such securities, according to their third-quarter filings. Those combined holdings
account for about 15% of the $1 trillion or so of U.S. subprime loans outstanding, according to trade
publication Inside Mortgage Finance. Other holders of securities backed by subprime loans include
banks, insurance companies, mutual funds and hedge funds.
"Fannie and Freddie have a lot more to gain than to lose" from a program that reduces defaults and
foreclosures, said Moshe Orenbuch, an analyst at Credit Suisse in New York. If modified loan terms can
prevent some foreclosures and delay others, that might buy time for the housing market to begin to
recover, he said.
A temporary freeze on troubled home loans may help stave off defaults, a plus for investors in
mortgage-backed securities, but it would also reduce the amount of interest the loans are expected to pay.
Investors' losses are likely to depend on what type of security they own. Some own riskier slices of debt
that may lose much or all of their value if a home goes into foreclosure. This group might benefit from a
plan that puts off foreclosures. Other investors might lose less from foreclosures, so long as the
foreclosed house can be sold for a reasonable sum.
"The tricky part is that...you have these investors who are all spread out, people owning different bonds
and all different classes and changing the loans may affect different classes in different ways," said Alex
Pollock, a resident fellow at the conservative American Enterprise Institute and the former president of
the Federal Home Loan Bank of Chicago.
The American Securitization Forum, which is part of the coalition and whose members issue, buy and
rate securities backed by bundles of mortgages, had been resisting broad modifications of loans. Now it
appears to be backing the idea of standard criteria that could be used to help large swaths of troubled
borrowers.
"Currently, we are striving to develop streamlined methods of segmenting borrowers with various
characteristics," said Tom Deutsch, the forum's deputy executive director, in testimony before a House
hearing in California yesterday.
Peter Haveles, a partner at the law firm Arnold & Porter in New York, said the agreements underlying
issues of mortgage securities generally give the servicers discretion to modify loans if they consider that
to be in the best interest of the holders of the securities. He said the possible litigation isn't likely to derail
the Treasury plan, in part because of the breadth of the coalition negotiating it.
A bill introduced by Rep. Mike Castle, a Delaware Republican, would temporarily free servicers from
any liability for modifying loan terms. "Investors are still going to get a return and it's in their better
interest to have those loans perform rather than fail," Mr. Castle said.
--Serena Ng contributed to this article.
Write to Deborah Solomon at deborah.solomon@wsj.com4, James R. Hagerty at bob.hagerty@wsj.com5
12/1/2007 7:24 PM
Some Investors Fault Plan to Aid Home Borrowers - WSJ.com
4 of 4
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and Lingling Wei at lingling.wei@dowjones.com6
URL for this article:
http://online.wsj.com/article/SB119646960597110177.html
Hyperlinks in this Article:
(1) http://online.wsj.com/article/SB119647643203110421.html
(2) http://online.wsj.com/article/SB119647031472310212.html
(3) http://online.wsj.com/article/SB119638615868608863.html
(4) mailto:deborah.solomon@wsj.com
(5) mailto:bob.hagerty@wsj.com
(6) mailto:lingling.wei@dowjones.com
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12/1/2007 7:24 PM
Moody's Warns Over Ratings of Some SIVS - WSJ.com
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December 1, 2007
Moody's Warns Over
Ratings of Some SIVS
By CARRICK MOLLENKAMP
December 1, 2007; Page B5
Debt-rating agency Moody's Investors Service, signaling a new turn for the
worse for some bank-affiliated funds, said it downgraded or put on review
debt totalling $119 billion that was issued by structured investment vehicles
that have been paralyzed by lack of investor appetite.
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Among the funds that face new scrutiny are those affiliated with Citigroup Inc., the biggest operator of
the funds, which are known as SIVs. Moody's said it had downgraded or put on review for a possible
downgrade debt totalling $64.9 billion that was issued by six Citigroup SIVs. A Citigroup spokesman
said the SIVs continue to focus on liquidity and reducing debt. Assets in the bank's SIVs have fallen
steadily to $66 billion from $83 billion on Sept. 30. Asset sales help raise cash.
In total, 20 SIVs were impacted by the Moody's review. Moody's downgraded $14 billion in debt and
placed on review another $105 billion.
The Moody's report highlights the sharp drop in the market value of the assets owned by the structures.
Those assets include bank debt as well as securities tied to subprime-mortgage loans. The sharpest
decline in market value of the assets held by SIVs was incurred by collateralized debt obligations that
own mortgage securities. Those assets saw a drop of 22% in market value in a short period between Oct.
19 and Nov. 23, according to SIV managers. Moody's also signaled the significant decrease in SIV net
asset values, which are the market values of the assets minus the debt -- commercial paper and
medium-term notes -- expressed as a percentage of the capital notes that cushion SIVs against losses.
SIVs typically sell short-term debt and buy debt with longer maturities that pay higher returns. But
investors, including money-market funds, have pulled back from debt sold by the SIVs because of
concern of exposure to subprime-mortgage securities. In a statement, Moody's said the ratings actions
reflected "the continued deterioration in market value of SIV portfolios combined with the sector's
inability to refinance maturing liabilities."
The drop in the market values and the inability to finance the SIV debt is expected to put new pressure on
banks such as Citigroup to support the billions of dollars in debt that SIVs face having to pay in coming
months. Citigroup and other U.S. banks are working to establish a so-called super fund that would
provide SIVs liquidity. The worsening in performance highlighted by Moody's on Friday, however, raises
questions whether that plan will have an impact.
"It's time for the bank-sponsored ones to step up, provide support," said Douglas Long, executive vice
president at London-based structured-finance software firm Principia Partners. "Or they need to
accelerate restructuring."
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A spokesman for Citigroup said that the SIVs it sponsors continue to rely on asset sales for funding. The
assets held by the SIVs totals $66 billion, compared with $83 billion on Sept. 30.
HSBC Holdings PLC, which operates two SIVs, had considered participating in the super fund. But the
British bank, in an example of the moves banks may have to take, recently said it would gradually shut
down its SIVs and take $45 billion in assets, including mortgage-backed securities, onto its own balance
sheet.
Write to Carrick Mollenkamp at carrick.mollenkamp@wsj.com1
URL for this article:
http://online.wsj.com/article/SB119647031472310212.html
Hyperlinks in this Article:
(1) mailto:carrick.mollenkamp@wsj.com
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12/2/2007 11:49 AM
Some Lending Pressures Ease, a Bit - WSJ.com
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December 13, 2007
CREDIT MARKETS
Some Lending Pressures Ease, a Bit
By TOM LAURICELLA, DEBORAH LYNN BLUMBERG and SERENA NG
December 13, 2007; Page C1
A crucial corner of the financial markets -- short-term lending -- showed
glimmers of improvement after the Fed stepped in to help yesterday, but
deep problems persist.
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Since the summer, banks have been less willing to make short-term loans to
each other and other financial companies. Yesterday, some short-term
lending rates -- such as the London interbank offered rate and rates on some
commercial paper -- eased on the Fed's action, while investors showed some willingness to venture away
from super-safe Treasurys.
Thus far, multiple efforts by policy makers to mitigate the problem have had limited impact: In addition
to a series of interest-rate cuts, the Fed has tried with limited success to entice banks to borrow at its
discount window for emergency borrowing.
Meanwhile, the Treasury has worked with financial institutions to modify terms on troubled mortgages
and to contain damage from troubled investment pools called structured investment vehicles.
Despite these efforts, the drumbeat of stress in short-term lending markets has persisted. Banks have
become reluctant to lend to each other, determined instead to conserve cash and also wary of lending to
other potentially problematic institutions.
Investors, who sit on deep pools of cash, also have been unwilling to step in for fear of being saddled
with holdings that might run into trouble.
The Fed and other central banks said they would take unprecedented steps to revive lending by
expanding the ways they inject cash into the financial system. But underlying worries about rising
defaults on mortgages, the complexity of many mortgage-related investments and an economic slowdown
will take more time to sort out.
"The Fed is coming up with some creative ways to attack the problem, but confidence is still very
challenged right now," said Chris Vincent, a portfolio manager at William Blair in Chicago, adding that
the problem is an overhang of securities that are hard to trade, and investors don't know their value. "We
didn't get into this situation overnight, and we're not going to get out of it overnight," he said.
The Fed's moves did help ease concerns that some borrowers would have problems arranging financing
for year end, a time when many financial companies might pull back capital as they close their books for
2007.
Among the bright spots was the market for loans between banks, measured by the London interbank
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offered rate. It has been a major trouble spot. Banks have been charging unusually high rates to lend to
each other.
For example, Tuesday the Fed notched down the funds rate by 0.25 percentage point, but Libor fell only
about 0.06 percentage point, a sign of banks' continued unwillingness to lend. However, Libor fell to
4.88% from 5.06% after news of the new efforts by the Fed to spur lending activity.
Treasurys, which had staged a big rally Tuesday after the rate cut, gave up their gains yesterday, a sign
they were slightly less risk-averse after the latest move. Investors tend to flock to Treasurys, pushing
down these yields, when worries are heightened.
The 10-year Treasury note fell $7.81 for every $1,000 traded, pushing its yield up to 4.075%. The yield
on two-year Treasury notes rose to 3.116% from 2.96% a day earlier.
Meanwhile, the
commercial-paper market,
where many companies fund
their short-term borrowing,
also welcomed word of the
plan.
The commercial-paper market
and its subset, the asset-backed
commercial-paper market, have
been under pressure amid
worries about the fallout from
the subprime-mortgage market.
The asset-backed commercial
paper market has used large
heapings of subprime
mortgages as underlying
collateral, the source of its
stress.
It has contracted significantly over the last few months. As of December 5, the volume of asset-backed
commercial paper outstanding had declined to $801 billion, down nearly a third from $1.19 trillion at the
end of July, according to Fed data.
Yesterday morning, there was an uptick in buying of three- and six-month commercial paper and
asset-backed commercial paper, noted Deborah Cunningham, head of the taxable money-market group at
Federated Investors.
In contrast, investors earlier had been moving to paper carrying shorter-dated maturities, such as
overnight or one-week holdings.
The difference between interest rates on some asset-backed commercial-paper issues and Libor narrowed
by around 0.25 percentage point yesterday, a sizable move, said John Kodweis, a managing director in
J.P. Morgan's short-term fixed-income group.
Another problem: The hangover from the trouble facing structured investment vehicles. So-called SIVs
were mainly set up by banks and profited by selling commercial paper and using the proceeds to buy
higher yielding long-term debt. But some of the debt backing the SIV commercial paper was
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lower-quality mortgages. Investors stopped buying the commercial paper, crippling the SIVs.
"The assumption was that the assets underlying some of the commercial paper were extremely safe, but
when several instances came to light that hadn't been the case, that made investors question things much
more broadly," says Christopher Molumphy, chief investment officer of the Franklin Templeton Fixed
Income Group.
The result is the practical boycotting of anything that isn't 100% transparent. "There's very large demand
for absolute safety," says James McDonald, a portfolio manager at T. Rowe Price Group Inc.
Banks and brokers with exposure to troubled SIVs and other securities backed by troubled mortgages
"have less room on their balance sheets and less capital" to make loans, says Scott Amero, co-head of
fixed income at BlackRock Inc. "That's the stress point in the market."
Security Capital Assurance Is Put on Review by Fitch
Fitch Ratings yesterday put Security Capital Assurance Ltd. and its insurance subsidiaries on review
for a two-notch downgrade from its current stellar triple-A rating.
The rater said the insurer's capital fell short by more than $2 billion under its triple-A guideline. SCA has
four to six weeks to shore up its capital or face the downgrade, Fitch said.
SCA, which is partially owned by XL Capital Ltd., is the first of the financial guarantors to receive such
a warning by a bond-rating firm. Fitch as well as Moody's Investors Service and Standard & Poors
Ratings Service are currently reviewing a slew of insurers to see whether they have sufficient capital to
maintain their triple-A ratings.
A downgrade of any of the insurers -- even if by one notch -- could trigger massive repricing of the
securities wrapped, or insured. About 45% of the investment-grade municipal-bond market is insured,
according to the Lehman Brothers Municipal Index. Insurers' wraps, because of the ratings of their firms,
give bonds triple-A ratings.
SCA ranks fifth among the triple-A insurers in net outstanding insurance. Structured finance makes up
almost half of Security Capital's business, with municipal and international bonds making up the rest.
It is the structured investments, known as collateralized debt obligations, that got SCA in trouble with
Fitch. The rapid deterioration in the subprime loans backing these complex securities means SCA faces
potentially big losses that would erode its capital base.
Fitch noted that "a number" of the $16.1 billion of triple-A rated collateralized debt obligations it insured
are now rated triple-B or speculative-grade, said Thomas Abruzzo, Fitch managing director, who
declined to give specifics in a conference call that discussed the agency's action.
--Romy Varghese and Lavonne Kuykendall
Write to Tom Lauricella at tom.lauricella@wsj.com1, Deborah Lynn Blumberg at
deborah.blumberg@dowjones.com2 and Serena Ng at serena.ng@wsj.com3
URL for this article:
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Hyperlinks in this Article:
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12/12/2007 11:50 PM
Fed Auction Gets Strong Response - WSJ.com
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December 19, 2007 10:44 a.m. EST
Fed Auction Gets Strong Response
By TOM BARKLEY
December 19, 2007 10:44 a.m.
WASHINGTON -- The Federal Reserve said Wednesday it awarded $20.0
billion in 28-day credit through Monday's term auction facility offering
amid strong demand. The interest rate on the facility -- the stop-out rate -was 4.65%, below the 4.75% discount rate, the Fed said.
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In the first of several auctions announced last week in a bid to alleviate a
squeeze in credit markets, the Fed said it received more than $61.55 billion
in bids. The bid-to-cover ratio, an indication of demand, was 3.08, the Fed said. There were 93 bidders,
and each bank was allowed to submit two bids.
"The amount reflects the generally tight financial conditions but the stigma that banks had previously
assigned to borrowing from the Fed under conditions of duress appeared to have diminished," said Joseph
Brusuelas of IDEAglobal.
The Fed's discount window has traditionally served as its primary source of emergency credit. However,
banks are reluctant to take advantage of this source of funding because of the sense that tapping
emergency credit could alarm peers and invite greater regulatory scrutiny. Furthermore, the higher
interest rate on discount borrowing also discourages its use.
Last week, the Fed cut its target for the benchmark federal funds rate by a quarter percentage point to
4.25%, with a similar reduction in the discount rate to 4.75%.
The stop-out rate represents the highest bid rate needed to cover the total offer amount, and all accepted
bids were awarded at that level. Bids at the stop-out rate were prorated at 1.96%, with awards rounded to
the nearest $10,000.
The minimum bid rate was 4.17%. The minimum bid amount was $10 million per bid, with a maximum
bid amount per institution of $2 billion, or 10% of the offering amount. The minimum award was
$10,000 and maximum was $2 billion. The settlement date is Thursday and the facility matures on Jan.
17, 2008.
The Fed plans to hold a series of auctions that would provide term funds to banks against the same wide
variety of collateral used to secure loans at the discount window. It plans to sell a total of $40 billion this
month with more auctions to follow in January.
A second auction is scheduled to be held Thursday, totaling $20 billion of 35-day funds. Two more
auctions are scheduled for Jan. 14 and Jan. 28. The Fed has said it might conduct more auctions in the
coming months, depending on evolving market conditions.
"The number of participants of the request implies that a broad number of financial institutions remain
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concerned with year end refunding, but the quantity demanded does not suggest an impending systemic
crash," Mr. Brusuelas added.
Last week's announcement was coordinated with similar actions by the European Central Bank, Bank of
England, Bank of Canada and Swiss National Bank in an effort to inject liquidity into global financial
markets. On Tuesday, the ECB allotted a record €348.61 billion in a 16-day refinancing operation, while
the Bank of England conducted the first of its additional £10.0 billion three-month repurchase agreement
auctions.
Tony Crescenzi, chief bond market strategist at Miller Tabak & Co., cautioned about reading too much
into the results of the Fed's auction, saying that a heavy amount of participations could be interpreted
either as an indication of strain in the system or that the facility is working.
"We must be careful about over-interpreting the results and should instead look to Libor and other money
market rates to gauge whether the short-term funding problem is being alleviated," Mr. Crescenzi said in
a note before the auction results were released.
Libor rates have been coming off since Tuesday's actions by the ECB and Bank of England, with the
one-month U.S. dollar Libor rate at 4.93% early Wednesday, down from 4.95% Tuesday and 4.97%
Monday.
Write to Tom Barkley at tom.barkley@dowjones.com1
URL for this article:
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Hyperlinks in this Article:
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12/19/2007 11:00 AM
The Game - WSJ.com
1 of 3
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December 18, 2007
THE GAME
By DENNIS K. BERMAN
Credit Crunch Could Worsen if...
Bond Insurers Sink, 'Buck Breaks'
December 18, 2007; Page C1
Wall Street's latest parlor game is best played with a comforting cocktail in
hand: trying to guess just how the ever-fragile banking crisis could tip into
doomsday territory.
The scenarios have the air of gritty science fiction -- a huge capital crunch
triggered by bond-market selloff and a money-market bloodbath.
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The scenarios have, by all accounts, a slim chance of occurring. But they are a reminder of how much the
rapidly changing financial system, for all its innovation, is still built on confidence. "Trust is a funny
concept, because our trust is increasingly built on abstractions," says Lawrence E. Mitchell, author of a
history of the financial industry called "The Speculation Economy."
Here are two leading scenarios as described by Wall Street bankers, traders, and regulators.
•
The bond-rating selloff
Rightfully designated as an obscure corner of the financial markets, the business of bond insurance is
obscure no more. A host of these insurers have reliably guaranteed $2 trillion of bond payments and
principal for years. But having waded into some sketchy mortgage-backed securities, they stand to need
significant, and potentially unattainable, heaps of fresh capital.
The fear is that ratings downgrades at MBIA, Ambac Financial Group, or Blackstone Group-led
Financial Guaranty Insurance might create a cascading effect of other bond downgrades. Without that
extra insurance, a triple-A-rated credit tranche might, for instance, become a double-A-rated or
single-A-rated piece of paper. This has deep consequences for all sorts of institutional investors, who
might be contractually mandated to carry only triple-A bonds, for instance.
In the doomsday case, a bond-insurer downgrade or bankruptcy sets off this bond-market fire sale. The
consequences of this could be unpredictable and severe.
Take a look at the effect of bond downgrades on capital-reserve ratios for banks and insurers. For each
piece of paper, these institutions have to value-weight their holdings, keeping some capital on their
balance sheet in turn. Obviously, a lower-rated A-rated bond requires more capital reserves than a
triple-A-rated one. This means that a bond-ratings blowup could also create a larger bank capital
clinch-up than that being experienced today.
Bond issuers can of course go find new underwriters. But what of the issuers who can't win the
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confidence of other capital-starved underwriting firms? In such a case, banks might force the hand of
regulators to relax their long-standing demands on capital cushions. These rules demand that a bank keep
at least 4% of its holdings in capital on hand, also known as Tier 1 reserves.
So far, the bond-insurance industry is hanging tough. MBIA recently received a $1 billion cash
commitment from Warburg Pincus. But late yesterday, one such insurer, FGIC Corp., was told by ratings
service Fitch that it needed to raise $1 billion or face its own downgrade.
•
Breaking the Buck and Much More
Confidence is at the very heart of the money-market mutual fund, where the sanctity of the "buck" is one
of the last American absolutes. "Breaking the buck" -- meaning to lose one's invested principal -- has
proved so utterly verboten that it's only happened once.
That's only kind of true. In reality, at least seven funds have been made whole because they have been
bailed out by issuing institutions keen to keep their reputations intact.
Some of these funds aren't traditional money-market funds. Rather, they are "enhanced funds" that stretch
for a bit more yield -- and that stretch involved investing in, you guessed it, asset-backed securities to
subprime.
The bailouts are comforting if a small money-market mutual fund falls behind. The worry is that the
credit contagion might go deeper into this market, potentially affecting a far greater sweep of
investments. One test case comes from money-market funds at Charles Schwab and Legg Mason, both
of which have massive funds with some exposure to less-than-desirable structured-investment-vehicle
paper. While the vast majority of these assets aren't impaired, it is still clear that the SIV paper is a riskier
credit because of its exposure to subprime mortgages.
If the value of this SIV paper drops even further, it could touch off losses through the money fund. What
would happen if a money manager had to make the choice between "breaking the buck" or paying for,
say, a crippling $2 billion shortfall?
For some on Wall Street, the threat is less about the capital shortfall and more about an ensuing crisis of
confidence in money funds, leading to liquidations, which in turns creates forced sell-offs and still
greater losses.
At Legg Mason, Moody's Investors Service downgraded the firm's senior debt, saying that Legg Mason
could lose less than $300 million for losses in its own money funds. It was a "very remote" possibility
that the losses would reach $1 billion, Moody's said.
Money market analyst Peter Crane, of Crane Data, dismisses such a scenario, saying that losses would
eventually be manageable, given lower interest rates and increased capital inflows into the sector. "No
one is going to have to pony up $1 billion," he said. Let's hope.
Email dennis.berman@wsj.com1. Get a complete, daily view of the world of deals and deal making at
wsj.com/deals2.
URL for this article:
http://online.wsj.com/article/SB119794339190835701.html
Hyperlinks in this Article:
(1) mailto: dennis.berman@wsj.com
(2) http://wsj.com/deals
12/19/2007 12:18 PM
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Fund Research
Subprime Shakeout
Lenders that Have Closed Shop,
Been Acquired or Stopped Loans
More than 80 mostly subprime mortgage lenders -- those that make home loans to the riskiest borrowers with questionable
credit -- have closed shop since the end of last year as clients defaulted on payments and banks cut off the funding required
to make the loans. The trend accelerated early this year, and by the spring it seemed companies both large and small were
stopping new loan activity, closing shop, declaring bankruptcy or being sold off every other day or two. Though California
suffered most of the casualties, with some 25 lenders going under, no region of the country was untouched. Here's a table of
the damage so far, which can be sorted by date, company name, home state, size based on loan volume or the lender's fate.
Please note that scope of the table has been expanded to include some companies that are still in business, but have at
least temporarily restricted loan activity. — Compiled by Worth Civils
Click on the category names to sort the columns.
Date Announced ↑ Company Name
Home State
Loans Originated
(bil. of $, 2005)
Outcome
Comment
08/16/07
First Magnus Financial Arizona
N/A
Stopped loans
The Tuscon lender,
reportedly the
second-biggest
privately held lender in
the U.S., stopped
funding new
mortgages, citing the
collapse of the
secondary mortgage
market.
08/14/07
Thornburg Mortgage
New Mexico
N/A
Stopped locking
rates
The Santa Fe REIT,
which originates
"jumbo" mortgages of
more than $417,000,
stopped locking in
rates on mortgages,
citing "unprecedented
and irrational
sentiment" in the credit
market. Moody's
downgraded its credit
and several analysts
downgraded its stock.
Thornburg delayed its
dividend payment after
getting margin calls
and finding it more
difficult to fund its
assets in the
commercial-paper and
asset-backed
securities markets. It
cut the book value of
its mortgage assets by
26%. Its shares
plunged 46%.
08/07/07
Impac Mortgage
Holdings Inc.
California
3.3
Stopped funding
loans
Irvine-based Impac,
which also acquired
about $19.5 billion in
mortgages in 2005 and
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another $8.55 billion in
2006, said it has
stopped funding Alt-A
mortgages, but has
met all margin calls so
far. It also has
negotiated the sale of
$1 billion of mortgages
it held using borrowed
money. Its shares fell
28% on the news. It
has since cut costs by
reducing staff and
closing some
operations.
08/07/07
HomeBanc Corp.
08/06/07
Georgia
6.4
Stopped loans
The Atlanta-based
lender shuttered
operations because its
funding has dried up. It
said it can't borrow on
its credit facilities and
was unable to fund its
mortgage-loan fund
obligations beginning
Aug. 6. Countrywide
Financial said it would
buy part of
HomeBanc's
retail-mortgage
operations.
Aegis Mortgage Corp. Texas
N/A
Bankrupt
The Houston-based
lender, one of the top
30 in the country,
suspended
originations and
notified mortgage
brokers that it is
unable to provide
funds for loans already
in the pipeline. Filed
Chapt. 11 on Aug. 13.
08/06/07
American Home
Mortgage Investment
New York
45.3
Bankrupt
The Melville,
N.Y.-based lender saw
its shares lose most of
their value last week,
and laid off 6,500
employees, leaving
1,000. It will no longer
take loan applications;
the company seeks to
maintain its thrift and
servicing businesses.
08/06/07
National City Home
Equity
Ohio
N/A
Stopped loans
The wholesale home
equity lending unit of
National City Corp.
said it had suspended
approvals of new
home equity loans and
lines of credit, citing
market conditions.
08/04/07
NovaStar Financial
Inc.
Missouri
9.3
Stopped loans
The Kansas City
lender suspended
approval and funding
of loans offered
through brokers due to
"severe dislocation" in
the market. On Aug. 6,
it said it would resume
making subprime
loans through brokers.
But it also said it was
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considering "strategic
alternatives," tightened
its underwriting
guidelines, raised
interest rates on loans,
changed the types of
products it offers and
cut 37% of its work
force.
07/25/07
Countrywide Financial California
491
Liquidity problems
The Calabasas lender,
the largest in the U.S.
with 17% of the $2.9
trillion home-loan
market in 2005,
reported a 33% drop in
second-quarter 2007
net income and
slashed its earnings
forecast. Announced
Aug. 9 that
"unprecedented
disruptions" in debt
and mortgage-finance
markets could hurt its
financial condition.
Merrill Lynch on Aug.
15 downgraded the
stock to "sell," warning
bankruptcy was
possible. Countrywide
later tapped an $11.5
billion line of credit and
had its banking arm
provide a greater
share of funding for its
loans. Its stock, down
55% on the year,
jumped 10% after the
Fed cut its discount
rate, a potential lifeline
for Countrywide.
06/29/07
Heartwell Mortgage
Corp.
Michigan
N/A
Closed
This longtime Grand
Rapids lender,
founded by the town's
mayor in 1970, closed
its retail and wholesale
operations. The
company will continue
to manage its
mortgage portfolio.
06/18/07
The Mortgage
Warehouse
Florida
0.3
Closed
This Clearwater-based
company started
operations in 1997 but
has now ceased
lending operations. It
employed about 50
people and originated
roughly $250 million in
loans per year. Firms
with similar names are
still operating in the
states of New York
and Washington.
06/15/07
First Street Financial
Inc.
California
N/A
Closed
This mortgage
wholesaler, based in
Irvine, was a
top-40-ranked
subprime lender based
on fourth-quarter data,
when it originated
nearly $175 million in
loans. First Street
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closed its doors and
transferred all its
servicing to a
third-party company
believed to be Option
One.
06/08/07
Oak Street Mortgage
LLC
Indiana
N/A
Bankrupt/Sold
Oak Street, which was
founded in 1999 by
former Bank One
executive Steve
Alonso and became a
high-flier with $2 billion
in loan volume and
poised to go public
with 700 employees at
its peak, filed for
Chapter 11 bankruptcy
protection. In
December, it sold
most of its assets to
Novastar Financial.
06/03/07
Accredited Home
Lenders Holding Co.
California
16.6
Sold
Accredited was viewed
as one of the stronger
independent lenders
because of its
relatively prudent
underwriting policies,
but its shares
plummeted in March. It
agreed in June to be
acquired by Lone Star
Fund for $400 million.
In August, Lone Star
said it might pull out of
the deal, blaming "the
drastic deterioration in
the financial and
operational condition"
of the lender.
Accredited sued to
hold Lone Star to the
deal.
06/01/07
No Red Tape
Mortgage
California
3
Closed
No Red Tape, which
had announced plans
to double its staff last
year, is winding down
operations, which had
been a jumbo
specialist but
expanded into the
Alt-A and Alt-B
businesss. A high rate
of delinquencies in
those markets
triggered the decision
to abandon the
business.
06/01/07
Lancaster Mortgage
Bankers LLC
New Jersey
N/A
Closed
This New Jersey
lender that offered
expanded criteria
programs and
specialized in Alt-A
and no-documentation
loan programs,
recently abandoned its
mortgage broker
business. Lancaster
had operations in 16
states.
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05/25/07
The Lending Group
Inc.
Florida
0.4
Closed
One of Florida's
fastest growing
companies, with 300%
growth, the
Jacksonville
wholesaler ran out of
funding and
suspended operations.
05/21/07
NetBank Funding
Services*
South Carolina
13.2
Stopped loans
This third-party
origination portion of
NetBank stopped
accepting new
business and is
expected to be closed
within 60 days. The
shutdown comes along
with NetBank's sale of
its loan portfolio and
depository assets,
totalling around $2.5
billion, to EverBank.
Earlier this year,
NetBank, which is
struggling to stay
afloat as shares
tumble, acquried
reverse mortgage
lender BNY Mortgage
Co. and apartment
lender Apartment
Lending Group.
05/17/07
Columbia Home
Loans LLC
New York
0.7
Closed
The unit's operations
were discontinued by
its New Jersey parent,
OceanFirst Financial,
which acquired it in
2000, citing significant
operating losses in the
last two quarters from
subprime mortgage
loan originations.
Columbia's president,
Robert Pardes, who
had been with the
company since the
1980s, resigned after
defaults were hidden
from top management
at OceanFirst. Talks in
late April to sell the
company failed.
05/09/07
Republic Mortgage
LLC
Nevada
1.1
Sold
First Horizon Home
Loans, which closed
its wholesale subprime
unit, bought this Las
Vegas retail and
prime-focused lender,
which was founded in
1988. Financial terms
were not disclosed.
05/07/07
Opteum Financial
Services
New Jersey
6.5
Closed/Sold
Florida-based parent
REIT Opteum Inc.
shuttered wholesale
and correspondent
businesses, based in
New Jersey, citing
undependable
secondary market, and
sold its retail
operations to Prospect
Mortgage Company for
$5 million, plus certain
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lease assumptions
and liabilities. Opteum
itself was acquired in
2005 for about $80
million by Bimini
Mortgage
Management, which
took its name. Late
last year, it sold a
7.5% stake to Citi.
05/07/07
Homeland Capital
Group
North Carolina
N/A
Closed
This second lien
wholesaler that was
shuttered in May is a
wholly owned
subsidiary of First
Greensboro Home
Equity. It acquired
Mortgage Consultants
of Columbia, Md., and
changed its name to
Homeland Capital
Group in 2002,
becoming the vehicle
used to launch the
company's wholesale
mortgage platform.
05/03/07
First Consolidated
Mortgage
Texas
N/A
Closed
Dallas-based
subprime wholesaler,
founded in 1994 and
with business in 25
states, shut down
operations, but is still
operating a direct
business.
05/02/07
Nation One Mortgage
Massachusetts
N/A
Stopped loans
This mid-sized
East-coast wholesale
lender, based in
Norwell, Mass. since
1989, stopped funding
mortgages in May,
although its Web site
is still operational.
04/30/07
Dana Capital Group
California
5
Closed
Founded in 1995 by
real estate industry
veteran Dana Smith,
this is yet another
Irvine firm that closed
its wholesale lending
business due to large
fines aimed at loan
originations. State
officials have begun
license-revocation
proceedings against
Dana in
Massachusetts, where
is has ceased
operations; it also
faces allegations in
New Jersey of
charging improper
fees.
04/26/07
All Fund Mortgage
Washington State
1.4
Sold
Tacoma-based All
Fund, which also
operates as All Fund
Inc. and Amerifund
Financial, was
acquired by CMXL, a
Sacramento
commercial real estate
financing firm, and will
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be held as a sister
company. All Fund has
230 retail offices and
over 2,500 loan
officers in throughout
46 states.
04/26/07
Reverse Mortgage of
America
Washington State
N/A
Sold
Bank of America
acquired this firm,
which is a division of
Seattle Mortgage Co.,
to step up its reverse
mortgage position.
The acquisition will
make BofA the
third-largest player,
trailing Financial
Freedom, a subsidiary
of IndyMac, and Wells
Fargo. A reverse
mortgage is a loan
aimed at senior
citizens that is taken
out against a homes
equity; borrowers
receive the
dollar-value of their
property via an
untaxed lump sum or
monthly amount.
04/26/07
First Horizon Home
Loan
Texas
1.6
Closed Unit
This subsidiary of
Memphis-based First
Horizon National
closed its wholesale
subprime unit only.
04/20/07
Innovative Mortgage
Capital
California
N/A
Closed
Another Irvine-based
firm ceases
operations. One of its
Las Vegas based
brokers set up a
MySpace page under
the name "Mortgage
Loans" that allowed
visitors to fill out an
application. The page
is still up and running
and he has 104
friends.
04/20/07
Mortgage Investment
Lending Associates
Washington State
4.5
Closed
Online based lending
firm, founded in 1984
by 18-year old Layne
Sapp and commonly
known by is acronym
MILA, decides to
close. It was owned by
Washington Consumer
Loan Co. and
employed 500 people.
04/18/07
AcuLink Mortgage
Solutions LLC
Florida
N/A
Closed
This Tampa-based
subsidiary of Option
One, which was
owned by H&R Block,
closed AcuLink
Mortgage Solutions, a
joint vendor
managment company
if formed with
ValuAmerica in 2005.
04/17/07
Option One Mortgage
Corp.
California
31
Sold
H&R Block, the Kanas
City tax-filing
company, sold its
troubled Option One
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subprime unit to
Cerberus Capital
Management for $1.3
billion, less than H&R
was hoping to get. The
deal excluded Option
One subsidiary H&R
Block Mortgage, which
the company shut
down.
04/17/07
Lime Financial
Services
Oregon
2.1
Sold
Lime, which picked up
some of Meritage's
shuttered operations,
was acquired for an
undisclosed by Credit
Suisse, which provided
a $10 million capital
facility to Lime last
year. Since 2003, Lime
grew from funding
loans in 5 states with
18 account executives
to funding loans
nationwide with a
sales force of more
than 300, posting a
418% volume increase
in 2004 and a 108%
increase in 2005.
04/17/07
Home Capital Inc.
Georgia
N/A
Closed
This online retail
lender, founded by
CEO Mike Berte in
Atlanta in 1999 and
with another office in
Arizona, closed its
doors.
04/13/07
Homefield Financial
Inc.
California
2.5
Closed Unit
The Alt-A lender,
which was established
in Irvine in 1998 and
was making hundreds
of hires as recently as
a year ago, closed its
wholesale unit.
04/13/07
First Source Funding
Group
California
N/A
Closed
This non-prime
wholesaler closed
shop in April. The
Cattaneo Team at
Crestline Funding in
Irvine, Calif., appears
to have taken over
their loans.
04/11/07
Alterna Mortgage
New Jersey
N/A
Closed
This niche wholesaler,
which identified itself
"an aggressive
wholesale Alt-A lender
specializing in
alternative
documentation
programs," ceased
operations in April.
04/11/07
Solutions Funding Inc. Florida
N/A
Closed
Jacksonville firm ends
operations same time
as Alterna after efforts
to find a buyer failed.
Firms based in Illinois
and Texas have
similar names.
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04/05/07
LowerMyPayment.com Connecticut
N/A
Closed
Mortgage lead
generation company,
which operated an
online portal for
consumers, said it
would shut down, with
operations ceasing
later in April.
LowerMyPayment.com
was founded by Greg
Kazmierczak, a 12
year veteran of the
mortgage industry who
now serves as a
marketing consultant.
04/05/07
WarehouseUSA
Capital Corp.
N/A
Stopped loans
The Atlanta
warehouse lender, a
division of troubled
subprime lender
NovaStar Financial,
stopped taking new
business.
WarehouseUSA was
founded in 2003 as
NovaStar Capital, but
changed its name last
year when a new Web
site was launched. It
also warehoused
mortgages for lenders
who write loans for
sale to NovaStar
Mortgage, the primary
mortgage lending unit
of NovaStar.
04/04/07
MortgageTree Lending California
Corp.
0.8
Sold
W.J. Bradley, a
Denver acquisition firm
that is consolidating
small and medium
sized mortgage
brokers and banks,
reached a deal to
acquire
Modesto-based
MortgageTree, which
was founded in 1986
and has about 400
employees, for an
undisclosed price.
Bradley has agreed to
buy 10 other mortgage
companies since the
start of 2005 and is
reportedly shopping for
more.
04/03/07
Millennium Funding
Group
Washington State
1
Closed
The national wholesale
lender, which cut 40%
of its staff in March in
a bid to stay alive,
abandoned recovery
plan and calls it quits.
04/02/07
Madison Equity Corp.
New Jersey
N/A
Closed
This supbrime
wholesaler, for which
William "The
Refrigirator" Perry was
once a spokesman,
stopped accepting
applications as a result
of market conditions.
Madison eventually
transferred its loan
pipeline to Impercial
Georgia
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Lending LLC of
Colorado
04/02/07
SouthStar Funding
LLC
Georgia
5.6
Bankrupt
Self-described
"aggressive" subprime
lender abruptly closed
its operations a result
of the "unprecedented
downturn and policy
changes in the
mortgage industry."
Filed for bankruptcy
protection on April 11.
04/01/07
People's Mortgage
Corp.
Connecticut
N/A
Closed/Sold
Closed by parent,
Webster Financial,
which took a $2.3
million charge in the
first quarter. It sold
some of its branch
offices to 1st Mariner
Mortgage, a division of
1st Mariner Bank of
Baltimore, for an
undisclosed amount.
PMC's 40 employees
provided over $1.5
billion in mortgages to
their customers in
Maryland and
Connecticut since
1995.
04/01/07
Zone Funding
California
N/A
Closed
This Simi Valley shop,
which said it was "a
boutique lender
offering a variety of
Sub-Prime and Alt-A
product with a focus
on what the wholesale
industry has largely
ignored," closed its
doors in early April.
03/30/07
EquiFirst Holdings
North Carolina
10
Sold
Birmingham,
Ala.-based Regions
Financial, which
acquired EquiFirst in
1998, sold the
non-conforming
wholesale mortgage
originator to Barclays
for $76 million,
two-thirds less than
originally planned.
EquiFirst was the 12th
largest non-prime
wholesale mortgage
originator in the U.S.,
originating its loans
through over 9,000
brokers in 47 states.
03/30/07
First NLC Financial
Services Inc.
Florida
6
Closed
Friedman Billings
Ramsey closed most
of its wholesale
operations centers for
this subprime lending
unit, which FBR
bought for $88 million
in 2005 from Florida
private-equity firm Sun
Capital Partners, in
response to reduced
loan volume.
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03/29/07
H&R Block Mortgage
03/22/07
Florida
4
Closed
The tax-filing company
shut down this retail
lending subsidiary,
which was founded in
2000 and is distinct
from its also troubled
Option One subprime
unit that the company
sold to Cerberus
Capital Management
for $1.3 billion on April
17.
Sunset Direct Lending Oregon
LLC
1.2
Bankrupt
This subprime
wholesale lender
ceased accepting loan
packages and filed for
bankruptcy. It is also
one of three firms
being sued by Credit
Suisse Group's DLJ
Mortgage Capital for
failing to honor
repurchase loan
requirements.
03/20/07
LoanCity
California
6.4
Closed
One of the biggest
non-subprime lenders
yet to close shop. It
was forced to shut as
credit tightened across
the industry. LoanCity,
which employed 300
people and used to
have dot com after its
name, says its
mortgage business
shrank nearly 40% last
year.
03/17/07
CoreStar Financial
Group Inc.
Maryland
N/A
Closed
CoreStar, founded in
2002 and with nearly
200 employees,
liquidated assets and
voluntarily surrendered
its state mortgage
license. Maryland state
official said no reason
was given.
03/16/07
LoriMac Inc.
California
N/A
Bankrupt
Most of its business
was with credit unions,
the biggest of which
was Transit
Employees FCU, with
$17.2 million in loans
serviced by the
company.
03/16/07
Ameriquest Mortgage
Co.
California
80
Closed Unit
Parent ACC Capital
Holdings started to
shut down last year,
but stayed in business
after Citigroup
provided it with new
capital in return for an
option to buy ACC's
Argent Mortgage and
the servicing arm of
Ameriquest. It recently
gave up naming rights
to Texas Rangers
baseball stadium and
sold its sponsorship of
a Nascar team,
reportedly to Aflac.
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Argent is one of Indy
driver Danica Patrick's
sponsors.
03/15/07
Investaid Corp.
Michigan
0.3
Stopped loans
Midwest lender based
in Southfield, Mich.,
and operating in 10
states said market
conditions were
"impossible to bear,"
so it stopped taking
new loan applications.
03/14/07
Master Financial Inc.
California
0.6
Closed
Hurt by margin calls,
this Southern
California firm closed
its doors. Master
funded subprime loans
to borrowers with poor
credit and Alt-A loans
to those with slightly
better credit.
03/14/07
People's Choice
Financial Corp.
California
4.5
Bankrupt/Sold
Combination of margin
calls, repurchase
requests and liquidity
issues forced a
bankruptcy filing,
becoming the fourth
firm to do so. It sold
residual interests to an
investor group for $21
million and
sub-servicing rights to
Popular Inc. for $25
million.
03/09/07
New Century Financial California
Corp.
56.1
Bankrupt/Sold
The poster child of
subprime problems,
the Irvine lender is the
biggest casualty so far
in the subprime
meltdown. It declared
bankruptcy in early
April, New Century's
shares were delisted
from the NYSE and
investigations into the
company and its
officers are underway.
Sold servicing platform
to Carrington Capital
for $188 million and
loan portfolio to
Ellington Management
for $58 million.
03/09/07
FMF Capital LLC
Michigan
3.8
Closed
Canadian parent FMF,
which was delisted
from the TSX in April,
decided to conduct an
"orderly wind-down" of
the unit after it began
losing money. Late last
year, FMF settled
three securities class
action lawsuits filed in
Michigan, Ontario and
Quebec for a total of
$28 million.
03/09/07
Maribella Mortgage
LLC
Minnesota
0.9
Closed
Loan buybacks hit this
Midwestern firm,
forcing it to close
shop. It previously
claimed to offer
"mint-on-the pillow"
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service. At its peak,
Maribella had 125
employees, with
outside operations in
Chicago and
Milwaukee.
Co-founder Keith
White also owns
Marketplace Home
Mortgage, a large
conventional lender
based in the same
building.
03/06/07
Ameritrust Mortgage
Co. LLC
North Carolina
0.9
Closed Unit
Shut its subprime
wholesale division as
WaMu cut off funding.
CEO John Owens
used his personal
savings to create the
firm in 1995.
03/06/07
Central Pacific
Mortgage
California
2.3
Closed
First casualty in
Northern California.
CEO was John
Courson, who spent
two years as president
of the Mortgage
Bankers Association.
03/05/07
Trojan Lending Inc.
California
N/A
Closed
This diversified lender,
based in Los Angeles
and taking its name
from Southern Cal's
mascot, ceased
wholesale mortgage
operations. Most of its
business was in the
Western U.S. and
Florida.
03/02/07
Domestic Bank
Rhode Island
0.1
Stopped loans
The bank, which has
only nine branches in
the state, ceased
wholesale lending
activities, at least
temporarily, citing
"extreme market
turmoil."
03/02/07
Fremont Investment & California
Loan
36.2
Closed Unit/Sold
Fremont General shut
down its residential
mortgage unit, making
it the second biggest
closure. It sold $2.9
billion of its subprime
loans to Ellington
Capital Management
in April, and in May,
Fremont agreed to sell
its
commercial-real-estate
lending business to
iStar Financial as part
of a $1.9 billion deal
that also resulted in
new management for
the troubled lender.
03/01/07
Champion Mortgage
N/A
Sold
Dallas-based
Nationstar Mortgage,
formerly Centex Home
Equity, in which
Fortress Investment
Group has a stake,
acquired the
loan-origination unit of
New Jersey
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Champion from
KeyCorp. Its $2 billion
loan portfolio was sold
separately to HSBC.
02/28/07
Senderra Funding LLC North Carolina
N/A
Sold
Avelo Mortgage LLC
bought this
Charlotte-based firm
and had fully merged it
into its operations by
May. Senderra was
founded in 2005 by
Brad Bradley, who
previously was the
founder, chairman and
CEO of EquiFirst,
another N.C. lender.
02/27/07
Eagle First Mortgage
Arizona
N/A
Closed
The state of Arizona
pulled the license of
this four-year-old Mesa
firm amid a probe into
fraud and illegal
lending practices. Most
of the fraud was
allegedly coming from
cash-back deals that
involved obtaining a
mortgage for more
than a home is worth
and pocketing the
extra money.
02/21/07
New York Mortgage
Trust
New York
3.4
Sold
This real estate
investment trust sold
its wholesale mortgage
lending platform
assets to Tribeca
Lending Corp., a
subsidiary of Franklin
Credit Management,
and certain assets of
the retail mortgage
banking platform to
IndyMac for $13.4
million. As a result of
the transaction,
co-CEO Steven
Schnall, resigned,
although he remains
as chairman.
02/14/07
Silver State Mortgage
Nevada
0.5
Bankrupt
Closed branches
nationwide as state
regulators looking at
books of Las Vegas
lender, which may try
to continue in some
capacity.
02/12/07
Concorde Acceptance Texas
0.2
Closed
Dallas-based firm
closed amid
deteriorating business
for primary and
secondary loans.
Concorde
management bought
80% stake from
America's Car-Mart for
$2.9 million in 2002.
02/12/07
ResMAE Mortgage
Corp.
6.9
Bankrupt/Sold
Filed for bankruptcy,
but was kept alive by
Credit Suisse, who
was expected to buy,
but sold assets to
California
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hedge fund Citadel
instead for $22.4
million.
02/08/07
Lenders Direct Capital Illinois
Corp.
1.2
Closed Unit
Lenders Direct shut its
wholesale operation
amid rumored loan
buybacks. It
supposedly funded in
excess of $200 million
per month at its peak.
02/05/07
ECC Capital Corp.
14
Sold Unit
ECC sold its mortgage
operation to Bear
Stearns for $26 million
in cash, but said it
would keep its 350
workers in California (it
laid off about 600
people nationwide last
year). ECC conducted
its mortgage
origination operations
through the Encore
Credit Corp. name,
which Bear retained.
01/31/07
Deep Green Financial Ohio
Inc.
5
Closed
Second-lien funder
closed by parent
company. Founded in
2000, it had business
in 47 states and was
bought in 2004 by
Lightyear Capital, a
New York
private-equity firm
based that manages
$2 billion and invests
in financial services
businesses and other
selected industries.
01/25/07
Mandalay Mortgage
LLC
California
0.9
Stopped loans
Mandalay stopped
accepting new loan
applications a week
after their initial
announcement. Its
Web site sends surfers
to three other
mortgage companies.
01/25/07
Millennium
Bankshares Corp.
Virginia
N/A
Closed
The communitiy bank
in Northern Virginia
decided to wind down
its mortgage lending
subsidiary when the
going got tough.
01/25/07
Summit Mortgage
West Virginia
N/A
Sold
Summit Financial
couldn't sell, so it sold
the lending unit. The
parent company also
took losses related to
Fannie Mae and
Freddie Mac stock.
01/23/07
Rose Mortgage Corp.
New Jersey
N/A
Closed
Rose closed down
abruptly in late
January after
Deutsche Bank
withdrew the
company's last lifeline,
a $50 million line of
credit, leaving CEO
Ralph Vitiello and two
colleagues as the only
ones left at the
California
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seven-year-old
subprime mortgage
banking firm, which
employed 60 people
earlier in the month. Its
Web site at
roseloans.com now
contains only jibberish.
01/22/07
EquiBanc Mortgage
Corp.
North Carolina
N/A
Closed
Wachovia shut its only
unit for
non-conforming loans.
Equibanc was founded
in 1996, acquired by
SouthTrust in 2001,
which was in turn
bought out by
Wachovia in 2004. The
bank also paid $24
billion last year for
mortgage specialist
Golden West
Financial.
01/17/07
Funding America LLC
Texas
N/A
Stopped loans
The two-year old
Houston-based
subprime loan
origination operation of
Florida's Ocwen
Financial stopped
accepting new
business earlier this
year. The founder
claims subprime loans
will return when
market corrects itself.
01/12/07
Bay Capital Corp.
Maryland
0.8
Closed
Parent Clear Choice
Financial of Nevada
closed this unit for not
meeting obligations.
Another main office
was in California.
01/09/07
Popular Financial
Services
New Jersey
N/A
Closed
Accounting problems
and mortgage losses
led Puerto Rico-based
Banco Popluar, also
the parent of E-Loan,
to close this wholseale
subprime unit.
01/08/07
Secured Funding
Corp.
California
1.3
Closed
Hurt by loan buybacks,
the firm closed its
doors. It was doing
$150 million of home
equity extractions per
month and had over
1,000 employees.
01/03/07
Preferred Advantage
Pennsylvania
N/A
Closed
This Pittsburgh lender
was closed by
Cleveland-based
parent National City
after Merrill Lynch
didn't include it as part
of its $1.3 billion deal
for National City's First
Franklin, which has
had its own problems.
Less than 50
employees of
Preferred Advantage
were laid off.
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01/03/07
MortgageIT Holdings
Inc.
New York
30
Sold
Founded in 1988,
MortgageIT was
acquired for $430
million by Deutsche
Bank, which maintains
its 50 branch offices,
employing 2,100
people. A $70 million
lawsuit accuses it of
failing to repurchase
587 subprime loans.
The German bank also
bought Chapel
Funding LLC, a
sub-prime wholesale
mortgage originator, in
May 2006.
01/02/07
Mortgage Lenders
Network USA Inc.
Connecticut
4.9
Bankrupt
Buyback and liquidity
woes led this
mortgage lender to
bankruptcy. It is one
the top five biggest to
close, originating $3.3
billion in loans in the
third quarter of 2006. It
was later sold to Wells
Fargo.
01/02/07
First Franklin
(NationPoint)
California
29
Sold
National City
completed the sale of
First Franklin, its
subprime mortgage
business, to Merrill
Lynch for $1.3 billion.
The deal, which was
announced in
September, includes
Merrill's purchase of
affiliated businesses
National City Home
Loan Services and
NationPoint.
12/27/06
Alliance Home
Funding LLC
Virginia
0.2
Closed/Merged
This unit, started in
2001, ceased
operations and
standalone operation
merged with parent,
Alliance Bankshares,
which will take a
charge of up to
$675,000.
12/20/06
Harbourton Mortgage
Investment Corp.
California
0.8
Closed
This company is wholly
owned by Harbourton
Capital Group of
McLean, Va., which
says it is likely to write
off its full investment in
the unit.
12/07/06
Ownit Mortgage
Solutions
California
8.3
Bankrupt
When Ownit defaulted
on its credit line in
mid-November, J.P.
Morgan gave the
company a month to
come up with
additional capital, and
Merrill Lynch
demanded that it buy
back poorly performing
loans. Ownit declared
bankruptcy within
weeks. Former CEO
William Dallas had ties
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to First Franklin and
LoanCity.
12/01/06
First Financial Equities New Jersey
1
Stopped loans
This company,
founded by David
Sadek in 1991,
stopped making loans
and let about 100
people go at the end of
last year.
12/01/06
Sebring Capital
Partners LP
Texas
1.2
Closed
Amid rising defaults, a
major investor cut off
funding, forcing
Sebring, which was
founded in 1996, to
seek a buyer. It closed
after potential
acquisition fell through.
11/21/06
Axis Mortgage &
Investments
Arizona
1
Closed
Alt-A wholesale
lending unit of Biltmore
Bank of Arizona, which
said it had some
buybacks, but was a
small percentage of
overall volume.
11/08/06
Meritage Mortgage
Corp.
Oregon
2.6
Sold
Liquidated by
Atlanta-based parent
NetBank, Meritage
was sold to Lime
Financial, which
acquired its Oregon
staff. The ther big
office was in
Jacksonville, Fla. Lime
was later acquired by
Credit Suisse.
8/16/07 First Magnus Financial Corp., which Bloomberg reports is the second-largest privately held U.S. mortgage lender,
has stopped funding new mortgages. A notice on its Web site blamed the collapse of the secondary mortgage market.
Bloomberg said that First Magnus was the 16th-largest U.S. home lender in the first half of this year, making $17.1 billion in
loans, according to newsletter Inside Mortgage Finance. Posted 1:35 p.m.
Note: *All of NetBank
Sources: SNL Financial, National Mortgage News, MortgageDaily.com, Mortgage Lender Implode-O-Meter, WSJ.com research
Write to Worth Civils at worth.civils@wsj.com
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Home | News | Technology | Markets | Personal Journal | Opinion | Weekend / Leisure | Portfolio | Markets Data Center |
Fund Research
SCORECARD: DEBT DILEMMAS
How Credit-Market Tremors Have Affected Junk Bonds, LBOs and Hedge Funds
The days of easy credit may be coming to an end. The jitters began with losses at two Bear Stearns hedge funds that
invested in subprime-mortgage debt that now are worth almost nothing. And over the past few weeks, a string of companies
has delayed or canceled debt offerings, a sign that investors may be less interested in debt deals that don't adequately
reward them for potential risk. — Compiled by Annelena Lobb and Cassandra Vinograd
Click on the category names to sort the columns.
Problems First
Reported ↑
Issuer or Fund
Problem
Description
The Latest
08/15/2007
KKR Financial Holdings
Inc.
Profit problems
The San Francisco
affiliate of buyout firm
KKR said it could lose
more than $200 million
from leveraged
investments in
mortgage-backed
securities, sending its
stock tumbling.
KKR Financial said it is
talking to other investors
in its portfolio about how
to resolve potential
funding disruptions.
08/14/2007
RAMS Home Loans
Group Ltd.
Profit problems
The Australian non-bank
lender said volatile credit
markets could hit its
earnings, sending shares
in the recently listed
lender down as much as
32%.
The first Australian
mortgage company to
suffer from global credit
squeeze and the first to
have problems related to
the asset-backed
commercial paper market
in the U.S.
08/14/2007
Sentinel Management
Group
Liquidity crunch
The Northbrook, Ill., firm,
which manages
short-term cash for
commodity trading firms
and hedge funds, stopped
allowing its clients to
withdraw funds, saying a
lack of liquidity in the
credit markets has made
it impossible to meet
redemptions without
selling securities well
below their fair value.
The company has hired
Lazard to explore
strategic alternatives. Its
shares have plunged to
less than $1.
08/14/2007
Thornburg Mortgage
Liquidity crunch
The Santa Fe,
N.M.-based REIT, which
originates "jumbo"
mortgage loans of more
than $417,000, stopped
locking in rates on
mortgages, citing
"unprecedented and
irrational sentiment" in the
credit market. Moody's
downgraded its credit and
several analysts
downgraded its stock.
Thornburg delayed its
dividend payment after
getting margin calls and
finding it more difficult to
fund its mortgage assets
in the commercial-paper
and asset-backed
securities markets. It cut
the book value of its
mortgage assets by 26%.
Its shares plunged 46%
on the day of these
announcements.
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08/13/2007
Mission West
Buyout scuttled
The real-estate
investment trust said
closure is unlikely on its
$1.8 billion buyout by an
unnamed private-equity
firm due to the withdrawal
of the buyer's primary and
secondary lenders from
the market.
Mission West is in talks
with three other potential
acquirers with internal
sources of financing.
08/09/2007
American International
Group
Profit problems
Operating income at its
consumer-finance
operations, which
includes a
subprime-mortgage
lender, fell 71%;
mortgage-guaranty
insurance business had a
quarterly operating loss of
$78 million
Acknowledged that
housing-market
weakness led to a
significant increase in
losses for its domestic
mortgage-insurance
business, but said it
remains "comfortable"
with its exposure to the
U.S. mortgage market
08/09/2007
BNP Paribas Investment
Bankers
Funds suspended
The "complete
evaporation" of liquidity in
certain parts of the
subprime mortgage
market pressured funds
Bank said it would
suspend three funds,
Parvest Dynamic ABS,
BNP Paribas ABS Euribor
and BNP Paris ABS
Eonia, worth a total of
about €1.5 billion
08/09/2007
Home Depot
Buyback trimmed
The retailer will now buy
back shares in a modified
Dutch auction at $37 to
$42 a share, down from
the range of $39 to $44 a
share announced in July.
Extended tender offer
deadline to Aug. 31; also
said price of sale on its
supply business might
fall. Recently delayed by
a week the closing of that
deal and warned there is
no guarantee the deal will
be completed.
08/09/2007
NIBC
Profit problems
The Dutch merchant
bank, owned by former
Goldman Sachs banker
Christopher Flowers, said
it has lost at least $187
million on subprime
investments
Investors in NIBC unable
to buy protection against
a default of the
company's debt amid
concerns about the
bank's health and rumors
it was being prepared for
a sale. JC Flowers, the
private equity firm that
owns NIBC with a
consortium of fellow
investors, is believed to
be preparing to sell the
embattled bank.
08/09/2007
Tarragon Corp.
Profit problems
The New York real-estate
developer said there were
doubts about its ability to
to continue as a going
concern, citing "liquidity
issues" and market
conditions. It also delayed
its 10Q filing and
postponed a spinoff of its
homebuilding business.
The company has hired
Lazard to explore
strategic alternatives. Its
shares have plunged to
less than $1.
08/07/2007
United Overseas Bank
Ltd.
Profit problems
The Singapore bank
reported a markdown of
about $22.4 million on its
portfolio of collateralized
debt obligations, the first
Singapore bank to
acknowledge such a loss
amid the subprime crisis.
UOB said it expects to
incur a further loss as of
the end of July.
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08/06/2007
Archstone-Smith Trust
Buyout delayed
A joint venture of
Tishman Speyer
Properties and Lehman
Brothers Holdings said it
would delay the
completion of its $15.2
billion acquisition of
apartment-owning titan
Archstone-Smith to early
October.
Financiers of this deal -seen as a bellwether in
the real-estate market -may be looking for fresh
financing sources to
minimize their own risk
08/06/2007
Luminent Mortgage
Capital
Margin calls
A week after reassuring
investors of its liquidity
and ability to pay a
dividend, the San
Francisco home-loan
investment company said
it was facing significant
margin calls, suspending
its dividend and exploring
strategic alternatives. It
said the econdary market
for mortgage loans and
mortgage-backed
securities "has
seized-up."
Luminent said it's trying to
"enhance its liquidity and
preserve the value" of its
portfolio of assets.
08/03/2007
KfW
Bailout loss
German state-owned
development bank said it
assumed "expected
possible losses" of as
much as $1.37 billion
from bailing out midsize
lender IKB
KfW put up the lion's
share of the 3.5 billion
euro rescue fund set up
to cover IKB's likely
losses when IKB does
sell its investments; IKB
said it has reserves that
are strong enough to
cover it for the next 12
months
08/02/2007
Mitchells & Butler
Venture postponed
U.K. pub operator had
planned to separate out
its property assets from
its operating divisions
Planned property joint
venture put on hold due
to unstable credit market
conditions
08/01/2007
Fortress Investments
Hedge fund losses
Macquarie bank's
high-yield Australian fund
said investors could face
losses of up to 25% due
to U.S. market fallout
Fortress has had to sell
some assets, said
average price of assets in
the portfolios had fallen
by 4% in June and may
have fallen a further
20-25% in July; could
face margin calls if assets
don't sell well
08/01/2007
Oddo & Cie
Fund losses
French securities firm
struggles with plunge in
collaterized debt
obligations
Three funds totaling 1
billion euros will be
closed (Correction: An
earlier version of this
table incorrectly said
these were hedge
funds)
07/31/2007
C-Bass
Margin Calls
MGIC Investment and
Radian Group say joint
venture C-Bass has been
subject to an
"unprecedented" amount
of margin calls, adversely
affecting liquidity
C-Bass said it is in
advanced discussions
with a number of
investors to provide
increased liquidity; MGIC
said it would write down
its $516 million
investment in C-Bass,
possibly to zero; Radian
Group said the same of
its $518 million stake
07/31/2007
Sowood
Hedge fund losses
Boston firm suffered
losses of more than 50%
this month, dropping the
firm's assets to about
Sowood said it will wind
down its two funds
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$1.5 billion from $3 billion
07/31/2007
CNA Financial
Profit problems
Chicago commercial
insurer reported lower
quarterly earnings as
investment losses
increased due to
write-downs on subprime
debt
Company says it suffered
$91 million in losses,
partly due to a $20 million
write-down related to
subprime debt; this
contributed to a 9%
decline in quarterly profit
07/30/2007
IKB Deutsche
Industriebank AG
Profit problems
CEO left; profit warning
issued
Company says it can't
maintain its earnings
forecast of EUR280
million for the 2007-08
financial year; IKB says it
has "felt the impact" of
the U.S. subprime crisis;
Commerzbank said the
difficulties will shave its
profits by 80 million euros
07/30/2007
American Home
Mortgage Investment
Margin Calls
Banks demanded more
cash after the lender
wrote down the value of
its loan and security
portfolios
Shares of the real-estate
investment trust were
halted for more than a
day; lender delayed
paying dividends on
common stock, may
delay payments on
preferred shares because
of margin calls; said may
have to sell assets, find
new financing, or
restructure debt to meet
banks' demands. Filed
Chapter 11 bankruptcy
Aug. 6 after laying off
majority of its workforce
the week before
07/30/2007
Stoneridge
Offering delayed
$200 million senior
secured term loan
postponed indefinitely due
to "unfavorable market
conditions
The electronic
component maker was
forced to cancel its tender
offer to purchase its $200
million in outstanding
senior notes
07/30/2007
Insight Communications
Offering delayed
Bids for the New York
cable operator were due
yesterday, now delayed
more than a week by the
firm's bankers
Bankers at Morgan
Stanley delayed to give
private-equity bidders
more time to line up
financing
07/30/2007
Commerzbank
Hedge fund losses
German bank said its
total exposure to the US
subprime market is 1.2
billion euros
Set aside 80 million euros
to cover exposure to US
subprime market
07/27/2007
Dana Gas
Offering delayed
The U.A.E.-based firm
postponed pricing its $1
billion convertible Islamic
bond due to market
volatility
Dana Gas was advised
by Barclays and Cit to
delay pricing until
September
07/27/2007
AA/Saga
Offering delayed
Merger underwriters
Barclays and Mizuho
banks have so far failed
to find sub-underwriters to
spread £4.8 billion risk
The sale of the GBP 4.8
billion of debt backing the
merger of Saga, a group
specializing in services
for over-50s, and
motor-vehicle recovery
and insurance company
AA has been postponed.
07/27/2007
Cadbury Schweppes
Extended auction bid
deadline
Final bids in the auction
of its U.S. drinks
business, including the
Extended the bid
deadline, citing "extreme
volatility" in the leveraged
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7-Up, Snapple and Dr.
debt markets
Pepper brands, were due
at the start of next week
07/27/2007
Sowood Capital
Management
Hedge fund losses
Down about 10% so far
this year
Sold various positions to
raise cash to deal with
credit difficulties and
potential margin calls;
faces no redemptions
until end of 2008
07/26/2007
Tyco
Offering pulled
Called off $1.5 billion
bond deal, citing
"unfavorable" market
conditions
Tyco had come to the
market with a three-part
note via Goldman Sachs
and UBS
07/26/2007
Gazprom
Offering delayed
Gazprom, the world's
Gazprom said it will
largest gas company,
release the bond as soon
decided not to price its
as the market settles
30-year benchmark dollar
Eurobond, citing market
conditions
07/26/2007
Absolute Capital
Hedge fund losses
Australian fund, which is Withdrawals suspended
half owned by ABN Amro, until market liquidity
temporarily suspends
improves
withdrawals on two funds
with about 200 million
Australian dollars
(US$176.7 million)
invested. The two funds,
exposed to structured
credit assets, lost up to
6% in value in July
07/26/2007
Beazer Homes
Credit Reduced
Banks halved the home
builder's credit line to
$500 million from $1
billion
Beazer vehemently
denies rumors it will file
for bankruptcy
07/26/2007
DAE Aviation
Offering delayed
Barclay's Capital
postpones a $937 million
loan, citing market
conditions
Barclay's successfully
priced $325 million in
senior notes tied to the
same deal
07/26/2007
Brazilian Federal
Treasury
Offering pulled
Called off a
regularly-scheduled sale
of its main LTN bonds,
citing "market conditions"
Early next week,
Treasury will issue its
August schedule;
typically, holds bond
sales once or twice a
week
07/25/2007
Countrywide Financial
Profit problems
Largest U.S. home
mortgage lender saw
losses on prime mortgage
loans and stirred fear the
subprime crisis would
spread
Lender said prime
mortgage loan losses
contributed to 33% drop
in second-quarter net
income; slashed earnings
forecast, citing
"increasingly challenging
housing and mortgage
markets." Announced
Aug. 9 that
"unprecedented
disruptions" in debt and
mortgage-finance
markets could hurt the
company's financial
condition. Merrill Lynch
downgraded the stock to
"sell," warning bankruptcy
was possible.
07/25/2007
Nomura Holdings
Profit problems
Japan's biggest
investment bank took a
$260 million write-down in
its fiscal first quarter to
account for subprime
Nomura slashed its
subprime positions to
$589 million from $1.74
billion and downsized its
mortgage bond business.
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losses.
It also shuttered its New
York fixed-income
research team, led by
Mark Adelson, its
high-profile managing
director of structured
finance research.
07/25/2007
Stolle Machinery
Offering pulled
$250 million bank loan
pulled due to market
conditions
Machinery supplier forced
to pull its Goldman
Sachs-led loan; earlier,
Stolle had offered rates
higher than investors
expected and had
restructured the intial deal
by adding a second-lien
price
07/25/2007
Oneida
Offering pulled
$120 million bank loan
canceled due to market
conditions
The seven-year term loan
was led by Credit Suisse;
rates had been higher
than investors expected
07/25/2007
Silverton Casino
Offering pulled
$215 million high-yield
bond sale pulled due to
market conditions
The casino operator says
it remains committed to
the project
07/24/2007
Oxygen Media
Offering pulled
$345 million loan
cancelled due to market
conditions
J.P. Morgan and RBS
Securities had launched
the senior secured
financing
07/24/2007
Allison Transmission
Offering delayed
Postponed a sale of $3.1
billion in loans to finance
Allison's buyout
The sale of Allison to
Carlyle Group and Onex
Group is likely to
proceed, but trouble
raising debt complicates
matters
07/23/2007
Intergen
Offering revised
The power company
Intergen lowered the
revised size and structure value of three-currency
of its bond issuance
bond issuance to $1.875
billion from $1.975 billion
07/23/2007
Manchester United
Offering delayed
The U.K. soccer club
delayed its plans to
refinance $1.4 billion in
debt
Manchester United cited
turbulence in the markets
as the reason behind its
decision
07/23/2007
Y2K Finance
Hedge fund losses
$2 billion London hedge
fund blamed price drops
on its holdings of U.S.
subprime assets in a
letter to investors
explaining losses
The firm, part of Wharton
Management, said its
investments dropped
7.3% in June; fund is
down 5.24% this year
07/20/2007
Stone Tower Credit Fund Hedge fund losses
Fund told investors its
portfolio value fell by
1.2% in June
June was the first down
month since the fund,
with $637 million under
management, began
investing in 2001; value
reportedly continues to
decline
07/20/2007
Basis Capital Funds
Management
Two funds invested in
instruments related to
U.S. subprime mortgages
posted steep losses last
month
The Sydney fund
restricted investor
withdrawals and is trying
to restructure. It was the
first hedge fund in Asia to
show significant fallout
related to U.S. subprime
woes. Recently said
losses in its Yield Alpha
Fund may exceed 80%.
Hedge fund losses
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07/20/2007
Alliance Boots
Offering delayed
Having trouble raising the Senior loan postponed
dollar equivalent of $18.4 indefinitely until market
billion in loans
conditions improve; junior
loans being offered to
investors at interest rates
higher than planned
07/20/2007
Chrysler Group
Offering delayed
Struggle to raise $20
billion in loans to finance
Cerberus Capital
Management's purchase
of an 80% stake in
Chrysler from
DaimlerChrysler, which is
still slated for August 3
Bankers have postponed
a sale of $12 billion in
debt for the auto
company, citing weak
demand, and plan to fund
the bulk of that debt from
their own pockets for the
time being. Bankers still
expect to raise another
$8 billion in loans for
Chrysler's profitable
finance unit, though they
have had to raise interest
rates on those loans.
07/19/2007
Edenor
Offering delayed
The Argentine electricity
distributor, also known as
Empresa Distribuidora,
postponed a $220 million
planned bond offering
due to market conditions
Edenor said it would
contemplate returning to
the market over the near
term, subject to
regulations and market
conditions
07/19/2007
Cyrela Brazil Realty
Offering delayed
Upscale Brazilian real
estate developer
postponed its $265 million
overseas bond issue
amidst unfavorable
market conditions
Cyrela cited growing
investor risk aversion for
the reason behind the
postponement
07/18/2007
OAC Rosneft
Offering delayed
Postponed bond
placement, pulled a $2
billion two-tranche offer
Rosneft still trying to
refinance part of the $22
billion of debt it took on to
buy assets of OAO Yukos
earlier this year.
07/18/2007
Harmony Gold
Offering delayed
Delayed $350 million
bond issue
Plans on hold pending
market improvement
07/18/2007
AXA SA
Fund losses
French insurer's billion
dollar bond fund lost
about 40% of its value
last month when credit
markets slid
Money-management unit
has offered to cash out
investors at current
estimated values, to
avoid having to conduct a
rapid sale of securities to
meet redemptions; had
earlier had to temporarily
close two funds
07/17/2007
A-TEC
Offering delayed
Delayed hybrid eurobond Plans on hold pending
release
market improvement
07/16/2007
Telemobil S.A.
Offering delayed
The Romanian
telecommunications
company postponed its
$125 million inaugural
senior secured notes
offering due to market
volatility
On hold indefinitely
07/16/2007
Maxeda
Offering pulled
$1.4 billion offering
canceled
KKR forced to alter loan
financing after Citigroup
and ABN Amro canceled
plans to sell $1.4 billion in
debt
07/12/2007
Aozora
Offering delayed
The Japan-based bank
postponed issuance of its
dollar-denominated,
step-up, callable,
subordinated bond due to
The bank said it intends
to return to the bond
market once conditions
stabilize
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market volatility
07/11/2007
Quebecor
Offering pulled
$750 million bond sale,
which was to be used to
acquire Osprey Media
Income Fund, postponed
Could get a bank bridge
loan
07/11/2007
First Gulf Bank
Offering delayed
Delayed launch of $3.5
billion eurobond program
due to market volatility
Plans on hold pending
market improvement
07/10/2007
Swift & Co.
Offering pulled
The meat processing
company was offering
$600 in notes to finance
the buyout of J&F
Participacoes
The offering, run jointly by
J.P. Morgan and Credit
Suisse, was withdrawn
07/06/2007
Bank of Moscow
Offering delayed
The bank postponed its
Unsure when or if the
inaugural, five-year
bank will still carry out the
$272.7 million bond issue euro-denominated issue
due to market volatility
07/06/2007
Caliber Global Investment Hedge fund losses
Cambridge Place's
London-based fund, once
worth $908 million, had
majority of its investments
in US subprime mortgage
debts
Suffered net loss of 8.8
million euros in the first
quarter alone; fund will
close, money to be
returned to investors
07/05/2007
Braddock Financial
Hedge fund losses
Fund invested mainly in
bonds backed by
subprime mortgages;
investors withdrew
money
$100 million in losses in
the Galena Street Fund;
fund closed
07/04/2007
Carphone Warehouse
Offering delayed
U.K. mobile-phone
retailer put its
sterling-denominated
bond issue on hold
because of turbulence in
credit markets
Carphone Warehouse is
expected to return to the
market in the fall, when
conditions are more
favorable
07/03/2007
United Capital Asset
Management
Hedge fund losses
Held $500 million in
assets, heavily tied to
subprime mortgages
Stopped letting investors
withdraw money after a
deluge of withdrawal
requests
07/03/2007
CanWest Mediaworks
Offering reduced
Market conditions caused
CanWest to abandon a
high-yield debt issue in
connection with its
purchase of Alliance
Atlantis
CanWest and partner
Goldman Sachs said
bridge financing has been
lined up and the $2.3
billion deal will close on
Aug. 15, a one-week
delay from the previous
plan.
06/29/2007
Oreck
Offering pulled
Vacuum company's $200 Plans on hold indefinitely
million debt refinancing
loan withdrawn due to
market conditions
06/29/2007
Bombardier Recreational
Products
Loan postponed
Subprime fallout forces
postponement of $1.12
billion bank loan,
according to Reuters
06/28/2007
Dollar General
Offering terms changed
Dollar General, which is
Offering closed; bonds
being acquired by private had 14 new covenants
equity firms, changes
terms of $1.9 billion junk
bond offering and raises
interest rates to entice
buyers.
06/27/2007
KIA Motors
Offering pulled
South Korea's KIA pulled
a five-year $500 million
bond offering due to
Waiting for the market to
settle
Company rumored to
consider trying again
when market conditions
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market conditions
become more favorable
06/27/2007
Magnum Coal
Offering delayed
Delayed a $350 million
junk offering
Underwriters postponed
offer indefinitely
06/27/2007
Myers Industries
Offering delayed
Delayed launch of a
buyout-financing deal in
the hope the market
would settle down in
coming days
Plans still on hold
06/27/2007
MISC BHD
Offering delayed
Market volatility
postpones $750 million
bond issue
The Malaysian carrier of
liquefied natural gas put
its 10-year bond issue on
hold until market
improves
06/26/2007
Arcelor Finance
Offering delayed
Put off plans to issue
$1.34 billion in bonds,
citing turbulent debt
market
Plans still on hold
06/26/2007
ServiceMaster
Offering pulled
Called off a $1.15 billion Received its financing
sale of junk to pay for
from a bridge loan directly
ServiceMaster's LBO;
from the underwriters
bond investors balked at
provisions that would
have enabled the
company to put off
interest payments and
instead take on additional
debt if the company were
to run short of cash.
06/26/2007
U.S. Foodservice
Offering pulled
Investors balk over terms
of $3.6 billion
bond-and-loan deal
needed to finance sale of
firm to private equity firms
KKR and Clayton Dubilier.
Underwriters left holding
debt on their books and
will try to sell later; so far,
have shopped it around
to a frosty reception
06/26/2007
Catalyst Paper
Offering pulled
Citing "adverse"
conditions, the company
pulled a $150 million
offering that had already
been cut from $200
million, planned for
funding its business and
other investments
Underwriters postponed
offer indefinitely
06/22/2007
Thomson Learning
Offering pulled
$540 million bond sale
canceled
Underwriters left holding
the debt
06/12/2007
Bear Stearns
Hedge fund losses
Two funds, which once
controlled $10 billion, had
invested in
subprime-mortgage debt;
a third had practically no
exposure to subprime
mortgages but had
suffered from a series of
refund requests and
markdowns on a range of
mortgages
The Enhanced Leverage
Fund quickly went belly
up. High-Grade
Structured Credit
Strategies got a $1.6
million bailout from Bear
Stearns, but lenders have
seized most of the fund's
remaining assets. Both
funds are now nearly
worthless, and filed for
bankruptcy protection
Aug. 1. Withdrawals from
the Asset-Backed
Securities Fund, which
had put about $850
million into mortgage
investments, were
suspended Aug. 1.
Conference call Aug. 3
tried to reassure
investors, said firm is
facing worst market
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conditions in years.
Co-President Warren
Spector resigned.
05/07/2007
Dillon Read Capital
Management
Hedge fund losses
UBS' in-house hedge
fund trading in mortgage
securities
$123 million in losses
from trades on mortgage
securities; fund closed
after losses weighed on
bank's fixed income
revenue; UBS said it
expects the bank to book
costs of up to $300
million to shut the fund
Sources: WSJ.com research, Reuters, S&P, Barings
Write to the Online Journal's editors at newseditors@wsj.com
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News Licensing Advertising About Dow Jones
8/20/2007 10:00 AM
J.P. Morgan Buys Bear in Fire Sale, As Fed Widens Credit to Avert Crisi...
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March 17, 2008
A DEAL FOR BEAR STEARNS
J.P. Morgan Buys Bear in Fire Sale,
As Fed Widens Credit to Avert Crisis
Ailing Firm Sold
For Just $2 a Share
In U.S.-Backed Deal
By ROBIN SIDEL, DENNIS K. BERMAN, and KATE KELLY
March 17, 2008; Page A1
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Pushed to the brink of collapse by the mortgage crisis, Bear Stearns Cos.
RELATED ARTICLES
agreed -- after prodding by the federal government -- to be sold to J.P.
Morgan Chase & Co. for the fire-sale price of $2 a share in stock, or about • Complete Coverage1
• J.P. Morgan Rescues Bear
$236 million.
Bear Stearns had a stock-market value of about $3.5 billion as of Friday -and was worth $20 billion in January 2007. But the crisis of confidence that
swept the firm and fueled a customer exodus in recent days left Bear
Stearns with a horrible choice: sell the firm -- at any price -- to a big bank
willing to assume its trading obligations or file for bankruptcy.
"At the end of the day, what Bear Stearns was looking at was either taking
$2 a share or going bust," said one person involved in the negotiations.
"Those were the only options."
Wall Street traders and analysts on their way to work expressed
both skepticism and hope in the wake of JP Morgan's bailout of
Bear Stearns.
Stearns2
03/17/2008
• Bear Stearns Discovers Risk of Its
Hedge-Fund Business3
03/17/2008
• Another Source of Quick Cash
Dries Up4
03/17/2008
• In a Crisis, It's Dimon Once Again5
03/17/2008
• Bear's Biggest Holders May Have
Little Choice but to Cut Their
Losses6
03/17/2008
• Fed Cuts Rates, Extends Loans to
To help facilitate the
Calm Markets7
deal, the Federal Reserve 03/17/2008
• Breakingviews: Stern Warning All
is taking the
Around8
extraordinary step of
03/17/2008
providing as much as $30 • J.P. Morgan Statement on Deal9
• MarketBeat: The Bear Stearns
billion in financing for
10
Fallout
Bear Stearns's less-liquid
• Deal Journal: A Short History of
assets, such as mortgage Troubled Investment Bank Sales11
securities that the firm
has been unable to sell, in
what is believed to be the TIMELINE
largest Fed advance on
The following is a timeline of recent
events at Bear Stearns:
record to a single
2007
company. Fed officials
June 14: Bear reports a 10 percent
wouldn't describe the
decline in quarterly earnings as the
exact financing terms or mortgage market shows signs of
cracking. Chief Financial Officer
assets involved. But if
Sam Molinaro says, "We are
those assets decline in
impacted in a weaker mortgage
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value, the Fed would bear any loss, not J.P. Morgan.
The sale of Bear Stearns and Sunday night's move by the Fed to offer loans
to other securities dealers mark the latest historic turns in what has become
the most pervasive financial crisis in a generation. The issue is no longer
whether it will yield a recession -- that seems almost certain -- but whether
the concerted efforts of Wall Street and Washington can head off a
recession much deeper and more prolonged than the past two, relatively
mild ones.
'Uncharted Waters'
Former Treasury Secretary Robert Rubin last week described the situation
as "uncharted waters," a view echoed privately by top government officials.
Those officials have been scrambling to come up with new tools because
the old ones aren't suited for this 21st-century crisis, in which financial
innovation has rendered many institutions not "too big too fail," but "too
interconnected to be allowed to fail suddenly."
Bear Stearns's sudden meltdown forced the federal government to come to
grips with the potential collapse of a major Wall Street institution for the
first time in a decade. In 1998, about a dozen firms, with encouragement
from the Federal Reserve Bank of New York, provided a $3.6 billion
bailout of Long-Term Capital Management that kept the big hedge fund
alive long enough to liquidate its positions. Bear Stearns famously refused
to participate in that rescue.
The scale of the financial system's troubles are even bigger this time
around. Since last summer, the Fed has lowered its target for the
federal-funds rate, charged on low-risk overnight loans between banks, to
3% from 5.25%, and it is expected to cut the rate again this week. Last
week, the Fed said it would lend Wall Street as much as $200 billion in
exchange for a roughly equivalent amount of mortgage-backed securities.
But those moves have failed to soothe investors and lenders, who are
worried about the true value and default risk of many debt securities or are
hoarding cash to meet their own needs. As worries grew that failing to find
a buyer for the beleaguered investment bank could cause the crisis of
confidence gripping Wall Street to worsen across the financial system,
federal regulators pushed Bear Stearns's board to sell the firm.
market until that industry turns
around."
June 18: Reports say Merrill Lynch
seized collateral from a Bear Stearns
hedge fund invested heavily in
subprime loans -- those made to
people with poor credit.
June 22: Bear commits $3.2 billion
in secured loans to bail out its
High-Grade Structured Credit Fund,
says company's troubles are
"relatively contained.''
July 17: Bear tells clients that the
assets in one of the troubled funds
are essentially worthless, while those
in the other are worth 9 percent of
their value at the end of April.
Aug. 1: The two funds file for
bankruptcy protection and the
company freezes assets in a third
fund.
Aug. 5: Co-President and Co-Chief
Operating Officer Warren Specter
resigns. Alan Schwartz becomes
sole president. CFO Molinaro takes
over co-COO role.
Aug. 6: Bear sends letters to clients
reassuring them the company is
financially sound. "Rest assured,
Bear Stearns has seen challenging
markets before and has the
experience and expertise to serve
you and us well,'' the firm says.
Sept. 20: Bear reports 68 percent
drop in quarterly income. The
company's accounts slipped by $42
billion between the end of May and
the end of August.
Nov. 14: CFO Molinaro says Bear
will write down $1.62 billion and book
a fourth-quarter loss.
Nov. 28: Bear lays off another 4% of
its staff, two weeks after cutting 2%
of its work force.
Dec. 20: Bear takes $1.9 billion
write-down. CEO Cayne says he'll
skip his 2007 bonus.
2008
Jan. 7: CEO Cayne retires under
pressure. Mr. Schwartz takes over.
Mid-January: Financial stocks
swoon as economists predict the
U.S. economy will slip into recession.
President Bush unveils a $150 billion
stimulus plan.
Mid-February: Subprime woes
spread to a broad range of assets,
including certain kinds of municipal
debt.
March 10: Market rumors say Bear
may not have enough cash to do
business. "There is absolutely no
truth to the rumors of liquidity
problems that circulated today in the
market,'' Bear says.
March 12: Schwartz goes on CNBC
to reassure investors his company
has enough liquidity and he is
"comfortable'' it turned a profit in the
fiscal first quarter.
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Simultaneously with the announcement of Bear Stearns's sale, the Fed took
the extraordinary measure of allowing securities firms to borrow from the
central bank under terms normally reserved for regulated banks. People
close to Bear Stearns were bitter about the move, saying that had the Fed
acted earlier, the firm could potentially have survived by borrowing
directly from the Fed and using its troubled securities as collateral.
March 14: The federal government
and J.P. Morgan Chase & Co. bail
out Bear. The company says it
sought the emergency funding after
realizing it would not be able to keep
up with a spike in demand from
lenders.
March 16: J.P. Morgan announces it
has acquired Bear Stearns for $2 per
share, or about $236 million.
–Associated Press
The deal already is prompting howls of protest from Bear Stearns shareholders, since the New York
company last week indicated that its book value was still close to its reported level of about $84 share at
the end of the fiscal year. "Why is this better for shareholders of Bear Stearns than a Chapter 11 filing?"
one Bear shareholder asked J.P. Morgan executives in a conference call last night.
J.P. Morgan referred the question to Bear Stearns executives, who weren't on the conference call. In a
statement, Bear Stearns Chief Executive Alan Schwartz said the deal "represents the best outcome for all
of our constituencies based upon the current circumstances."
One person familiar with the sale process said federal officials delivered a decisive prod to the firm's
directors. "The government said you have to do a deal today," this person said. "We may not be there
tomorrow to back you up."
Shock Waves
The Fed, according to a person familiar with the matter, didn't care so much about the equity holders and
was trying to prevent a bankruptcy filing that could have sent shock waves through the markets.
Bear Stearns's fortunes started to take a dramatic turn for the worse on Thursday as its trading partners
started making margin calls. By Thursday night, Bear had told government officials that it might have to
file for bankruptcy protection.
On Friday, after the Fed and J.P. Morgan agreed to provide emergency funding to the firm, its stock went
into a free fall. Late Friday, credit-ratings firms downgraded Bear Stearns to two or three levels above
junk status. The downgrades also had a big impact on Bear Stearns's viability, as they severely crimped
the firm's number of potential trading partners.
By Friday evening, the walls were closing in around Bear. Banks and other counterparties were refusing
to do any business with it at all. They stopped taking collateral on short-term lines of credit, even those
backed by the highest-quality mortgage bonds backed by Fannie Mae and Freddie Mac. Prime-brokerage
clients were also fleeing. So much was moving out of Bear accounts, that a final accounting was still
going on through the weekend.
For the Bear executives and advisers -- including Lazard Deputy Chairman Gary Parr and veteran
takeover lawyers Peter Atkins of Skadden, Arps, Slate, Meagher & Flom, Sullivan & Cromwell's H.
Rodgin Cohen, and Cadwalader Wickersham & Taft's Dennis Block -- it became increasingly apparent a
bankruptcy was imminent absent a sale.
A number of potential buyers came to inspect what Bear had to offer, including private-equity investors
J.C. Flowers & Co. and Kohlberg Kravis Roberts & Co., as well as banks Barclays PLC and Royal Bank
of Canada. None of them could put together a deal by last evening.
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Bankers worked through Saturday and were close to reaching a deal around
midnight that would have valued Bear Stearns at more than the $2-a-share terms
announced in the final deal. But on Sunday morning, that deal began to crumble
as J.P. Morgan executives grew increasingly concerned about their exposure. The
negotiating teams scrambled for a solution. The goal: to reach a deal before the
markets in Asia opened this morning.
By late afternoon, however, the two sides had reconciled their differences and the
current deal began to take hold.
In addition to James Dimon, its chairman and chief executive, J.P. Morgan
brought in its most senior executives to hammer out the deal. Among them were Michael Cavanagh,
chief financial officer, Steve Black and Bill Winters, co-heads of the J.P. Morgan's investment bank, and
Stephen Cutler, the firm's general counsel.
James Cayne, Bear Stearns's chairman, who had been participating in a bridge
tournament when the crisis unfolded, returned to New York on Saturday and
participated in the negotiations, said one person familiar with the discussions.
"We're very comfortable with what we found [in due diligence] and what we
acquired, but we needed a pretty substantial cushion" from the Fed, Bill Winters,
co-head of J.P. Morgan's investment bank, said in a conference call last night.
The deal is expected to close by the end of June, an unusually quick time frame.
Federal regulators already have signed off on the deal, which will require a vote
of Bear Stearns shareholders.
Late yesterday, some Bear Stearns employees and shareholders were grumbling
about the deal. If the feeling is widespread it could emerge as a potential obstacle to the completion of the
deal because Bear Stearns employees own about a third of the company's shares.
"I've got to think we can get more in a liquidation, I'm not selling my shares, this price is dramatically
less than the book value Alan Schwartz told us the company is worth," said a midlevel Bear Stearns
executive. "The building is worth $8 a share."
Many well-known investors, from billionaire Joe Lewis to Bruce Sherman, the head of Legg Mason Inc.'s
Private Capital Management Inc. money-management firm, have seen the value of their stakes in Bear
Stearns plummet. The pain could be most acute for Bear Stearns's employees.
"We have every expectation that Bear Stearns shareholders will approve the deal," Mr. Winters said.
With the deal, J.P. Morgan is essentially getting Bear's coveted prime brokerage business for free. It is
twice the size of Bank of America's prime brokerage, which is on the auction block for about $1 billion,
according to a person familiar with the matter.
"J.P. Morgan Chase stands behind Bear Stearns," said J.P. Morgan's Mr. Dimon. "Bear Stearns' clients
and counterparties should feel secure that J.P. Morgan is guaranteeing Bear Stearns' counterparty risk."
Betting on Merger Deals
In addition to the prime brokerage business, J.P. Morgan is also likely to integrate Bear's clearing
business, and some of its fixed-income and equity-trading operations. Furthermore, Bear Stearns also has
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an energy-trading business, which could fit into J.P. Morgan's fledgling energy operations. Bear is also
well-known for its risk-arbitrage business in which traders bet on the outcome of merger deals. Bear's
investment-banking unit is of less interest to J.P. Morgan, however.
Through the weekend, Bear Stearns bankers were summoned to the company's headquarters on New
York's Madison Avenue, where they were told to prepare lists of ongoing deals and business
relationships. Representatives from prospective buyers circulated through conference rooms, with J.P.
Morgan executives asking questions of Bear Stearns's senior management.
Analysts and investors still are bracing for more bad news as securities firms report earnings this week,
though Bear Stearns's results are expected to surpass the average estimate from analysts surveyed by
Thomson Financial, say people familiar with the matter. A Bear spokesman declined to comment.
Shaky Ground
Meanwhile, worries persist that other securities firms and commercial banks might be on shaky ground.
Lehman Brothers Holdings Inc. Chief Executive Richard Fuld, concerned about the markets and possible
fallout from Bear Stearns's troubles, cut short a trip to India and returned home Sunday, ahead of
schedule, according to people familiar with the matter. The decision came after a series of calls Saturday
to both senior executives at the firm and Treasury Secretary Henry Paulson, these people say.
Investors' concerns that the flight of worried Bear Stearns customers last week might spread to other
firms is likely to make for a tense opening today on Wall Street, despite the J.P. Morgan deal. Senior Fed
officials told reporters that no major U.S. securities firm is in a similar situation to Bear Stearns.
Yesterday, Mr. Paulson said in a TV interview that the government "would do what it takes" to protect
the integrity of the financial system.
On several occasions over the weekend, Mr. Paulson spoke about the Bear Stearns negotiations with
Federal Reserve Chairman Ben Bernanke and New York Federal Reserve Bank President Timothy
Geithner, according to people familiar with the matter.
Bankruptcy experts said filing for bankruptcy protection wouldn't have been an attractive option for Bear
Stearns, partly due to recent changes in the federal Bankruptcy Code.
"They can send you a letter saying the value of the assets is falling, so either pay us back or we will
liquidate the asset," said Holly Etlin, a managing director at AlixPartners, a turnaround and business
advisory firm.
Financial regulators beefed up their presence inside Bear Stearns over the weekend. Staff from the
Securities and Exchange Commission's examinations group and trading and markets division, which
monitors capital levels for soundness, worked with representatives from Wall Street's self-regulator, the
Financial Industry Regulatory Authority, and Federal Reserve.
Unwinding Positions
The SEC and Finra staff inspected Bear Stearns's books to ensure that if customers began pulling their
accounts that there was a process to unwind the positions fairly, so as to prevent additional losses. The
regulators also were monitoring the brokerage firms' capital levels amid speculation that they too could
face liquidity problems. A person familiar with regulators said the moves weren't meant to suggest that
any particular firm was in trouble, rather it was to examine whether there was enough cash on hand to
deal with potential problems.
The deal could potentially affect J.P. Morgan's plans to build a new facility for its investment bank at the
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World Trade Center site in lower Manhattan. Bear's new headquarters is located only steps from J.P.
Morgan's Park Avenue headquarters in midtown Manhattan.
--Susanne Craig, Michael M. Phillips, Greg Ip, Gregory Zuckerman, Kara Scannell, Heidi N. Moore, Jenny Strasburg and Jeffrey
McCracken contributed to this article.
Write to Kate Kelly at kate.kelly@wsj.com12
URL for this article:
http://online.wsj.com/article/SB120569598608739825.html
Hyperlinks in this Article:
(1) http://online.wsj.com/page/2_1553.html
(2) http://online.wsj.com/article/SB120569598608739825.html
(3) http://online.wsj.com/article/SB120571237393540313.html
(4) http://online.wsj.com/article/SB120571167285740199.html
(5) http://online.wsj.com/article/SB120571533558140459.html
(6) http://online.wsj.com/article/SB120571021671940207.html
(7) http://online.wsj.com/article/SB120571194513840285.html
(8) http://online.wsj.com/article/SB120571437902540359.html
(9) http://online.wsj.com/article/SB120571649360440487.html
(10) http://blogs.wsj.com/marketbeat/2008/03/16/the-bear-stearns-fallout/
(11)
http://blogs.wsj.com/deals/2008/03/16/a-short-history-of-troubled-investment-bank-sales/
(12) mailto:kate.kelly@wsj.com
Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved
This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our
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RELATED ARTICLES FROM ACROSS THE WEB
Related Articles from WSJ.com
•
•
•
•
Fed Races to Rescue Bear Stearns In Bid to Steady Financial System Mar. 16, 2008
Bear Stearns to Get Backing From J.P. Morgan, N.Y. Fed Mar. 14, 2008
Bear to Renegotiate Citic Deal Mar. 06, 2008
Working for the Weekend: The Lawyers on the Bear/J.P. Morgan Deal Mar. 16, 2008
Related Web News
•
•
•
•
Price of $2 a Share Reflects the Depth of Firm’s Problems Mar. 17, 2008 nytimes.com
BEAR STEARNS FORCED TO SELL FOR $2 PER SHARE Mar. 17, 2008 huffingtonpost.com
J.P. Morgan to buy Bear Stearns for $2 a share Mar. 17, 2008 marketwatch.com
JPMorgan close to Bear buy - report - Mar. 16, 2008 Mar. 16, 2008 money.cnn.com
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3/17/2008 10:29 AM
Bankers Cast Doubt On Key Rate Amid Crisis - WSJ.com
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April 16, 2008
PAGE ONE
LIBOR FOG
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Bankers Cast Doubt
On Key Rate Amid Crisis
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By CARRICK MOLLENKAMP
April 16, 2008; Page A1
LONDON -- One of the most important barometers of the world's financial
health could be sending false signals.
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In a development that has implications for borrowers everywhere, from
Russian oil producers to homeowners in Detroit, bankers and traders are expressing concerns that the
London inter-bank offered rate, known as Libor, is becoming unreliable.
Libor plays a crucial role in the global financial system. Calculated every
morning in London from information supplied by banks all over the
world, it's a measure of the average interest rate at which banks make
short-term loans to one another. Libor provides a key indicator of their
health, rising when banks are in trouble. Its influence extends far beyond
banking: The interest rates on trillions of dollars in corporate debt, home
mortgages and financial contracts reset according to Libor.
In recent months, the financial crisis sparked by subprime-mortgage
problems has jolted banks and sent Libor sharply upward. The growing
suspicions about Libor's veracity suggest that banks' troubles could be
worse than they're willing to admit.
The concern: Some banks don't want to report the high rates they're
paying for short-term loans because they don't want to tip off the market
that they're desperate for cash. The Libor system depends on banks to tell
the truth about their borrowing rates. Fibbing by banks could mean that
millions of borrowers around the world are paying artificially low rates on
their loans. That's good for borrowers, but could be very bad for the banks
and other financial institutions that lend to them.
True Borrowing Costs
No specific evidence has emerged that banks have provided false information about borrowing rates, and
it's possible that declines in lending volumes are making some Libor averages less reliable. But bankers
and other market participants have quietly expressed concerns to the British Bankers' Association, which
oversees Libor, about whether banks are reporting rates that reflect their true borrowing costs, according
to a person familiar with the matter and to government documents. The BBA is now investigating to
identify potential problems, the person says.
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Questions about Libor were raised as far back as November, at a Bank of England meeting in which
United Kingdom banks, the firms that process bank trades and central bank officials discussed the recent
financial turmoil. According to minutes of the meeting, "several group members thought that Libor
fixings had been lower than actual traded interbank rates through the period of stress." In a recent report,
two economists at the Bank for International Settlements, a sort of central bank for central bankers, also
expressed concerns that banks might report inaccurate rate quotes.
On the Agenda
RESOURCES
• Libor Loan Tutorial1
• Libor Rate Mortgage Loans and more2
• Calculator: Fixed Rate Mortgage vs. LIBOR
ARM3
A spokesman for the BBA, John Ewan, said the trade group is
monitoring the situation. "We want to ensure that our rates are
as accurate as possible, so we are closely watching the rates
banks contribute," Mr. Ewan said. "If it is deemed necessary,
we will take action to preserve the reputation and standing in
the market of our rates." Libor is expected to be on the agenda
of a bankers' association board meeting on Wednesday.
In a recent research report on potential problems with Libor, Scott Peng, an interest-rate strategist at
Citigroup Inc. in New York, wrote that "the long-term psychological and economic impacts this could
have on the financial market are incalculable." Mr. Peng estimates that if banks provided accurate data
about their borrowing costs, three-month Libor would be higher by as much as 0.3 percentage points.
A small increase in Libor can make a big difference for borrowers. For example, an extra 0.3 percentage
points would add about $100 to the monthly payment on a $500,000 adjustable-rate mortgage, or
$300,000 in annual interest costs for a company with $100 million in floating-rate debt. On Tuesday, the
Libor rate for three-month dollar loans stood at 2.716%.
Libor has become such a fixture in credit markets that many people trust it implicitly. Concerns about its
reliability are "actually kind of frightening if you really sit and think about it," says Chris Freemott, a
Naperville, Ill., mortgage banker who depends on Libor to tell him how much his firm, All America
Mortgage Corp., owes First Tennessee bank for a credit line that he uses to make loans.
The Libor system was developed in the 1980s. Banks were looking for a benchmark that would allow
them to set rates on syndicated debt -- corporate loans that typically carry interest rates that adjust
according to prevailing short-term rates. By pegging lending rates to Libor, which is supposed to
represent the rate banks charge each other for loans, banks sought to guarantee that the interest rates their
clients pay never fall too far below their own cost of borrowing.
Banks typically set their lending rates at a
certain "spread" above Libor: A company
with decent credit, for example, might pay
an interest rate of Libor plus one-half
percentage point. A risky "subprime"
mortgage loan might carry an interest rate
of Libor plus more than six percentage
points.
Today, Libor rates are set for 15 different
loan durations -- from overnight to one
year -- and in 10 currencies, including the
pound, the dollar, the euro and the Swedish
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krona. They serve as the basis for payments
on trillions of dollars in corporate loans,
mortgages and student loans. Libor rates
are also used to set the terms of more than $500 trillion in "derivatives" contracts such as interest-rate
swaps, which companies all over the world, including U.S. mortgage guarantors Fannie Mae and Freddie
Mac, use to protect themselves against sudden shifts in the difference between long-term and short-term
interest rates.
When banks want to borrow money, they contact banks directly or phone a loan broker, such as ICAP
PLC in London. Much of the interbank lending takes place between 7 a.m. and 11 a.m. London time. In
broker speak, a bank might ask for a "yard" -- one billion in a designated currency. Brokers communicate
with bank clients by phone or through desktop voice boxes, which are faster. At ICAP, brokers track bids
and offers by looking up at a big whiteboard above the trading floor, where a "board boy" posts
information. The actual rates at which banks borrow from each other are known only to the lenders and
borrowers, and possibly to their brokers.
Every morning by 11:10 London time, "panels" of banks send data to Reuters Group PLC, a
London-based business-data and news company, on what it would cost them to borrow a "reasonable
amount" in a designated currency. The dollar Libor panel, for example, consists of 16 banks, including
U.S. banks Bank of America Corp. and J.P. Morgan Chase & Co. and U.K. banks HBOS PLC and
HSBC Holdings PLC. Reuters uses the reported borrowing rates to calculate Libor "fixings." To reduce
the possibility that any bank could manipulate an average by reporting a false number, Reuters throws
out the highest and lowest groups of quotes before calculating averages.
Justin Abel, global head of data operations for Reuters, said in a statement that his company's role is
solely to calculate fixings based on the information provided by banks. "It is their data alone we
distribute. Reuters is purely the facilitator," he said.
Wary of Lending
The global financial crisis that began last summer has made it more difficult for banks to package and
sell all kinds of loans as securities, as well as to issue bonds and short-term IOUs to investors.
Increasingly, banks have turned to the interbank market to borrow cash. But their mounting losses on
mortgage securities and other investments have raised fears that a major institution could go bust. That's
made banks increasingly wary of lending to one another.
Such jitters have made many banks
unwilling to extend loans to each other for
more than one week. As a result, the rates
they quote for loans of three months or more
are often speculative, because there's little to
no actual lending for that time period,
brokers say. "It amounts to an average best
guess," says Don Smith, an economist at
ICAP, the London broker of interbank loans
and derivatives.
These bank problems are proving costly to
other kinds of borrowers around the world.
One way to measure the rough cost is by
comparing the three-month Libor rate with
an interest rate that doesn't reflect worries
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about banks' financial health -- such as the
yield on a three-month Treasury bill, which
is backed by the U.S. government. The gap
between the two stood at 1.58 percentage points Tuesday, and has averaged 1.39 percentage points since
the crisis began in August. In the five years before the financial crisis started, it averaged only 0.28
percentage points.
Citigroup's Mr. Peng believes banks could be understating even those abnormally high Libor rates. He
notes that the Federal Reserve recently auctioned off $50 billion in one-month loans to banks for an
average annualized interest rate of 2.82% -- 0.1 percentage point higher than the comparable Libor rate.
Because banks put up securities as collateral for the Fed loans, they should get them for a lower rate than
Libor, which is riskier because it involves no collateral. By comparing Libor with that indicator and
others -- such as the rate on three-month bank deposits known as the Eurodollar rate -- Mr. Peng
estimates Libor may be understated by 0.2 to 0.3 percentage points.
Other Benchmarks
In one sign of increasing concern about Libor, traders and banks are considering using other benchmarks
to calculate interest rates, according to several traders. Among the candidates: rates set by central banks
for loans, and rates on so-called repurchase agreements, under which borrowers provide banks with
securities as collateral for short-term loans.
In a report published in March by the Bank for International Settlements, economists Jacob Gyntelberg
and Philip Wooldridge raised concerns that banks might report incorrect rate information. The report said
that banks might have an incentive to provide false rates to profit from derivatives transactions. The
report said that although the practice of throwing out the lowest and highest groups of quotes is likely to
curb manipulation, Libor rates can still "be manipulated if contributor banks collude or if a sufficient
number change their behaviour."
Write to Carrick Mollenkamp at carrick.mollenkamp@wsj.com4
URL for this article:
http://online.wsj.com/article/SB120831164167818299.html
Hyperlinks in this Article:
(1) http://www.mtgprofessor.com/Tutorials2/Libor_Loan_Tutorial.htm
(2) http://www.liborratemortgage.com/
(3) http://www.finance.cch.com/sohoApplets/MortgageFixedvsLibor.asp
(4) mailto:carrick.mollenkamp@wsj.com
Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved
This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our
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Reprints at 1-800-843-0008 or visit www.djreprints.com .
RELATED ARTICLES FROM ACROSS THE WEB
Related Articles from WSJ.com
• British Bankers Group Steps Up Review of Widely Used Libor Apr. 17, 2008
• Central Banks Pump In Added Cash Mar. 17, 2008
• Australia's Central Bank Adds Funds to Ease Fears Mar. 11, 2008
Related Web News
• European Central Bank rate unchanged after England cuts - Apr. 10, 2008 Apr. 10, 2008 money.cnn.com
• Brit Mortgage Approvals Near 10-Year Low Apr. 04, 2008 businessweek.com
4/17/2008 11:07 AM
Bank of England's Swap Plan Aims to Jump-Start Lending - WSJ.com
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April 21, 2008 8:46 a.m. EDT
Bank of England's Swap Plan
Aims to Jump-Start Lending
By ADAM BRADBERY, NATASHA BRERETON and LAURENCE NORMAN
April 21, 2008 8:46 a.m.
LONDON -- The Bank of England Monday launched a plan to allow banks
to temporarily swap £50 billion ($100 billion) of mortgage-backed and
other securities for United Kingdom Treasury bills, in a bid to ease the
current credit crunch.
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The central bank said that by tackling an overhang of assets on bank balance sheets, the plan should
improve the liquidity of the banking system and increase confidence in financial markets. It said that
financial markets aren't working normally and that failure to intervene in this way would risk a wider
impact on the U.K. economy. (Read the bank's statement.1)
Banks will be able to enter into new asset swaps starting Monday for the next six
months, and the Bank of England said it may extend that period. The central bank
said that the swaps will last for one year but be renewable for up to three years
and that the risk of losses on the securities will remain with the banks. It said the
swaps will be available only for assets in existence at the end of 2007, ruling out
newer mortgage loans.
BOE Governor Mervyn King told reporters that if the facility is successful in
restoring confidence in the financial system, U.K. commercial banks will pass
recent cuts in the Bank of England's key interest rate on to borrowers. He stressed
that the new facility doesn't amount to bailing out banks, saying the institutions
are paying and will continue to pay a high price for their "excessive" lending
habits.
Banks will continue to go through a "difficult and painful adjustment of their balance sheets," but the
new facility will "allow that adjustment to take place over a longer time frame," which should ensure that
the economy is protected from the consequences of banks' mistakes, Mr. King said.
The bank will swap bills for a range of high-quality assets including AAA-rated securities backed by
U.K. and European residential mortgages. It will also accept AAA-rated credit card debt. However, the
central bank said it won't accept securities backed by U.S. mortgages. If the collateral offered by a bank
is downgraded, it will have to replace it with different AAA-rates assets.
The fee for entering the swap arrangement will be the spread between the three-month London interbank
interest rate and the rate charged for a repurchase agreement on a three-month gilt, or Treasury bond. The
minimum fee will be 0.20 percentage points. The Bank of England said that haircuts, or the discount
charged for riskier assets, would be determined by the value of those assets. In each case, it will
determine the necessary margin between the value of bills borrowed and the value of assets required as
collateral.
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As the central bank moved to quickly take on banks' securities, United Kingdom banks are expected to
raise tens of billions of pounds in capital and also increase write-downs in coming weeks. The
write-downs are expected to put U.K. banks more in line with U.S. banks, which have been more
aggressive in discounting securities that have seen their value evaporate during the credit crisis.
Prime Minister Gordon Brown has said that any measures to unclog the mortgage market would have to
be matched by better bank disclosure of losses. The goal of both the government and banks is to
jump-start corporate lending and reignite funding for consumers at a time when some banks have sharply
cut their mortgage businesses. (See related article2).
But Mr. King said the Bank of England's decision to launch the new facility wasn't conditional on U.K.
banks speeding up the disclosure of problem assets or attempting to raise new capital. "The BoE has no
power or authority to instruct the banks to do anything," he said, but welcomed recent steps by some
banks to raise new capital.
Royal Bank of Scotland Group PLC is expected to lead the way. On Tuesday, Chief Executive Fred
Goodwin is expected to announce that the bank plans to pitch a £10 billion stock issuance to investors
and also write down as much as £7 billion. On Monday, RBS issued a brief statement confirming that it is
considering a rights issue, but offered no further details. Merrill Lynch & Co., Goldman Sachs Group
Inc. and UBS AG tentatively are set to handle the stock sale, according to a person familiar with the
situation.
Market reaction to the plan was lukewarm, with sterling falling against most major currencies and
financial stocks trading lower on London's FTSE 100. Barclays PLC was recently down 2.07%. The
pound was at $1.9826 from $1.9953 late Friday. Short sterling contracts initially moved higher but
trimmed those gains later, with traders saying the package was broadly in line with expectations.
However, in one positive sign, the sterling 3-month London Interbank Offered rate, or Libor, was fixed
slightly lower Monday at 5.885% versus 5.89375% Friday.
The U.K.'s Council of Mortgage Lenders welcomed the launch of the special swap facility, but warned it
may not reverse the recent trend to higher mortgage costs. "The recent trend of mortgage products being
removed and mortgage prices increasing for new customers will be affected more by how Libor responds
to the announcement. The improved liquidity is unlikely to reverse the trend to higher mortgage costs we
have seen in recent weeks," CML director general Michael Coogan said.
The CML said it had two chief concerns regarding the plan: that the scheme doesn't give all mortgage
lenders access to the new funds, and that "further details are...awaited on how much of the additional
liquidity might be recycled responsibly into mortgage products or pricing" so that lenders are able to
meet mortgage demand this year. The CML was to meet Tuesday with U.K. Chancellor of the Exchequer
Alistair Darling to discuss how best to help the mortgage market.
Meanwhile, a European Commission's spokesman said it is "far too early" to start speculating on whether
the bank's support constitutes state aid. Under European Union rules, the commission scrutinizes state
funding for private companies to ensure fair competition.
BoE Gov. King said the plan won't add to the U.K. public sector's net debt because the assets pledged by
banks will be of roughly equal value to the new treasury bills.
--Carrick Mollenkamp, Alistair MacDonald and Paul Hannon contributed to article
Write to Adam Bradbery at adam.bradbery@dowjones.com3, Natasha Brereton at
4/21/2008 9:12 AM
Bank of England's Swap Plan Aims to Jump-Start Lending - WSJ.com
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natasha.brereton@dowjones.com4 and Laurence Norman at laurence.norman@dowjones.com5
URL for this article:
http://online.wsj.com/article/SB120876259143130753.html
Hyperlinks in this Article:
(1) http://www.bankofengland.co.uk/publications/news/2008/029.htm
(2) http://online.wsj.com/article/SB120868632486729093.html
(3) mailto:adam.bradbery@dowjones.com
(4) mailto:natasha.brereton@dowjones.com
(5) mailto:laurence.norman@dowjones.com
Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved
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Reprints at 1-800-843-0008 or visit www.djreprints.com .
RELATED ARTICLES FROM ACROSS THE WEB
Related Articles from WSJ.com
•
•
•
•
BOE Maps a Plan To End Credit Crisis, But Will It Work? Apr. 20, 2008
BOE Readies Bailout Plan for U.K. Banks Apr. 18, 2008
UBS to Disclose Further Write-Downs Apr. 01, 2008
Auction-Rate Securities — the Latest Legal Rage? Apr. 18, 2008
Related Web News
•
•
•
•
Britain to unveil plan for lending - The Boston Globe Apr. 21, 2008 boston.com
Bank of England offers $100B plan to ease credit crisis Apr. 21, 2008 npr.org
Bank of England - Apr. 21, 2008 Apr. 21, 2008 money.cnn.com
Bank of England to unveil mortgage bailout Apr. 20, 2008 marketwatch.com
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4/21/2008 9:12 AM
Heard on the Street - WSJ.com
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April 22, 2008
HEARD ON THE STREET
New Threat: Loan Losses
By PETER EAVIS
April 22, 2008
The next earnings nightmare for banks has begun.
Until now, losses at many banks have come from multibillion dollar
write-downs on toxic debt. But analysts believe the costs of building
bad-loan reserves could cause just as much pain -- and for a lot more banks.
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Banks establish bad-loan reserves as a cushion against expected losses on
defaulted loans. Additions to these reserves, called "provisions," get booked as an expense in a bank's
income statement and reduce earnings.
Now, as the economic downturn starts to bite, rising defaults are
prompting banks to add larger sums to the reserves, a development that
has hurt first-quarter earnings at some lenders.
Bank of America Corp. is the most recent victim. The bank's
first-quarter earnings, reported Monday, were worse than expected
because of a $6 billion addition to its loan-loss reserve. That expense
dwarfed the bank's $1.31 billion of trading-related losses in the quarter
-- an indication that reserve building is taking over from write-downs as
the newest big threat to earnings.
To be sure, investors have been expecting bank earnings to get whacked
by bad-loan reserves. But, as Bank of America's first-quarter numbers
show, that expense can cause a lot more pain than the market
anticipates. And, if defaults continue to rise, banks may have to make
large, earnings-depleting additions to their reserves for several quarters.
"It's a good thing that banks have started to reserve more," says Kevin Fitzsimmons, banks analyst at
Sandler O'Neill & Partners. "The bad news is that they are going to need those reserves."
The size of the provisions is based on a bank's analysis of default history and forecasts of the loans on its
balance sheet. Provisions build up the reserve, but when a bank decides a loan is uncollectible, the loss
on that loan is realized. That realized loss -- or "charge-off" -- is subtracted from the reserve, making it
smaller.
So if a bank had a loan-loss reserve of $100 million at the end of the fourth quarter and $25 million of
charge-offs, it would need a $25 million provision to take it back up to $100 million.
But if that bank thought loan defaults were going to get worse, it might want to add more than that to take
the reserve above $100 million.
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While Bank of America shocked investors with a big provision Monday, it may have some benefit if it
convinced investors that management is being conservative and taking its lumps when it should.
Two yardsticks make it look like Bank of America is girding itself well amid the credit storm: First, its
loan-loss reserve was equivalent to 1.71% of loans and leases at the end of the first quarter, up from
1.33% at the end of the fourth quarter. And its $6 billion provision was well in excess of its $2.72 billion
of annualized charge-offs in the period.
If defaults at Bank of America continue to go up, it may turn out to be under-reserved. "Based on what
we know today and what we're seeing in the market, we believe our reserves are adequate," a BofA
spokesman says.
Wells Fargo reported earnings April 16. Oppenheimer analyst Meredith Whitney argued Monday that
Wells Fargo's bad-loan reserve looked too low.
A Wells Fargo spokeswoman declined to comment on the report but referred to the bank's first-quarter
earnings statement, which said: "We believe the allowance was adequate for losses inherent in the loan
portfolio at March 31, 2008."
Write to Peter Eavis at peter.eavis@wsj.com1
URL for this article:
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Bank of America Braces for Consumer Loan Losses Apr. 21, 2008 nytimes.com
Bank of America profit falls 77%; loan-loss reserve bolstered Apr. 21, 2008 marketwatch.com
Wachovia's Loss a Grim Sign for Banks Apr. 14, 2008 usnews.com
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4/21/2008 10:35 PM
Has the Financial Industry's Heyday Come and Gone? - WSJ.com
1 of 3
http://online.wsj.com/article_print/SB120933096635747945.html
April 28, 2008
THE OUTLOOK
Has the Financial Industry's Heyday Come and
Gone?
By JUSTIN LAHART
April 28, 2008; Page A2
For the past three decades, finance has claimed a growing share of the U.S.
stock market, profits and the overall economy.
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But the role of finance -- the businesses of borrowing, lending, investing
and all the middlemen in between -- may be ebbing, a shift that would
redefine the U.S. economy. "The role of finance in the economy is going to come down significantly in
the coming years," says Carlos Asilis, chief investment officer at Glovista Investments, a New Jersey
money manager. "From a societal standpoint, we got carried away with finance."
The trend already has hurt companies beyond banks and Wall Street firms. General Electric Co.'s
first-quarter profits at its financial-services businesses were 21% lower than a year earlier. Retailer
Target Corp., which got 13% of its before-tax profit last year from credit cards, last month wrote off
$55.5 million in credit-card loans, 8.1% of its total portfolio at an annualized rate.
CAST YOUR VOTE
• Question of the Day:1 What's your forecast for
the U.S. financial industry over the next two years?
"I think you're seeing a clear inflection point," says Tom
Gallagher, an ISI Group analyst. "Whether it's financials as a
share of the stock market or financials as a share of GDP,
we've peaked."
Finance was lifted by deregulation, globalization and technological innovation. Combined, these forces
allowed capital to flow far more freely around the globe, brought flexibility to the economy and made
finance lucrative.
Domestic financial-sector profits accounted for 13% of pretax profits in 1980, the Federal Reserve says.
Last year, they accounted for 27%. In 1980, GE garnered 92% of its profit from manufacturing. In the
first quarter, profit from GE's financial businesses, which extend credit from personal loans to factory
purchases, represented 56% of profit.
As finance rose, financial workers took a bigger chunk of total U.S. pay. And as technology allowed
financial firms to do more with fewer people, individual paychecks got fatter. Finance was a major factor
in the widening gap between the very rich and the middle class. In 1980, finance workers made about
10% more than comparable workers in other fields, estimates New York University economist Thomas
Philippon. By 2005, that premium was 50%.
That money diverted some of the brightest minds from other pursuits. "We're seeing significantly more of
our students going into the financial sector," says Vincent Poor, dean of Princeton's engineering school.
"Traditionally, engineering students had not followed that path."
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The creation of securities backed by mortgages and other loans and other innovations made it easier for
financial firms to spread risk, and thus they became more willing to lend to households to fuel spending.
Household debt including mortgages and credit cards went from 13% of household assets in 1980 to 19%
last year. During that period, personal savings rates fell to nearly zero.
In the 2000s, finance went into overdrive, creating an alphabet soup of derivatives that, it turned out,
didn't have the risk-reducing properties they were supposed to have. Mr. Philippon compares some to
"sheep with fifth legs -- something you would see in a zoo and wonder what Nature was thinking."
For finance workers, this shift could resemble the 1980s, when manufacturing lost its pole position in the
U.S. labor market and thousands found that skills they had honed over the years were less marketable.
The Bureau of Labor Statistics already counts 60,000 fewer people working in finance than a year ago.
Merrill Lynch & Co. is cutting 4,000 jobs, and Lehman Brothers Holdings Inc. is cutting 1,425. Many
of Bear Stearns Cos.' 14,000 employees are expected to lose their jobs when J.P. Morgan Chase & Co.
swallows the firm.
Mr. Philippon argues that the surge of financial activity that began in 2002 created an employment
bubble that is now busting. His model suggests total employment in finance and insurance has to fall to
6.3 million to get back to historical norms, and that means losing an additional 700,000 jobs in the sector.
Finance has seen job cuts before and bounced back. After the 1987 stock-market crash, E.F. Hutton &
Co. was taken over by Shearson Lehman Brothers, then a division of American Express Co., and shed
5,000 jobs. Among them was Jeffrey Applegate's job as a strategist. He spent the subsequent year doing
carpentry and thinking he might make a career of it if financial jobs didn't come back. He got hired by
Shearson Lehman, which evolved into the present-day Lehman Brothers.
Now chief investment officer for Citigroup Inc.'s Citi Global Wealth Management, Mr. Applegate thinks
the damage to the financial sector this time will be more lasting than 1987. (Citigroup has announced
6,000 job cuts since the credit crisis began.)
But he doubts finance's role in the economy will ebb much. Globalization's demand for free-flowing
capital will continue. And the process of turning loans into securities is too powerful a tool for risk
management and credit creation to abandon. "Is securitization going to go away? I doubt it," he says. "Is
it going to be more transparent? Are ratings going to be more robust? Is there going to be more
regulation? Yeah."
Global governments are moving to require financial firms -- both commercial banks and investment firms
like Bear Stearns -- to hold bigger capital cushions against the credit they extend so they are better able to
withstand financial tornadoes. And that lower leverage, inevitably, means lower profits for finance.
But even before new regulations bite, investors are wary of the securities that ultimately are tied to
mortgages and other loans made to consumers. And that could pinch American consumers long
dependent on credit to spend, sometimes beyond their means.
Harley-Davidson Inc. last year earned about 15% of its operating income through its financial services
division, which offers financing to its motorcycle customers; that's up from 5% a decade ago. In the first
quarter, Harley had a hard time selling the loans it originated; its financial-services profits fell by 41%, as
a result. With its customers feeling the economic downturn and less able to borrow to buy bikes, the
company, which shipped 330,619 Harley-Davidson motorcycles last year, plans to ship between 23,000
and 27,000 fewer in 2008.
4/28/2008 9:45 AM
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Write to Justin Lahart at justin.lahart@wsj.com2
URL for this article:
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Hyperlinks in this Article:
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(2) mailto:justin.lahart@wsj.com
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4/28/2008 9:45 AM
What's Subprime's Magic Number? - WSJ.com
1 of 3
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May 3, 2008
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Key Gauges Begin
To Bring Into View
The Crisis's Cost
By LIAM PLEVEN
May 3, 2008; Page B3
No one really has a clue how much money will be lost on subprime
mortgages -- estimates range from $400 billion to $1 trillion and more. But
with each passing month, investors come a little bit closer to knowing the
full extent of the damage.
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The banks, hedge funds and insurers whose financial futures depend on those final numbers are focusing
most intensely on monthly data on delinquencies, housing prices, interest-rate resets and the "roll rate,"
which shows how many borrowers are falling further and further behind on their payments. They also are
watching the slowing economy and rising unemployment. Some expect the subprime picture to start to
clear as early as this fall, while others think it could take much longer.
"Right now, we're still right in the middle of it, and so you have enormous variation using very small
differences in assumptions about what's going to happen," says Joseph "Jay" Brown, chief executive of
MBIA Inc., a bond insurer that sold protection on mortgage-linked bonds, and took a write-down of more
than $3 billion for 2007.
These days, worst- and best-case projections about what will happen with recent mortgages often vary by
at least 50%, Mr. Brown says. But, he adds, "time narrows that uncertainty."
For insurers, it's akin to a hurricane
churning toward land. When a storm is
days away and its path and strength still
uncertain, losses could be small or
catastrophic. But as it gets closer and then
makes landfall, insurers get a better idea,
for better or worse, of how costly the
damage will be.
In the mortgage market, things are still
getting worse. For typical subprime
mortgages issued between the second half
of 2005 and the first half of 2007, when
underwriting standards were at their
weakest, between 25% and 40% of
borrowers on average are more than 60
days behind on their payments. Overall,
that number of delinquencies is still rising each month, though some people are noticing potentially
5/4/2008 6:12 PM
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important shifts in some delinquency rates and expect greater clarity in the next several months.
The subprime crisis really began to bite when mortgages issued in 2006 and 2007 began to go bad much
more quickly than in any recent year. For instance, nearly 15% of subprime borrowers who took out
mortgages in 2006 were 60 days late within a year, according to First American CoreLogic,
LoanPerformance data. It took nearly twice as long for loans from 2000 and 2001 to look that bad.
This early jump suggested that defaults would reach heights unseen in the years since it became routine
to package loans into securities. The question now is: Even though the delinquency rates are climbing,
will the loans follow the same path as in previous years? In 2000 and 2001, for instance, the growth in
the 60-day delinquency rate slowed when those subprime loans were about three years old and peaked
after a little more than four years, then started to fall.
"Every single month, what we're looking for is a peaking in the delinquencies," says Robert Selvaggio, a
managing director at Ambac Financial Group Inc., which also insured mortgage-linked bonds.
That appears to be happening for loans issued in 2005, where the growth in 60-day delinquency rates has
been effectively flat for four months at just over 30%, according to First American. If delinquency rates
begin to decline, it would mean that 2005 is following the pattern of previous years, even though
underwriting standards were already weakening. That would give investors confidence that 2006 and
2007 might do the same, even though default rates would likely be higher.
Analysts are also looking at the "roll rate." That shows how many 30-day delinquencies become 60-day
and 90-day delinquencies, and so helps determine what lenders and investors lose on mortgages. Last
month, roll rates for most recent subprime mortgages went down, according to Clayton Fixed Income
Services.
A short-term drop might not be so meaningful, however. "Those things can bump around a bit," says
Kevin Kanouff, president of the firm, a unit of Clayton Holdings Inc. But a drop that lasts for a few
months could be more significant.
Another key number that could drive delinquencies is interest-rate resets. Mr. Kanouff points to autumn,
when the proportion of subprime mortgages due to reset at higher interest rates will begin to decline, so a
shrinking percentage of those borrowers will face higher monthly payments.
For example, more than 4% of the nation's subprime mortgages outstanding with adjustable rates are due
to reset in May. That percentage will start a steady decline in the fall, ending the year below 3% and
dropping to less than 1% by mid-2009.
On the other hand, recent interest-rate cuts by the Fed are already dulling the impact of rate resets on
some borrowers.
Because all of these numbers are linked, improvements in one can affect others. Other factors, such as the
unemployment rate, also affect how much investors and insurers ultimately lose. And when home prices
stabilize, lenders will have a better sense of how much they'll recover in foreclosures, and that will
further clarify the picture.
Write to Liam Pleven at liam.pleven@wsj.com1
URL for this article:
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Hyperlinks in this Article:
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• Rate of Mortgage Delinquencies Rises Apr. 10, 2008
• It’s Law Day! Let’s Take a Look Back . . . . May. 01, 2008
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• Buffett buys subprime mortgages, freezes resets May. 04, 2008 marketwatch.com
• Buffett buys subprime mortgages, freezes resets May. 04, 2008 marketwatch.com
• Report: No help yet for most subprime borrowers - Apr. 22, 2008 Apr. 22, 2008 money.cnn.com
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5/4/2008 6:12 PM
Buffett to Fans: Opportunity Exists But Berkshire May Not Be Best Bet...
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May 5, 2008
DOW JONES REPRINTS
Buffett to Fans: Opportunity Exists
But Berkshire May Not Be Best Bet
By KAREN RICHARDSON
May 5, 2008; Page C1
Investors, take heart: Warren Buffett sees investment opportunities in the
U.S. stock and bond markets, and believes widespread financial turmoil
from the credit crunch is behind us.
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Speaking
MARKETBEAT
to reporters
Karen Richardson and Alistair Barr
Sunday, a report from Omaha.
1
day after
Berkshire
• Buffett's Bond Success2
• Buffett on Beijing
Hathaway
Olympics3
Inc.'s
• Buffett's Dollar Talk4
annual
• Munger for President5
fan-fest for • All My Shareholders6
• The 5 a.m. Buffett Breakfast Club7
• All posts8
MORE ON BERKSHIRE
All eyes were on Warren Buffett at Berkshire Hathaway's annual meeting at the
Qwest Center in Omaha, Neb.
shareholders at the Qwest Center in Omaha, Neb., both Mr. Buffett, 77
years old, and Vice Chairman Charlie Munger, 84, criticized regulators,
politicians and accountants for lax oversight of financial institutions that
are at the center of the subprime-mortgage crisis, and, according to Mr.
Munger, were guilty of "deep conflicts of interest."
• Buffett Makes His Selection10
04/29/08
• Page One: Mars's Takeover of
Wrigley Creates Global
Powerhouse11
04/29/08
• General Re Chief Quits Post12
04/15/08
"The regulators and the accountants have failed us terribly," Mr. Munger said, adding that
mark-to-market accounting rules are necessary but can obscure other problems within a company.
This year at Mr. Buffett's annual gathering for shareholders -- often called "Woodstock for Capitalists" -31,000 Buffett enthusiasts were serenaded by Fruit of the Loom minstrels, enjoyed samples of Berkshire
portfolio companies such as Dilly Bars and watched artist Michael Israel speed-paint a Buffett portrait
with Benjamin Moore paints.
Mr. Buffett credited the Federal Reserve for helping to avert a
more-widespread crisis on Wall Street by orchestrating a bailout of Bear
Stearns Cos. that "prevented, in my opinion, the contagion where you're
going to have runs on investment banks."
5/5/2008 10:48 AM
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Bank losses "aren't over by a long shot, but a lot of it has already been
recognized," he said, adding that the depth of the housing crisis,
unemployment and other economic factors would help determine how
long the write-downs continue.
"The idea of financial panic -- that has been pretty much taken care of," he
said.
As to buying opportunities, Mr. Buffett told shareholders, "We are happy
to invest in businesses that earn their money in the euro, or in companies
that derive their earnings in Germany, or from the sterling in the [United Kingdom], because I don't have
a feeling that those currencies are going to depreciate in a big way against the dollar." Sunday he said a
Berkshire unit is close to buying a midsize company in the U.K., but he didn't elaborate. This month, Mr.
Buffett is scheduled to tour five European cities looking for more buying opportunities.
What may not be an attractive buying opportunity? Berkshire itself, Mr. Buffett said on Saturday.
"Anyone who expects us to come close to replicating the past should sell their stock. It's not gonna
happen," he said. "You may have something better to do with your money than buy Berkshire."
Mr. Buffett also said Berkshire
Hathaway's four-month-old
municipal-bond insurance business
garnered more than $400 million of
premiums in the first quarter, boasting
that this made its new business bigger
than that of its rival. "This whole
company has been built in just a couple
of months," Mr. Buffett said.
Sunday he took a few jabs at rivals,
saying he was confounded by the ability
of his municipal-bond insurer's biggest
rivals, MBIA Inc. and Ambac Financial
Corp., to retain their triple-A ratings.
No, his face isn't on the dollar bill. Yet.
"If you can find another illustration of a
company whose stock that's gone down by 95% in one year and is still rated triple-A, I have yet to see it,"
Mr. Buffett said.
Write to Karen Richardson at karen.richardson@wsj.com9
URL for this article:
http://online.wsj.com/article/SB120990596389565539.html
Hyperlinks in this Article:
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(4) http://blogs.wsj.com/marketbeat/2008/05/03/dollar-talk/
(5) http://blogs.wsj.com/marketbeat/2008/05/03/munger-for-president/?
mod=WSJBlog
(6) http://blogs.wsj.com/marketbeat/2008/05/03/lucci-for-chairman/? mod=WSJBlog
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(10) http://online.wsj.com/article/SB120942663501051187.html
(11) http://online.wsj.com/article/SB120938614337749423.html
(12) http://online.wsj.com/article/SB120818504357212797.html
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•
•
•
•
A Great Investor Gets a Close Look Apr. 30, 2008
Spitzerism Lives Apr. 17, 2008
Smith & Nephew Finds ‘Unacceptable’ Sales Practices in Europe May. 01, 2008
FDA Sneezes at Claritin-Singulair Combo Pill Apr. 28, 2008
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•
•
•
Buffett sees credit crisis easing May. 04, 2008 news.bbc.co.uk
Buffett and Munger reassure shareholders about succession May. 03, 2008 usnews.com
Warren Buffett at annual Berkshire meeting: Think small - May. 3, 2008 May. 03, 2008 money.cnn.com
Buffett warns long-term stock returns to shrink May. 03, 2008 marketwatch.com
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5/5/2008 10:48 AM
Bernanke Sees Better Conditions In Markets, Still Not 'Normal' - WSJ.com
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May 13, 2008 2:48 p.m. EDT
Bernanke Sees Better Conditions
In Markets, Still Not 'Normal'
By BRIAN BLACKSTONE
May 13, 2008 2:48 p.m.
WASHINGTON -- Federal Reserve Chairman Ben Bernanke said Tuesday
that the Fed's recent liquidity measures have led to improved market
conditions including a narrowing of credit spreads and better performance
of repurchase agreement markets.
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But he warned that market conditions "are still far from normal" and pledged to increase the size of the
Fed's term auction facility -- which has already been more than tripled since its inception in late 2007 -- if
needed.
"To date, our liquidity measures appear to have contributed to some improvement in financing markets,"
Mr. Bernanke said in prepared remarks to the Atlanta Fed's annual conference in Sea Island, Georgia.
(Read the full remarks1)
In addition to the TAF, the Fed has in recent months broadened use of the discount window to include
investment banks and has lent out Treasurys to primary dealers against a broad range of collateral
through a separate Term Securities Lending Facility. Those initiatives have in turn led to a big drop in the
Fed's holdings of Treasury securities -- though they still stood at about $537 billion last week.
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• Bernanke Speaks on Liquidity, Invokes Bagehot5
• Economists See Housing Weakness Until 20106
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• Bubble Isn't Price Driver, WSJ Survey Says7
05/09/08
• Fed Seeks Approval to Pay Interest to Banks8
05/07/08
Mr. Bernanke ticked off a list of markets that have seen better
conditions recently, including the Treasury repo market,
agency mortgage-backed securities, jumbo mortgages and
corporate debt.
"These are welcome signs," Mr. Bernanke said, "but at this
stage conditions in financial markets are still far from normal,"
he said.
Though credit spreads have narrowed, Mr. Bernanke said they
remain elevated, "and pressures in short-term funding markets
persist."
Meanwhile, spreads between interbank lending rates as
measured by the London interbank offered rate, or Libor, and
comparable overnight swap rates "have receded some" from
recent highs "but remain abnormally high," Mr. Bernanke
said.
Mr. Bernanke also said that strong participation in the Fed's TAF auctions -- even as the auction sizes
swelled from $20 billion to $75 billion -- reflect ongoing funding pressures. He also noted that
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commercial banks "have borrowed significant amounts" through the discount window's primary credit
facility for terms of up to 90 days.
Policy makers, Mr. Bernanke said, "stand ready to increase the NEWSHOUND QUIZ
size of the [TAF] auctions further if warranted by financial
9
developments."
Care to test your memory of recent news
events in WSJ.com's weekly Newshound
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Mr. Bernanke's remarks, delivered via satellite from
look for the latest installments in your inbox on
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policy. Two weeks ago, officials lowered the fed funds rate
target at which banks lend to each other by 0.25 percentage
point to 2%. It was the seventh cut since September totaling 3.25 percentage points. In an accompanying
statement, officials seemed to suggest that they'd like to hold rates steady for an extended period, a view
supported by pricing in fed funds futures markets.
Mr. Bernanke spent a good deal of his prepared remarks defending the Fed's extraordinary response to
recent financial turmoil that included the collapse of the investment bank Bear Stearns Cos. The Fed
agreed to finance $29 billion in Bear Stearns assets to facilitate its proposed takeover by J.P. Morgan
Chase & Co.
Mr. Bernanke invoked the 19th century British writer and economist Walter Bagehot as being part of a
"long intellectual lineage" concerning the idea that central banks should provide liquidity in times of
crisis.
Regarding the rescue and proposed takeover of Bear Stearns and the Fed's role, Mr. Bernanke said
officials "judged that it was appropriate to use its emergency lending authorities...to avoid a disorderly
closure of Bear."
Mr. Bernanke said that once financial markets normalize "the extraordinary provision of liquidity by the
Federal Reserve will no longer be needed." However, he cautioned that process, which must be
undertaken by financial market participants, "is likely to take some time."
Write to Brian Blackstone at brian.blackstone@dowjones.com11
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5/13/2008 9:03 PM
SEC Will Scour Bear Trading Data - WSJ.com
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May 28, 2008
PAGE ONE
SEC Will Scour Bear Trading Data
By KATE KELLY
May 28, 2008; Page A1
Bear Stearns Cos. plans to turn over documents to securities regulators
showing that several financial giants, including Goldman Sachs Group
Inc., Citadel Investment Group and Paulson & Co., slashed their exposure
to the securities firm in the weeks before its collapse.
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The Securities and Exchange Commission, as part of an ongoing inquiry
into the events surrounding Bear Stearns's implosion in March, has sought
and will examine these trading records, people familiar with the matter say. The SEC is expected to use
the data to determine whether any trading activity was improperly coordinated in any way, constituted
manipulation or otherwise contributed to Bear Stearns's collapse.
THE FALL OF BEAR STEARNS
Part One: Missed Opportunities1. As the firm's
fortunes spiraled downward, executives squabbled
over raising capital and cutting its inventory of
mortgages.
Today: Run on the Bank2. Executives believed
they were about to turn a corner, but rumors and
fear sent clients, trading partners and lenders
fleeing.
Part Three: Deal or No Deal? The Fed pressured
Bear Stearns to sell itself, but a misstep in the
hastily drawn agreement nearly scuttled the deal.
The trading records, which were reviewed by The Wall Street
Journal, open a window into the frenzied selling that came
amid a bank run on Bear Stearns in early to mid-March. In the
three weeks preceding Bear Stearns's collapse, Goldman,
Citadel and Paulson exited about 400 trades where Bear
Stearns was the trading partner, more than any other firms did,
the data show. The SEC has asked Bear Stearns to highlight
any unusual activity in the trading documents, which Bear
Stearns is expected to do soon, according to people familiar
with the matter.
The documents don't suggest any improper activity. There
could be many reasons why hedge funds and others wanted to limit their exposure to Bear Stearns. And
some financial players, including Goldman, simultaneously increased trading exposure to Bear Stearns
on some deals even as they cut their risk on others.
Any SEC case alleging manipulation wouldn't be easy to prove because of the complexity of the trades
and because there were widespread concerns about Bear Stearns's health in the market. Representatives
of the SEC, Bear Stearns, Goldman, Citadel and Paulson declined to comment.
The SEC already has sent broad document and data requests to a number of hedge funds as part of its
informal inquiry into whether there was insider trading or market manipulation of Bear Stearns, people
familiar with the matter say. They say the requests were broad and sought trading data, including short
positions -- bets on a decline in a security -- and options and other derivatives, which are financial
contracts whose value shifts with the movement in an underlying security. The SEC has delved more
deeply into the ties among hedge funds, their clients and their prime brokers with a particular focus on
flows of information and potential insider trading.
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The SEC is interested in who was exiting contracts in which Bear Stearns was the counterparty during
the first two weeks of March, people familiar with the matter say. Bear Stearns effectively ran out of cash
on the afternoon of March 13, and it was considering a bankruptcy-court filing before J.P. Morgan
Chase & Co. and the Federal Reserve agreed to a bailout on the morning of March 14.
The confidential documents identify for the first time market players that traded with Bear Stearns in the
fateful weeks leading to its collapse, as well as how many trades were executed and whether Bear Stearns
owed money to its trading partners. It's rare that such a detailed picture of confidential trading activity
becomes public, particularly in the opaque market for derivatives transactions, which are lightly
regulated.
Spelled out in the documents are Bear
Stearns's trading in credit-default swaps,
financial contracts in which one party, for
a price, assumes the risk that a bond or
loan will go bad. Swaps are like side bets
on a sports game: The seller of the swap
promises the buyer a big payment if a
company's bonds or loans default. In
return, the seller gets quarterly payments.
Neither party needs to hold the underlying
debt when entering into a swap contract.
At issue for Goldman, Citadel, Paulson
and other players trading with Bear
Stearns was what's known as counterparty
risk -- in this case, the risk that Bear
Stearns couldn't pay its end of the trade
when due. To reduce counterparty risk, a
trading partner can transfer a trade to a
third party, a process known as novation.
The records show that Goldman was
active on two fronts: both offloading to
others the contracts it had agreed to with
Bear Stearns, and taking on swap
contracts with Bear Stearns that other
parties no longer wanted.
Beginning March 3, Goldman Sachs Asset
Management stepped out of dozens of
swaps it had with Bear Stearns. Those
transactions had been undertaken entirely
on behalf of clients, according to the
records. Most of those trades were
completed by March 6.
Goldman's international unit, which
comprises its European, Middle Eastern
and African operations, also unloaded a
number of swap contracts it had with Bear Stearns, beginning on Feb. 25 and ending on March 19, three
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days after the sale of Bear Stearns to J.P. Morgan was announced. The positions were transferred to a
variety of players, including Lehman Brothers Holdings Inc. and Morgan Stanley, the records show.
Paulson's activity appears to have been more one-sided, according to the documents. Beginning March
10, Paulson Advantage Ltd. and other funds managed by the New York hedge-fund firm unloaded dozens
of credit-default swaps with Bear Stearns. The positions were taken on almost entirely by Goldman Sachs
International, the records show. In every case, Bear Stearns owed Paulson money on the swaps, based on
mark-to-market values at the time of the transfer.
Citadel, a Chicago hedge-fund firm run by Kenneth Griffin, was active on March 3, transferring about 80
contracts, most of them interest-rate swaps, from one Citadel trading entity -- Fairfax International
Investments Ltd. -- to another, Citadel Equity Fund Ltd.
These trades were part of a planned winding down of Fairfax as Citadel restructures parts of its trading
business, according to a person familiar with Citadel's operations. Other Citadel transfers of trades with
Bear Stearns were done in the "normal course of business" and reflected volumes typical for Citadel in its
dealings with Bear Stearns, which had a relatively small piece of Citadel's swap business, the person said.
In any event, the volume of credit-default-swap trades with Bear Stearns that hedge funds and others
shifted to other parties in the two weeks before Bear Stearns's collapse was 10 times to 20 times the
normal volume of such activity, according to a counterparty-risk analyst at a Wall Street firm.
These so-called novation requests picked up sharply on Tuesday, March 11, as word spread among
hedge-fund traders and brokers that Bear Stearns might not be able to pay what it owed to trading
partners in swaps trades, according to the Bear Stearns trading records and hedge-fund managers.
One New York hedge-fund manager ascribed some hedge funds' decisions to unload risk with Bear
Stearns to a fiduciary duty owed to investors. In some cases, it became impossible to transfer trades
because brokers were overrun with requests or simply unwilling to assume additional exposure to Bear
Stearns, the manager said.
Months before Bear Stearns ran into trouble, there was unusual activity in the credit-default-swap market.
The cost of insuring against a default on Bear Stearns's own debt rose significantly above the cost of
insuring the debt of rival firms.
John Sprow, a bond-fund manager in Boulder, Colo., noticed in mid-January that the cost of insurance on
Bear Stearns's debt had risen to 2.3% annually, or $230,000 for every $10 million in debt insured, more
than double the cost for Morgan Stanley and four times that for Deutsche Bank AG. A month earlier, the
same Bear Stearns protection had cost 1.6%. The jump suggested some market players believed Bear
Stearns was becoming riskier.
Mr. Sprow, whose investment firm is Smith Breeden Associates, says he didn't believe Bear Stearns
would collapse overnight. But he became concerned that other dealers might become less willing to trade
with Bear Stearns if concerns persisted, because Bear Stearns swaps "were off in a world of their own."
-- Serena Ng, Jenny Strasburg and Kara Scannell contributed to this article.
Write to Kate Kelly at kate.kelly@wsj.com3
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• Lost Opportunities Haunt Final Days of Bear Stearns May. 27, 2008
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Money Markets Make Progress - WSJ.com
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May 28, 2008
CREDIT MARKETS
Money Markets Make Progress
By MIN ZENG and KATE HAYWOOD
May 28, 2008; Page C8
Strained money markets are slowly returning to life thanks to the Federal
Reserve's supply of funds, with a host of risk measures showing
improvement. But the recovery will be slow and will see periodic setbacks
as investors remain concerned about the impact of the weak housing market
on the financial system.
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"As long as the Fed stays very serious about continuing to keep liquidity in
the system, things will get better at a reasonable pace," said James Caron, head of U.S. interest-rate
strategy at Morgan Stanley in New York. But the recovery will "have its ups and downs along the way."
The money markets have suffered three major routs -- in August, November and March -- since the
subprime-mortgage turmoil broke out last summer. Each episode saw banks hoard cash and tighten
lending to counterparts, pushing up short-term funding costs and sparking a seizure in interbank lending
and security-repurchase markets.
This time around, as brokers and the large commercial banks prepare for the quarter-end, the picture is
different. Steep rate cuts, a series of creative cash-pumping measures to help both commercial and
investment banks, and the bailout of troubled Bear Stearns Cos. have all contributed to a thaw in the
crunch.
Fed officials from Chairman Ben Bernanke on have recognized that the measures appear to be working.
Tuesday, San Francisco Fed President Janet Yellen said "although overall financial conditions are still far
from normal, there are some rays of hope that the strains may be easing a bit."
From the London interbank offered rates to the interest-rate-swaps market, credit-risk gauges are
showing an improvement in sentiment. Libor -- a benchmark for corporate and consumer loans and the
rate that banks charge each other for unsecured borrowing -- has come off highs. The gap between
three-month Libor and super-safe Treasury-bill yields has been shrinking steadily, hitting 0.755
percentage point Tuesday compared with over two percentage points in mid-March.
Two-year swap spreads have tightened sharply after setting record wide levels in March. In the repo
markets, the general rate to borrow a basket of Treasurys is back above the federal-funds rate, suggesting
the run on the Treasury market is over.
The risk is that the economy, which has held up better than expected, could take another lurch downward
should the housing market deteriorate significantly. That would raise concerns about bank earnings and
the need for further write-downs.
In a sign that such worries remain on investors' radar, the benchmark credit-derivatives index, the Markit
CDX index, has indicated more risk aversion since early May. As brokers prepare to close their books for
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the quarter, "reality is seeping back into the market" said Scott MacDonald, director of research at
Aladdin Capital Holdings. "There is a real concern that the broker earnings may not be as robust" as
hoped.
United Kingdom's FSA
To Overhaul Asset Rules
The United Kingdom's Financial Services Authority said Tuesday that lenders see a need for stronger and
more rigid rules governing the type of assets banks need to hold to make sure they can meet their
payments.
This paves the way for the FSA to overhaul the current system in the U.K., which is generally driven by
broad guidelines, though it also uses some detailed rules or benchmarks. It said it expects to issue its
proposals this autumn.
The FSA's existing liquidity policy failed to avert the collapse of Northern Rock, a U.K. mortgage lender
that relied heavily on borrowings in the capital markets and found itself unable to get funds through the
interbank or secured-lending markets. The bank has since been nationalized.
The FSA proposed in December that it set limits to the funding gap -- the difference between income and
outgoing payments -- that banks can have at any one time.
--Adam Bradbery
Treasurys Drop Sharply
As Stock Market Gains
A pullback in oil prices and gains in stocks sent Treasurys sharply lower Tuesday as investors returned
from the long Memorial Day weekend.
The benchmark 10-year note ended down 24/32 point, or $7.50 for every $1,000 invested, to yield
3.923%.
That's up from 3.833% on Friday as yields rise when bond prices fall.
Write to Min Zeng at min.zeng@dowjones.com1 and Kate Haywood at kate.haywood@dowjones.com2
URL for this article:
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Hyperlinks in this Article:
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Help for Vietnam Stocks? May. 22, 2008
Is Debt Thaw on Borrowed Time? May. 15, 2008
Risk Aversion Abates, a Bit, As Investors Test the Markets Apr. 28, 2008
British Mortgage Approvals Nose-Dive Apr. 23, 2008
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6/3/2008 8:54 PM
Real-Estate Woes of Banks Mount - WSJ.com
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June 6, 2008
PAGE ONE
Real-Estate Woes of Banks Mount
Lenders Dumping Bad Loans at Discount;
Regulators See Losses Continuing
By MICHAEL CORKERY, JONATHAN KARP and DAMIAN PALETTA
June 6, 2008; Page A1
Federal regulators warned Thursday that banking-industry turmoil would
continue as financial institutions come to terms with piles of bad loans they
made to finance the construction of homes and condominiums.
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Until now, most of the damage to banks from the housing crisis has come from homeowners defaulting
on their mortgages. But amid a dismal spring sales season for new homes, loans to home and condo
builders are looking increasingly shaky. Banks have begun to dump them at what will likely be steep
discounts, setting the stage for billions of dollars in fresh losses.
"As long as the housing market is on a downward path, as long as those prices continue to fall, I think
there's a risk that the losses could continue to mount on a variety of loans," Federal Reserve Vice
Chairman Donald Kohn told the Senate Banking Committee Thursday.
At the same hearing, Federal Deposit Insurance Corp. Chairman Sheila
Bair said banks that aren't diversified, or those with high exposures to
residential construction and development, are of particular concern.
"That's where we are really seeing the delinquencies spike," she said.
The surprisingly gloomy outlook is at odds with the sentiment of
investors, who appear to have moved on from worrying about the health of
the financial system to obsessing about gasoline prices and consumer
spending. The Dow Jones Industrial Average rose 213.97 points, or 1.7%,
on Thursday on the back of surprisingly strong retail-sales data.
The health of the economy is heavily dependent on the willingness of
banks and other financial institutions to lend to consumers and businesses.
Many banks have already taken substantial losses, and either will have to
pare their lending or raise new capital to rebuild their safety nets. The
Federal Reserve and Treasury Department have been pressing banks to
raise capital so as not to further reduce lending.
Banks with swelling portfolios of troubled loans tied to land and housing are struggling to unload some
of their real-estate debt. IndyMac Bancorp Inc., a Pasadena, Calif., lender, is trying to sell $540 million in
loans made to finance land purchases and housing construction projects. Winning bids on many of the
loans were, on average, about 60 cents on the dollar, according to people familiar with the matter. But
some winning bids were only about 20 cents on the dollar.
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Cleveland-based KeyBank, a unit of KeyCorp., is trying to unload $935 million in loans tied to land and
residential developments, while Wachovia Corp. is shopping a $350 million loan portfolio, according to
two people who have seen the offerings. Representatives of the banks declined to comment.
The sales are a response to a growing problem: Home builders are falling behind on loan payments, and
the value of the land and housing developments that serve as loan collateral is plummeting. Over the next
five years, U.S. banks could "charge off" as bad debt between 10% and 26% of their loans tied to
residential construction and land assets, which would amount to about $65 billion to $165 billion,
according to a report sent to clients Thursday by housing research firm Zelman & Associates. That
compares with charge-offs of about 10% of construction-related bank assets, totaling $31.6 billion, when
adjusted for inflation, during the last housing downturn in the late 1980s and early 1990s. In 2007 and the
first quarter of this year, banks wrote down just 0.7% of such assets, according to Zelman.
"We believe this period of procrastination is nearly over," says Ivy
Zelman, chief executive of Zelman & Associates.
The prospect of a new wave of losses worries federal regulators, given the
large proportion of loans to housing developers held by many banks and
thrifts. The problems are worse at small banks that can't easily absorb
losses, and at banks with big exposure in states hit hard by the housing
crisis. Banks in Arizona have 36% of their total loans tied to construction
and development. In Georgia that number is 34%, and in North Carolina
it's 28%. Zelman said construction and development loans, as a percentage
of total loans, are at their highest levels since at least 1975.
Grab Bag of Assets
IndyMac is trying to sell debt backed by a grab bag of assets, including
partially built subdivisions, condo buildings and large parcels of raw land
covered in sagebrush in parts of California, where the housing crisis is
acute, according to people familiar with the offering.
Selling real-estate loans could help larger lenders like IndyMac shore up their balance sheets. But such
sales, by setting a market value for distressed real-estate loans, could trigger problems at smaller banks
with real-estate exposure, which might have a difficult time absorbing such losses.
Office of Thrift Supervision Director John Reich told Congress that the number of savings-and-loan
associations at a heightened risk of failure jumped from 12 at the end of March to 17 today. Federal
regulators have met privately with Treasury officials to discuss the potential fallout from a larger number
of bank failures, people familiar with the matter said. Four banks have already failed this year, more than
in the prior three years combined.
The FDIC's Ms. Bair said she would be "very surprised" if a large bank failed, but added that "we need to
be prepared for all contingencies."
Federal regulators said they have increased scrutiny of banks with high concentrations of real-estate
loans, with Comptroller of the Currency John Dugan saying a formal initiative is in place to review asset
quality.
Signs of Improvement
At the same time, regulators praised the banking industry for raising capital and for building up reserves
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against losses. They added that some pockets of the credit markets were showing signs of improvement.
Over the last week, for example, direct lending by the Federal Reserve to investment banks and
commercial banks declined, suggesting that credit strains across the industry were easing. Average daily
borrowing by securities firms was $8.3 billion in the week ending Wednesday, down from $12.3 billion a
week earlier, the Fed said Thursday.
Real-estate lenders had been hoping for a decent spring sales season for new homes, which would have
helped builders stay current on their loans. But the selling season has been a bust. The rate of
foreclosures on homeowners hit a record, as did the rate at which they fell behind on their mortgage
payments. In the first quarter, 6.35% of mortgages were at least 30 days delinquent, not including those
already in foreclosure, a rise of 1.51 percentage points from the year-earlier period.
"We've seen a real change in the market," says Ricardo Chance, a managing director at KPMG Corporate
Finance LLC, who is helping troubled builders restructure their businesses. "Finally the banks are
capitulating and saying, 'Let's mark to market and flush this all out.' The market is going to get worse. We
don't want to hold on to this stuff."
The glut of foreclosed homes has made life hard for home builders. "I've been through three cycles, and
this is the worst," says Mark Connal, a vice president at Michael Crews Development, a closely held
Escondido, Calif., builder. "You can buy brand new homes for less than the cost of construction."
At the peak of the housing boom, during the second quarter of 2005, luxury-home builder Toll Brothers
Inc. signed 3,120 contracts. In its latest quarter ended April 30, buyers signed just 929 contracts for new
homes in the builder's 300 communities across the nation.
In Riverside County, Calif., where the housing market is dismal, developers are offering upgrades and
services to move unsold homes. "They used to landscape the front yard," says Gloria Britt, of Prudential
California Realty in Riverside. "Now they're doing the back, upgrading the patio, whatever the buyer
asks for."
Write to Damian Paletta at damian.paletta@wsj.com1
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6/6/2008 9:41 AM
Bonds Sound Diverse Alarms - WSJ.com
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June 9, 2008
MARKET MOVERS
Bonds Sound Diverse Alarms
Investors Are Signaling
Europe Risks Slowdown,
While Asia Faces Inflation
By TOM LAURICELLA
June 9, 2008; Page C1
Stock investors looking for good news after Friday's rout in the U.S. won't
be happy with the message coming from global bond markets.
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Economic strength outside the U.S. has been a source of stability for corporate earnings amid the turmoil
of the real-estate market collapse and credit crunch. Now, global bond markets, which have been more
pessimistic than stock markets, are flashing warning signs about the outlook for both growth and
inflation.
For big developed economies -- most notably Europe, bond
investors are signaling that the big risk is a severe economic
slowdown. In emerging markets like China and India, inflation
is a more serious threat. If these economies stumble or run into
an inflation problem, that removes an important prop from under
the stock market.
"More bond markets are at extremes," says Alan Ruskin, chief
international strategist at RBS Greenwich Capital. "We've got a
world divided between people saying we're concerned about the
inflation repercussions of high oil...and those worried about the
growth implications."
These concerns were front and center Friday, driving U.S.
stocks sharply lower. On the same day employment data showed
the U.S. economy continues to struggle, oil prices surged 8.4%
Scott Pollack to a new high. That drove the Dow Jones Industrial Average
down 394.64 points, or 3.1%, to 12209.81, its biggest drop since February 2007. In early Asian trading
Monday, oil was down 74 cents to $137.80.
Asian stock markets fell sharply early Monday. In Japan, the Nikkei was off 2.5%, while Korea's Kospi
Composite was 2.6% lower.
Questions about the outlook for economies around the globe are showing
up in the relationship between short-term interest rates and long-term
interest rates. When short-term rates are much higher than long-term rates
-- something that is relatively uncommon -- it is a signal that an economic
slowdown could be brewing. But when long-term rates are much higher, it
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is an inflation signal.
In the United Kingdom and the euro zone, tough monetary policy is
keeping short-term rates elevated while long-term rates are lower amid
signs of economic weakness. In emerging markets such as Thailand,
Indonesia and China, interest rates have been rising and in some,
long-term yields are meaningfully above short-term rates. In a number of
Asian emerging markets, official interest rates also are below the inflation
rate, a stance that fuels economic growth and even more inflation.
This reflects the tug of war at work in the global economy. Many
developed economies are still hurting because of the collapse of real-estate
markets and the credit crunch. Wednesday the Eurostat statistics agency
said retail sales in the 15 countries that share the euro fell in April for the
third straight month, surprising analysts who had been predicting an increase.
On the other side of the divide are the strong-growth emerging economies whose demand for raw
materials and energy has driven prices higher. They are now seeing the challenges of that boom. In India,
the government last week was forced to increase retail prices of fuel products. The result, analysts say,
will likely be upward pressure on the country's lofty inflation rate, which could lead to higher interest
rates and ultimately slower growth.
"We're no longer looking at one harmonized world," says Mohamed El-Erian, co-chief investment officer
at bond-investment titan Pacific Investment Management Co., or Pimco. The "shock embedded in the
energy and food-price increases has caught countries around the world in different economic and
financial circumstances."
In late 2006, yields on short-term U.S. Treasurys were above yields on long-term debt, a scenario known
as an inverted yield curve. This is often seen as a predictor of an economic downturn because it suggests
that bond investors believe the central bank -- in the case of the U.S., the Federal Reserve -- will have to
cut rates to revive a slowing economy.
At the time, many investors, especially in the stock market, dismissed the significance of the inverted
yield curve as a distortion, arguing that long-term interest rates were being depressed by foreign buying.
While foreign buyers may have helped keep yields low, they were wrong about the economy.
The yield curve in the U.S. is now pointing the other direction, with yields on 10-year Treasury notes
1.54 percentage points higher than yields on two-year notes, roughly half a percentage higher than the
average of the past 10 years, according to data from Merrill Lynch & Co. That yellow light on inflation is
already seen as limiting the Federal Reserve's ability to further reduce interest rates to support the
economy.
Indeed, says Art Steinmetz, portfolio manager at OppenheimerFunds, either short-term rates will have to
rise substantially or currencies are going to have to meaningfully depreciate.
It is a different story in Europe and the U.K., where the curve is either inverted or essentially flat,
depending on which benchmark is used. In Germany, two-year notes are yielding about 0.20 percentage
point above the 10-year note.
The European Central Bank and the Bank of England have inflation control as their sole mandate and
don't have much choice but to keep short-term rates high. This was hammered home last week by
comments from ECB President Jean-Claude Trichet warning that interest rates could be raised as soon as
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next month because of higher commodity prices. Yield curves have been inverted also in Poland,
Hungary and Denmark, according to data from RBS Greenwich Capital.
Those inverted yields curves show the market believes "that monetary policy is too tight from a growth
perspective to be sustained in the longer-term," says RBS's Mr. Ruskin.
In emerging markets, many countries are keeping rates low in order to help spur exports and economic
development. But with the commodities surge, in places like Singapore, Hong Kong (where rates are
pegged to the U.S.) and Thailand, the markets are signaling an inflation threat.
In Thailand, the yield on the 10-year note has risen by three-quarters of a percentage point in the past
month and is at its highest level in nearly two years. Meanwhile, the gap between one-year and five-year
government bonds has grown by about half a percentage point and is at its widest since late 2005,
according to Merrill's data.
"In a large slug of the Asian emerging world...policy is just too easy," Mr. Ruskin says.
For a few countries, the yield curve is steep, but some investors say these countries are taking steps to
combat inflation. That is the case with Brazil, where the gap between three-month and five-year debt is
nearly two percentage points, but interest rates are well above the rate of inflation.
Write to Tom Lauricella at tom.lauricella@wsj.com1
URL for this article:
http://online.wsj.com/article/SB121295844546455357.html
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Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved
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6/9/2008 9:16 AM
The Subprime Credit Crisis of 07*
September 12, 2007
Revised July 9 2008
Michel G. Crouhy, Robert A. Jarrow and Stuart M. Turnbull
JEL Classification: G22, G30, G32, G38
Keywords:, ABS, CDOs, monolines, rating agencies, risk management, securitization, SIVs,
subprime mortgages, transparency, valuation.
Michel G. Crouhy: Natixis, Head of Research & Development, Tel: +33 (0)1 58 55 20 58, email:
michel.crouhy@natixis.com;
Robert A. Jarrow, Johnson Graduate School of Management, Cornell University and Kamakura
Corporation, Tel: 607 255-4729, email raj15@cornell.edu;
Stuart M. Turnbull, (contact author) Bauer College of Business, University of Houston, Tel: 713743-4767, email: sturnbull@uh.edu
Abstract
This paper examines the different factors that have contributed to the subprime mortgage credit
crisis: the search for yield enhancement, investment management, agency problems, lax
underwriting standards, rating agency incentive problems, poor risk management by financial
institutions, the lack of market transparency, the limitation of extant valuation models, the
complexity of financial instruments, and the failure of regulators to understand the implications of
the changing environment for the financial system. The paper sorts through these different issues
and offers recommendations to help avoid future crises.
Credit Crisis
Crouhy, Jarrow and Turnbull
2
Introduction
The credit crisis of 2007 started in the subprime1 mortgage market in the U.S. It has
affected investors in North America, Europe, Australia and Asia and it is feared that write-offs of
losses on securities linked to U.S. subprime mortgages and, by contagion, other segments of the
credit markets, could reach a trillion US dollars.2 It brought the asset backed commercial paper
market to a halt, hedge funds have halted redemptions or failed, CDOs have defaulted, and
special investment vehicles have been liquidated. Banks have suffered liquidity problems, with
losses since the start of 2007 at leading banks and brokerage houses topping US$300 billion, as of
June 2008.3,4 Credit related problems have forced some banks in Germany to fail or to be taken
over and Britain had its first bank run in 140 years, resulting in the effective nationalization of
Northern Rock, a troubled mortgage lender. The U.S. Treasury and Federal Reserve helped to
broker the rescue of Bear Stearns, the fifth largest U.S.Wall Street investment bank, by JP
Morgan Chase during the week-end of March 17, 2008.5 Banks, concerned about the magnitude
of future write-downs and counterparty risk, have been trying to keep as much cash as possible as
a cushion against potential losses. They have been wary of lending to one another and,
consequently, have been charging each other much higher interest rates than normal in the inter
bank loan markets.6
The severity of the crisis on bank capital has been such that U.S. banks have had to cut
dividends and call global investors, such as sovereign funds, for capital infusions of more than
US$230 billion, as of May 2008, based on data compiled by Bloomberg.7 The credit crisis has
caused the risk premium for some financial institutions to increase eightfold since last summer. It
has now become more expensive for financial than for non-financial firms, with the same credit
rating, to raise cash.8
The crisis has affected the general economy. Credit conditions have tightened for all
types of loans since the subprime crisis started nearly a year ago. The biggest danger to the
economy is that, to preserve their regulatory capital ratios, banks will cut off the flow of credit,
causing a decline in lending to companies and consumers. According to some economists, tighter
credit conditions could knock 1 ¼ percentage point from first-quarter growth in the U.S. and 2 ½
points from the second-quarter growth of 2008. The Fed lowered its benchmark interest rate 3.25
percentage points to 2 percent between August 2007 and May 2008 in order to address the risk of
a deep recession. The Fed has also been offering ready sources of liquidity for financial
institutions, including investment banks and primary dealers, that are finding it progressively
harder to obtain funding, and has taken on mortgage debt as collateral for cash loans.
Credit Crisis
Crouhy, Jarrow and Turnbull
3
The deepening crisis in the subprime mortgage market has affected investor confidence in
multiple segments of the credit market, with problems for commercial mortgages unrelated to
subprime, corporate credit markets,9 leverage buy-out loans (LBOs),10 auction-rate securities, and
parts of consumer credit, such as credit cards, student and car loans. In January 2008, the cost of
insuring European speculative bonds against default rose by almost one-and-a-half percentage
point over the previous month, from 340 bps to 490 bps11, while the U.S. high-yield bond spread
has reached 700 bps over Treasuries, from 600 bps at the start of the year.12
This paper examines the different factors that have contributed to this crisis and offers
recommendations for avoiding a repeat. In Section 2, we briefly analyze the chain of events and
major structural changes that affected both capital markets and financial institutions that
contributed to this crisis. The players and issues at the heart of the current subprime crisis are
analyzed in Section 3. In Section 4, we outline a number of solutions that would reduce the
possibility of a repeat, and a summary is given in Section 5.
Section 2: How It All Started 13
Interest rates were relatively low in the first part of the decade.14 This low interest rate
environment has spurred increases in mortgage financing and substantial increases in house
prices.15 It encouraged investors (financial institutions, such as pension funds, hedge funds,
investment banks) to seek instruments that offer yield enhancement. Subprime mortgages offer
higher yields than standard mortgages and consequently have been in demand for securitization.
Securitization offers the opportunity to transform below investment grade assets (the investment
or collateral pool) into AAA and investment grade liabilities. The demand for increasingly
complex structured products such as collateralized debt obligations (CDOs) which embed
leverage within their structure exposed investors to greater risk of default, though with relatively
low interest rates, rising house prices, and the investment grade credit ratings (usually AAA)
given by the rating agencies, this risk was not viewed as excessive.
Prior to 2005, subprime mortgage loans accounted for approximately 10% of outstanding
mortgage loans. By 2006, subprime mortgages represented 13% of all outstanding mortgage loans
with origination of subprime mortgages representing 20% of new residential mortgages compared
to the historical average of approximately 8%.16 Subprime borrowers typically pay 200 to 300
basis points above prevailing prime mortgage rates. Borrowers who have better credit scores than
subprime borrowers but fail to provide sufficient documentation with respect to all sources of
Credit Crisis
Crouhy, Jarrow and Turnbull
4
income and/or assets are eligible for Alt-A loans. In terms of credit risk, Alt-A borrowers fall
between prime and subprime borrowers.17
During the same period, financial markets had been exceptionally liquid, which fostered
higher leverage and greater risk-taking. Spurred by improved risk management techniques and a
shift by global banks towards the so-called “originate-to-distribute” business model, where banks
extend loans and then distribute much of the underlying credit risk to end-investors, financial
innovation led to a dramatic growth in the market for credit risk transfer (CRT) instruments.18
Over the past four years, the global amount outstanding of credit default swaps has multiplied
more than tenfold,19 and investors now have a much wider range of instruments at their disposal
to price, repackage, and disperse credit risk throughout the financial system.
There were a number of reasons for this growth in the origination of subprime loans.
Borrowers paid low teaser rates over the first few years, often paid no principal and could
refinance with rising housing prices. There were two types of borrowers, generally speaking: (i)
those borrowers who lived in the house and got a good deal, and (ii) those that speculated and did
not live in the house. When the teaser rate period ended, as long as housing prices rose, the
mortgage could be refinanced into another teaser rate period loan. If refinancing proved
impossible, the speculator could default on the mortgage and walk away. The losses arising from
delinquent loans were not borne by the originators, who had sold the loans to arrangers. The
arrangers securitized the loans and sold them to investors. The eventual owners of these loans,
the ABS trusts, generated enough net present value from the repackaging of the cash flows that
they could absorb these losses. In summary, the originators did not care about issuing below fair
valued loans, because they passed on the loan losses to the ABS trusts and the originators held
none of the default risk on their own books.
CDOs of subprime mortgages are the CRT instruments at the heart of the current credit
crisis, as a massive amount of senior tranches of these securitization products have been downgraded from triple-A rating to non-investment grade. The reason for such an unprecedented drop
in the rating of investment grade structured products was the significant increase in delinquency
rates on subprime mortgages after mid-2005, especially on loans that were originated in 20052006. In retrospect, it is very unlikely that the initial credit ratings on bonds were correct. If they
had been rated correctly, there would have been downgrades, but not on such massive scale.
The delinquency rate for conventional prime adjustable rate mortgages (ARMs) peaked
in 2001 to about 4% and then slowly decreased until the end of 2004, when it started to increase
again. It was still below 4% at the end of 2006. For conventional subprime ARMs, the peak
Credit Crisis
Crouhy, Jarrow and Turnbull
5
occurred during the middle of 2002, reaching about 15%. It decreased until the middle of 2004
and then started to increase again to approximately 14% by the end of 2006, according to the
Mortgage Bankers Association.20 During 2006, 4.9% of current home owners (2.45 million) had
subprime adjustable rate mortgages. For this group, 10.13% were classified as delinquent21; this
translates to a quarter of a million home owners. At the end of 2006, the delinquency rate for
prime fixed rate mortgages was 2.27% and 10.09% for subprime.22
There are four reasons why delinquencies on subprime loans rose significantly after mid2005. First, subprime borrowers are typically not very creditworthy, often highly levered with
high debt-to-income ratios, and the mortgages extended to them have relatively large loan-tovalue ratios. Until recently, most borrowers were expected to make at least 20% down payment
on the purchase price of their home. During 2005 and 2006 subprime borrowers were offered
“80/20” mortgage products to finance 100% of their homes. This option allowed borrowers to
take out two mortgages on their homes. In addition to a first mortgage for 80% of the total
purchase price, a simultaneous second mortgage, or “piggyback” loan for the remaining 20%
would be made to the borrower.
Second, in 2005 and 2006 the most common subprime loans were of the “short-reset”
type. They were the “2/28”or “3/27” hybrid ARMs subprime. These loans had a relatively low
fixed teaser rate for the first two or three years, and then reset semi-annually to a much higher
rate, i.e., an index plus a margin for the remaining period with a typical margin in the order of
400 to 600 bps. Short-term interest rates began to increase in the U.S. from mid-2004 onwards.
However, resets did not begin to translate into higher mortgage rates until sometime later. Debt
service burdens for loans eventually increased, which led to financial distress for some of this
group of borrowers. The distress will continue, as US$500 billion in mortgages will reset in 2008.
Third, many subprime borrowers had counted on being able to refinance or repay
mortgages early through home sales and at the same time produce some equity cushion in a
market where home prices kept rising. As the rate of U.S. house price appreciation began to
decline after April 2005, it became more difficult for subprime borrowers to refinance and many
ended up incurring higher mortgage costs than they expected to bear at the time of taking their
mortgage. 23
Fourth, a decline in credit standards by mortgage originators in underwriting over the last
three years, was a major factor behind the sharp increase in delinquency rates for mortgages
originated during 2005 and 2006.24 The pressure to increase the supply of subprime mortgages
arose because of the demand by investors for higher yielding assets. A major contributor to the
Credit Crisis
Crouhy, Jarrow and Turnbull
6
crisis was the huge demand by CDOs for BBB mortgage-backed bonds that stimulated a
substantial growth in home equity loans. This CDO demand for BBB ABS bonds was due to the
fact that the bonds had high yields, and the CDO trust could finance their purchase by issuing
AAA rated CDO bonds paying lower yields. This was because the rating agencies assigned AAA
ratings to the CDO’s senior bond tranches that did not reflect the CDO bond’s true credit risk.25
Because these tranches were mis-priced, the CDO equity holders generated a positive net present
value investment from just repackaging cash flows. This process boosted the demand by CDOs
for residential mortgage-backed securities (RMBS). Furthermore, this repackaging was so
lucrative, that it was repeated a second time for CDO squared trusts. A CDO squared trust
purchased high yield (low rated) bonds and equity issued by other CDOs. To finance the purchase
of this collateral, they issued AAA rated CDO squared bonds with lower yields. This, in turn,
created demand for CDOs containing mortgage-backed securities (MBS) and CDO tranches.
This environment encouraged questionable practices by some lenders.27 Some mortgage
borrowers have ended up with subprime mortgages, even though their credit worthiness qualifies
them for lower risk types of mortgages, others with mortgages that they were not qualified to
have.28 Some borrowers and mortgage brokers took advantage of the situation and fraud
increased.29
Section 3: Players and Issues at the Heart of the Crisis
The process of securitization takes a portfolio of illiquid assets with high yields and
places them into a trust. This is called the trust’s collateral pool. To finance the purchase of the
collateral pool, the trust hopes to issue highly rated bonds paying lower yields. The trust issues
bonds that are partitioned into tranches with covenants structured to generate a desired credit
rating in order to meet investor demand for highly rated assets. The usual trust structure results in
a majority of the bond tranches being rated investment grade. This is facilitated by running the
collateral’s cash flows through a “waterfall” payment structure. The cash flows are allocated to
the bond tranches from the top down: the senior bonds get paid first, and then the junior bonds,
and then the equity. To ensure that a majority of the bonds get rated AAA, the waterfall specifies
that the senior bonds get accelerated payments (and the junior bonds get none), if the collateral
pool appears stressed in certain ways.30 Stress is usually measured by (collateral/liability) and
(cash-flow/bond-payment) ratios remaining above certain trigger levels. A surety wrap (insurance
purchased from a monoline) may also be used to ensure super senior AAA credit rating status. In
addition, the super senior tranches are often unfunded, making them more attractive to banks.
Credit Crisis
Crouhy, Jarrow and Turnbull
7
There are costs associated with securitization: managerial time, legal fees and rating
agency fees. The equity holders of an asset-backed trust (ABS) would only perform
securitization if the process generated a positive net present value. This could occur if the other
tranches were mispriced. For example, if an AAA rated tranche added a new security with
unique characteristics, this could generate demand and attract new sources of funds. However,
asset securitization started in the mid 1980s, so it is difficult to attribute the demand that we have
witnessed over the last few years for AAA rated tranches to new sources of funds. After this
length of time, investors should have learnt to price tranches in a way that reflects the inherent
risks. If ABS bond mispricing occurred, the question is why? The AAA rated liabilities could be
mispriced either because of the mispricing of liquidity or the rating of the trust’s bonds were
inaccurate.
In this section, we identify the different players in the crisis, their economic motivation
and briefly describe the events that have unfolded since 2005-2006. We start with the role of the
rating agencies, as the issues of timely and accurate credit ratings have been central to the crisis.
Then, we turn to the role of the mortgage brokers and lenders. We then describe some of the
institutions that have been at the center of the storm. We also discuss how central banks reacted to
the current crisis. We then address the issues of valuation and transparency that have been
catalysts for the crisis. We end this section explaining why systemic risk occurred.
3.1 Rating Agencies31
In the summer of 2006, it became clear that the subprime mortgage market was in stress.
At this time, the rating agencies issued warnings about the deteriorating state of the subprime
market. Moody’s first took rating action on 2006 vintage subprime loans in November 2006. In
February 2007, S&P took the unprecedented step of placing on “credit watch” transactions that
had been closed as recently as the last year. From the first quarter of 2005 to the third quarter of
2007, Standard and Poor’s (2008) reports for CDOs of asset backed securities, 66% were
downgraded and 44% were downgraded from investment grade to speculative grade, including
default. For residential subprime mortgage backed securities, 17% were downgraded, and 9.8%
were downgraded from investment grade to speculative grade, including default.32 These changes
are large and naturally raise questions about the rating methodologies employed by the different
agencies.
Rating agencies are at the center of the current crisis as many investors relied on their
ratings for many diverse products: mortgage bonds, asset back commercial paper (ABCP) issued
by the structured investment vehicles (SIVs), Derivative Product Companies (DPCs) and
Credit Crisis
Crouhy, Jarrow and Turnbull
8
monolines which insure municipal bonds and structured credit products such as tranches of
CDOs. Money market funds are restricted to investing only in triple-A assets, pension funds and
municipalities are restricted to investing in investment grade assets and base their investment
decision on the rating attributed by the rating agencies.33 Many of these investors invested in
assets that were both complex and contained exposure to subprime assets. Investors in complex
credit products had considerably less information at their disposal to assess the underlying credit
quality of the assets they held in their portfolios than the originators. As a result, these endinvestors often came to rely heavily on the risk assessments of rating agencies. Implicitly in the
investment decision is the assumption that ratings are timely and relatively stable. No one was
expecting, until recently, a triple-A asset to be downgraded to junk status within a few weeks or
even a few days. The argument could be made that as the yields on these instruments exceeded
those on equivalently rated corporations, the market knew they were not of the same credit and/or
liquidity risk. But investors still mis-judged the risk.
The CDO rating process worked as follows. The CDO trust partners, the equity holders,
would work with a credit rating agency to get the CDO’s liabilities rated. They paid the rating
agency for this service. The rating agency told the CDO trust the procedure it would use to rate
the bonds – the methods, the historical default rates, the prepayment rates, and the recovery rates.
The CDO trust structured the liabilities and waterfall to obtain a significant percent of AAA
bonds (with the assistance of the rating agency). The rating process was a fixed target. The CDO
equity holders designed the liability structure to reflect the fixed target. Note that given the use of
historic data, the ratings did not reflect current asset characteristics, such as the growing number
of undocumented mortgages and large loan-to-value ratios for subprime mortgages.
From the CDO equity holders’ perspective, if not enough of the CDO bonds are rated
AAA, it would not be economically profitable to proceed with the CDO. Creation of the CDO is
also in the interest of the rating agencies, because the CDO trust requires continual monitoring by
the rating agency, with appropriate fees paid.34 This ongoing fee payment structure created a
second incentive problem for the credit rating agency.
Rating agencies such as Moody’s, Standard and Poor’s and Fitch are Nationally
Recognized Statistical Rating Organizations, which provides a regulator barrier to entry. The
reputation of rating agencies depends in part on their performance. However, there are
institutional and regulatory features that imply there is always demand for their services. Many
investors are restricted to invest in assets with certain ratings. For example, money market funds
can only invest in AAA rated assets, while many pension funds are restricted to investing in
Credit Crisis
Crouhy, Jarrow and Turnbull
9
investment grade assets. Basel II uses credit ratings to determine the amount of regulator capital a
regulated financial institution must hold. Reputation is of course important. However, there is no
guarantee that the incentive structures offered to management that are essentially short term in
nature, will align management to act in the best long run interests of the firm.35 The European
Commission and Barney Frank, chair of the House Financial Services Committee, have held
separate hearings on the agencies response to the subprime mortgage crisis, and possible conflicts
of interest arising from (a) rating agencies being paid by issuers and (b) rating agencies offering
advisory services to issuers.
Originators make loans and supposedly verify information provided by the borrowers.
Issuers and arrangers of mortgage backed securities bundle the mortgages and should perform
due diligence. The rating agencies receive data from the issuers and arrangers and assume that
appropriate due diligence has been performed. Rating agencies clearly state that they do not cross
check the quality of borrowers’ information provided by the originators.36 Normally mortgages
tend to have high recovery rates, but with the declining underwriting standards in the subprime
market and high debt to value ratios, this was no longer the case. Failure to check the data meant
that estimates of the probability of default and the loss given default did not reflect reality. This
meant that the probability of default and the loss given default were probably under estimated. It
also affected the ability to model default dependence amount the assets in the collateral pool.
The rating process proceeds in two phases. First, the estimation of the loss distribution
over a specified horizon and, second, the simulation of the cash flows. The simulations
incorporated the CDO waterfall triggers, designed to provide protection to the senior bond
tranches in case of bad events, and were used to investigate extreme scenarios. The loss
distribution allows the determination of the credit enhancement (CE), that is, the amount of loss
on the underlying collateral that can be absorbed before the tranche absorbs any loss. If the credit
rating is associated with a probability of default, the amount of CE is simply the level of loss such
that the probability that the loss is higher than CE is equal to the probability of default. CE is thus
equivalent to a Value-at-Risk type of risk measure. In a typical CDO, credit enhancement comes
from two sources: “subordination”, that is, the par value of the tranches with junior claims to the
tranche being rated, and “excess spread” which is the difference between the income and
expenses of the credit structure. Over time, the CE, in percentage of the principal outstanding,
will increase as prepayments occur and senior securities are paid out. The lower the credit quality
of the underlying subprime mortgages in the ABS CDOs, the greater will be credit enhancement,
for a given credit rating. Deterioration of credit quality, will lead to a downgrade of the ABS
structured credits.
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Rating agencies seek to make the rating of subprime related structured credit stable
through the housing cycle, as with the rating of corporate bonds. Therefore, rating agencies must
respond to anticipated shifts in the loss distribution during the housing cycle by increasing the
amount of CE needed to keep the ratings constant as economic conditions deteriorate, or by
downgrading the structured credit. The contrary happens when the housing market improves.37
Unanticipated changes may result in a rating agency changing a rating for a product. What was
not anticipated by some investors was the volatility of the rating changes that followed as the
housing market started to deteriorate.38
For example, during the second week of July 2007, S&P downgraded US$7.3 billion of
securities sold in 2005 and 2006. A few weeks later, Moody’s Investor Service slashes ratings on
691 securities from 2006, originally worth US$19.4 billion. Some 78 of the bonds had Moody’s
top rating of Aaa. The securities were backed by second lien mortgages that included piggyback
mortgages. Moody’s stated that the cause for the downgrades was the dramatically poor overall
performance of such loans and rising default rates. Fitch also downgraded subprime bonds sold
by Barclays, Merrill Lynch and Credit Suisse. In October, S&P lowered the ratings on residential
mortgaged backed securities with a par value of US$22 billion. In November, Moody’s
downgraded 16 special investment vehicles with approximately US$33 billion in debt and in
December another US$14 billion was downgraded with US$105 billion under review.
3.2 Mortgage Brokers and Lenders
Originating brokers had little incentive to perform due diligence and monitor borrowers’ credit
worthiness, as most of the subprime loans originated by brokers were subsequently securitized.
This phenomenon was aggravated by the incentive compensation system for brokers, based on the
volume of loans originated, with few negative consequences for the brokers if the loan defaulted
within a short period.39
Distress among subprime mortgage lenders was visible during 2006. Problem started to
appear when the Fed started to raise interest rates. This raised the cost of borrowing and made it
more expensive for people to meet their floating rate interest payments on their loans. At the end
of the year, Ownit Mortgage Solutions Inc. ranked as the 11th largest issuer of subprime
mortgages closed its doors. This was perhaps surprising, given that Merrill Lynch & Co had
purchased a minority stake in Ownit the previous year. In the first quarter of 2007, New Century,
ranked as the number two lender in the subprime market, also closed its doors. Others also failed
or left the business.
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Problems with mortgage lenders spread from the subprime to other parts of the mortgage
market, as concerns about collateral values increased. The share price of Thornburg Mortgage
Inc., which specializes in large (jumbo) prime home loans, dropped 47% after it stated that it was
delaying its second quarter dividend and was receiving margin calls from creditors, due to the
declining value of mortgages used as collateral. National City Home Equity Corp., the wholesale
broker equity lending unit of National City Corp. announced that in response to market
conditions, it has suspended approvals of new home equity loans and lines of credit. Aegis
Mortgage Corp. (Houston) announced it is unable to meet current loan commitments and stopped
taking mortgage applications. Other institutions also withdrew from the subprime and Alt-A
markets. Alt-A originators, such as American Home Mortgage, filed for bankruptcy.
Small mortgage brokers were being hurt in a number of different ways. GMAC LLC
announced that it was tightening its lending terms. It would not provide warehouse funding for
subprime loans and mortgages for borrowers who did not verify their income or assets. Many
small lenders use short-term warehouse loans that allow them to fund mortgages until they can be
sold to investors. The inability to warehouse reduces the availability of credit.
Originators also spent funds persuading legislators to reduce tough new laws restricting
lending to borrowers with spotty credits. Simpson (2007) reports that Ameriquest Mortgage Co.,
which was one of the nation’s largest subprime lenders, spent over US$20 million in political
donations. Citigroup Inc., Wells Fargo & Co. Countrywide Financial Corp. and the Mortgage
Bankers Association also spent heavily on lobbying and political giving. These donations played
a major role in persuading legislators in New Jersey and Georgia to relax tough predatory-lending
laws passed earlier that might have contained some of the damage.40
3.3 Special Investment Vehicles 41
A special, or structured, investment vehicle (SIV) is a limited purpose, bankrupt remote,
company that purchases mainly highly rated medium and long term assets and funds these
purchases with short term asset backed commercial paper (ABCP), medium term notes (MTNs)
and capital. Capital is usually in the form of subordinated debt, sometimes tranched and often
rated. Some SIVs are sponsored by financial institutions that have an incentive to create off
balance sheet structures that facilitate the off balance sheet transfer of assets and generate
products that can be sold to investors. The aim is to generate a spread between the yield on the
asset portfolio and the cost of funding by managing the credit, market and liquidity risks. Trading
the slope of the yield curve would not have been profitable enough to justify the capital allocated
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to support most SIV if they had to pay a credit spread for their borrowings. Hence, for almost all
SIVs, the AAA rating for their debt was essential. This is also partly due to the commercial paper
(CP) market, and how it operates. CP is held by money market funds, and most want only AAA
rated paper.
General descriptions of the methodologies employed for SIVs by the agencies are
publicly available on their web sites. The basic approach is to determine whether the senior debt
of the vehicle will retain the highest level of credit worthiness, (for example, AAA/A-1+ rating)
until the vehicle is wound-down for any reason. The level of capital is set to achieve this AAA
type of rating, with capital being used to make up possible short falls. The vehicle is designed
with the intent to repay senior liabilities, with at least an AAA level of certainty, before the
vehicle ceases to exist. If a trigger event occurs and the SIV is wound-down by its manger
(defeasance) or the trustee (enforcement), the portfolio is gradually liquidated. Wind-down
occurs if the resources are becoming insufficient to repay senior debt. No debt will be further
rolled over or issued and the cash generated by the sale of assets is used to payoff senior
liabilities.
The risks that a SIV has to manage to retain its AAA rating include credit, market,
liquidity, interest rate and foreign currency, and managerial and operational risk. Credit risk
addresses the credit worthiness of each obligor and the risk during the wound-down period when
the SIV assets have suffered credit deterioration. For market risk, the manager is required on a
regular basis to mark-to-market the liquid assets of the portfolio and mark-to-model the illiquid
assets. When a SIV is forced to sell assets under unfavorable conditions, this will in general
affect the value of all its assets. The manager’s ability to address this type of situation is
assessed. Liquidity risk arises because of (a) the need of refinancing due to the maturity
mismatch between assets and liabilities; and (b) some of the portfolio’s assets will require due
diligence by potential investors and this will increase the length of the sale period. The SIV must
demonstrate that apart from the vehicle’s cash flows that provide liquidity, it has backstop lines of
credit from different institutions, and highly liquid assets that can be quickly sold, so that it is
able to deal with market disruptions. In a SIV, the liabilities are rolled over, provided that
defeasance42 has not occurred. In theory, a SIV could continue indefinitely.43
According to Moody’s (September 5, 2007), there were some 30 SIVs and the total
volume under management of SIVs and SIV-Lites44 had nominal values of approximately
US$400 billion and US$12 billion respectively at the end of August 2007. The weighted average
life of the asset portfolios in these vehicles is in the 3-4 year range.
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The SIVs relied on being able to continuously roll over their short-term funding and,
even though they were “bankruptcy remote” from their sponsors, those that were unable to
achieve this were able to turn to their sponsoring banks that had undertaken to provide them with
backstop liquidity via credit lines in such situations. In fact these SIVs, akin to “unregulated
banks” funding long-term assets with short-term funding resources, have been a contributor to the
current credit crisis.
As the credit crisis intensified and the mortgage-backed securities held by the SIVs
suddenly started to decline in value, some of the ABCP were downgraded, sometimes all the way
to default within a few days. An increasing number of SIVs became unable to roll their ABCP,
due to concerns about the value of collateral, and turned to their sponsor banks for rescue. HSBC
was the first bank (November 28, 2007) to transfer US$45 billion of assets on to its balance sheet.
Other banks soon followed: Standard Chartered took (December 5, 2007) US$1.7 billion,
Rabobank (December 6, 2007) took US$7.6 billion, and Citigroup (December 14, 2007) US$49
billion. This is not a complete listing. Société Générale bailed out its investment vehicle with a
US$4.3 billion line of credit (December 11, 2007).
The plight of SIVs continues. In February 2008, Citigroup announced that it plans to
provide a US$3.5 billion facility to support six of the seven SIVs it took onto its balance sheet to
shore up their debt rating and protect creditors. Also in February, Standard Chartered faced the
prospect of a fire sale at its US$7.1 billion Whistlejacket SIV. The value of the assets had fallen
to less than half of the amount of start-up capital, which is a trigger for calling in receivers. More
recently (February 21, 2008) Dresdner Bank announced that it is providing a backstop facility of
at least US$17 billion on senior debt for its US$19 billion K2 SIV, to avoid a forced sale of its
assets.45
3.4 Monolines
Monoline insurers provide insurance to investors that they will receive payment when
investing in different types of assets. Given the low risk of the bonds and the perceived low risk
of the structured transactions insured by monolines, they have a very high leverage, with
outstanding guarantees amounting to close to 150 times capital.46 Monolines carry enough capital
to earn a triple-A rating and this removes the need for them to post collateral.47 (This triple-A
rating is essential to stay profitable, as capital is costly and the spreads earned on insurance are
small.) The two largest monolines, MBIA and AMBAC, both started out in the 1970s as insurers
of municipal bonds and debt issued by hospitals and nonprofit groups. The size of the market is
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approximately US$2.6 trillion, with more than half of municipal bonds being insured by
monolines. This insurance wrap guarantees a triple-A rating to the bonds issued by U.S.
municipalities.
In recent years, much of their growth has come in structured products such as assetbacked bonds and CDOs. The total outstanding amount of bonds and structured financing insured
by monolines is around US$2.5 trillion. According to S&P, monolines insured US$127 billion of
CDOs that relied, at least partly, on repayments on subprime home loans and face potential losses
of US$19 billion.
Since the end of 2007 monolines have been struggling to keep their triple-A rating. Only
the two major ones, MBIA and AMBAC, and a few others less exposed to subprime mortgages
such as Financial Security Assurance (FSA) and Assured Guaranty, have been able to inject
enough new capital to keep their sterling credit rating.48
The issue from a systemic point of view is that when a monoline is downgraded, all of the
paper it has insured must be downgraded too, including the bonds issued by municipalities. And
holders of downgraded bonds under “fair value“ accounting have to mark them down as well,
impairing their capital. Some institutional investors, such as pension funds and so-called
“dynamic” or “enhanced” money market funds, may hold only triple-A securities, raising the
prospect of forced sales. In addition, some issuers such as municipalities might lose their access
to bond markets, which may result in an increase in the cost of borrowing money to fund public
projects. Some municipalities and local agencies have issued tender option bonds, which are
auctioned weekly or monthly. The underlying collateral – municipal bonds – is insured by
monolines. Concern about the credit worthiness of the monolines has caused disruptions to this
market. The loss of the triple-A rating could cost investors up to US$200 billion according to
Bloomberg. Already, banks have had to write off around US$10 billion of the paper they insured
with ACA.49
In response to this crisis, a group of banks explored a bailout plan of the largest
monolines with the New York’s insurance regulator, who was asking the banks to contribute as
much as US$15 billion to help MBIA and AMBAC preserve their ratings. The main
consideration was whether the cost of participating in a bailout was greater than any loss of value
in their holdings.50 On Feb 14, 2008 Eliot Spitzer, New York governor, gave bond insurers three
to five business days to find fresh capital, or face potential break-up by state regulators who want
to safeguard the municipal bond markets.51 Under a division of the bond insurers into a “good
bank/ bad bank” structure, the insurers’ municipal bond business would be separated from their
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riskier activities, such as guaranteeing complex structured credit products. Warren Buffet’s
Berkshire Hathaway Assurance Corp has already offered to take over the municipal bond
portfolios of AMBAC, MBIA and FGIC.52 While these plans would help to restore faith in the
municipal bond market, they would do little to help the structured products insured by the
monolines.53 Monolines are counterparties to credit derivatives held by financial institutions and
have sold surety wraps to financial institutions. A break-up of the bond insurers would have
grave implications for financial institutions that face massive write-downs on these instruments.
3.5 ABS Trust, CDO and CDO Squared Equity Holders.
These equity holders made profits by repackaging a pool of mortgages’ cash flows and
selling these new cash flows in the form of bond tranches. The repackaging of a mortgage’s cash
flows only has a positive net present value if the repackaged cash flows (the ABS bonds issued to
finance the purchase of the mortgages) are over valued by the market.
Unsophisticated investors were less informed than sophisticated investors (defined to be
those investors involved in the origination process in some manner). This asymmetric information
was generated by two facts. First, the complexity of the ABS trust waterfall. The waterfalls were
complex with various triggers (to divert cash flows to the more senior bonds in the case of
financial stress in the collateral pool). The complexity of the waterfall made the ABS hard to
value. In addition, the waterfalls were unique to a particular trust, so each new ABS needed to be
programmed and modeled. Second, the scarcity of generally available and timely data on the
collateral pool of specific ABS trusts made the modeling (and simulation for scenario analysis) of
the cash flows nearly impossible. Although data could have been purchased from Loan Pricing
Corporation, it was incomplete with respect to the current state of the underlying mortgage loans.
Furthermore, alternative historical databases with histories of mortgage loans were not
representative of new risk trends because the new mortgage loans had teaser rates, no principal
payments in the beginning, and different loan standards (high loan to value ratios, and no
documentation).
The information asymmetry in markets was even greater for CDOs than for ABS trusts,
because a typical CDO collateral pool depends on the ABS bonds of many different ABS trusts
(approximately 100). Thus, to model the CDO collateral pool, one needs to model the different
ABS bonds - hence, the ABS collateral pool. This multiplier in terms of modeling complexity,
and the absence of readily available data on the collateral pools, made the accurate modeling of
CDOs cash flows nearly impossible (even for sophisticated investors).
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Also crucial in the creation of CDOs was the existence of credit default swaps on ABS
bonds (ABS CDS). This was essential for two reasons. First, there were not enough ABS bonds
trading to construct the underlying CDO collateral pools. CDOs were being constructed and
issued in great quantities in 2006 and 2007. Consequently, a majority of the CDOs’ collateral
pools were synthetic ABS bonds (ABS CDS). This leveraging of the real ABS bonds multiplied
the effect of defaulting mortgage holders significantly beyond the original notional values
increasing systemic risk. Second, the use of ABS CDS meant that less capital was needed to
construct the collateral pool. This facilitated the rapid growth of CDO issuance. In fact, one
reason for the creation of CDO squared trusts was the desire to finance the equity capital of
CDOs by including CDO equity in a CDO squared’s collateral pool.
3.6 Financial Institutions
The change in the bank regulatory framework to Basel II has had perhaps unanticipated
consequences. The required regulatory capital requirement for holding AAA rated assets is 56
basis points (a 7% risk weighting and an 8% capital requirement). This provided banks with an
incentive to hold highly rated AAA rated assets. Thus, banks were willing customers for super
senior AAA rated tranches. Being this highly rated, it was thought that there was an insignificant
chance of the assets being impaired due to defaults in the collateral pool. With the tranches being
held in the trading book and marked-to-market, this did expose banks to risk of write downs,
especially if a surety wrap had been provided by a monoline insurance company. Banks and
regulators never anticipated these risks.
The credit rating of AAA reduced, if not removed, incentives for investors (pension
funds, insurance companies, mutual funds, hedge funds, regional banks) to perform their own due
diligence about the collateral pool. The short-term horizon of management’s payment structure
(bonus) further reduced their incentives to perform due diligence. If their investments soured,
managers might lose their jobs, but labor markets are imperfect. Failed money managers seem to
get new jobs even after horrific losses. CDO bonds offered higher yields than corporate bonds
with the same credit rating. The managers working in these financial institutions wanted AAA
bonds (or investment grade bonds) with higher yields (and rewards) for “equivalent risk.”
Although the risks were not really equivalent, the incentives were against doing due diligence.
3.7 The Economy and Central Banks
At the end of spring 2007, Ben Bernanke, Chairman of the Federal Reserve, stated (May
17, 2007), “We do not expect significant spillovers from the subprime market to the rest of the
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economy or the financial system.” It was vain hope, since at the start of August the European
Central Bank injected 95 billion euro (US$131 billion) and informed banks that they could
borrow as much money as they wanted at the bank’s current 4% base rate without limit. The
Bank of Canada issued a statement that it pledges to “provide liquidity to support the Canadian
financial system and the continued functioning of financial markets.” Exhibit 1 summarizes the
actions of central banks.
In the second week of August, the Fed reported that the total commercial paper (CP)
outstanding fell more than US$90 billion to US$2.13 trillion over the previous week.
Traditionally, prime corporate names used the CP market to finance short term cash needs.
However, the low levels of interest rates during the past few years has meant that many of these
issuers moved away from the CP market and issued low cost debt with maturities ranging from 5
to 10 years. The current lack of demand for CP made it very difficult for borrowers to rollover
debt. William Poole, President of the St. Louis Federal Reserve publicly argued against a rate cut
(August 16). The Fed took the unusual step of issuing a public statement that Mr. Poole’s
comments did not reflect Fed policy.
During the same week, a flight to quality occurred, with investors buying Treasuries. The
yield on the three month T-bill fell from approximately 4% to as low as 3.4%. The FTSE 100
index declined by 4.1%, with financial companies being the hardest hit. Man Group fell 8.3%
and Standard Chartered fell 7.6%. The Chicago Board Options Exchange Vix index, an indicator
of market volatility, jumped above 37, its highest level in five years. It did ease back to 31.
Unwinding of carry trades caused a sudden 2% increase in the yen/dollar exchange rate. Further
unwinding occurred two days later, with hedge funds and institutional investors reversing carry
trades, causing the yen to increase 4% against the dollar, 5.3% against the euro, 5.8% against the
pound, 10.3% against the New Zealand dollar and 11.5% against the Australian dollar.
Also during this period, the Fed injected US$5 billion into the money market through 14day repurchase agreements and another US$12 billion through one-day repurchase agreements.54
The Russian Central Bank injected Rbs 43.1 billion (US$1.7 billion) into the banking system.
Foreign investors had started to flee the ruble debt market, causing a liquidity squeeze. The
European Central Bank pumped money into Europe’s overnight money markets. The Fed took
similar actions in the US.
Four banks, Citigroup, JP Morgan, Bank of America and Wachovia, each borrowed
US$500 million from the Fed. In a statement, JP Morgan, Bank of America and Wachovia, stated
that they had substantial liquidity and had the capacity to borrow money elsewhere on more
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favorable terms. They were trying to encourage other banks to take advantage of the lower
discount rate at the Fed window.
During the third week of August, the flight to quality continued. At the start of trading in
New York, the yield on the 3 month T-bill was 3.90%, during the day, it fell to 2.51%, and by the
end of day, it closed at 3.04%. However, other parts of the fixed income markets continued to
function, with investment grade companies issuing debt: Comcast Corp sold US$3 billion in
notes; Bank of America sold US$1.5 billion in notes and Citigroup US$1 billion in notes. There
was a rare high yield issuing by SABIC Innovative Plastics. It sold US$1.5 billion in senior
unsecured notes.
The volatility in the foreign exchange market caused some hedge funds to close their yen
carry trade positions. Between August 16-22, investors poured US$42 billion into money market
funds. Institutional investors switched from commercial paper to Treasuries.
In April 2008, the Fed took the unprecedented measure of introducing a new lending
facility, called the Primary Dealer Credit Facility (PDCF), for investment banks and securities
dealers that allows them to use a wide range of securities as collateral for cash loans from the
Fed. Among other things the securities pledged by dealers must have market prices and
“investment grade” credit ratings.55
3.8 Valuation Uncertainty
One of the critical issues driving the crisis has been the difficulty of valuing structured
credit products.56 In a fair value accounting framework57 and with liquid markets, it is
straightforward to value standardized instruments, though there are issues with non-standard
instruments. In this framework, there are three levels used for classifying the type of fair
valuation employed: Level 1 – clear market prices;58 Level 2 – valuation using prices of related
instruments; and Level 3 – prices cannot be observed and model prices need to be used. For
example, valuation under Level 1 can be achieved for standard instruments such as credit default
swaps for well known obligors. For a credit default swap with a non-standard maturity, direct
market prices cannot be observed. Prices of credit swaps for the same obligor with standard
maturities can be used to calibrate a valuation model to price the non-standard maturity. This
would fall under Level 2 classification. There are many instruments that are non-standard and are
illiquid, making valuation difficult. For such instruments, model valuation must be employed.
This situation would fall under Level 3 classification. Faith in the reliability of these values is
highest for Level 1 and lowest for Level 3, which is more subjective. There are numerous
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difficulties associated with implementing fair value accounting, even in liquid markets.59 In the
first quarter of 2008, level 3 assets have increased in U.S. banks. Goldman Sachs reported an
increase of 40% of these assets to reach a total of US$96.4 billion of which US$25 billion are
ABS. Level 3 assets are US$78.2 billion and US$42.5 billion for Morgan Stanley and Lehman
Brothers, respectively.
Model prices are used for marking-to-model illiquid assets. For model estimation, prices
of other assets and time series data may be used. Inferring the parameters necessary to use the
model becomes problematic in turbulent markets. This increases the uncertainty associated with
the model prices. If markets are in turmoil, the number of instruments that can be valued under
Level 1 decreases and the difficulties associated with implementation greatly increase. This
increases the uncertainty associated with the valuation of instruments held in portfolios and this
uncertainty feeds back into the market turmoil. Lenders want collateral for their loans, but
turbulence in the markets increases the potential for disagreement between borrowers and lenders
over the valuation of collateral. This can place borrowers in the position of being forced to sell
assets, and in some cases cause funds to close, adding to the market turmoil.
One of the major issues in an illiquid market and one that has been repeatedly raised in
the current crisis, is that due to the high degree of uncertainty, current prices for certain
instruments are well below their ‘true’ values. Pricing assumptions that were reasonable a few
weeks ago must be re-evaluated. In fair value accounting, the price of an instrument is what you
would receive if sold. This implies that many institutions and funds have been forced to mark
down their portfolios. For some funds, this has triggered automatic shut down clauses. In the
case of the asset backed commercial paper market, it has brought the market to a close. Hedge
funds borrow in the commercial paper market, pledging assets as collateral. Lenders look at the
value of the pledged assets, which in many cases were related to the subprime market. Given the
increasing levels of uncertainty associated with the valuation of assets, lenders refused to extend
credit. This caused a major disruption to the asset backed commercial paper market and was one
of the critical events in the crisis.
When financial institutions report their quarterly earnings, for Level 3 assets their
valuation methodologies and associated inputs will in general differ. This is unavoidable given
the use of models. Institutions know this and have incentives to pick their inputs to ensure that
their results are “reasonable.” Investors know that this game is going on, so even when quarterly
results are published, uncertainty remains about the value of Level 3 assets.
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The problems arising from the valuation of collateralized mortgage obligations
containing subprime, and the rolling over of asset backed commercial paper came to a head
during the summer. At the beginning of summer, two of Bear Stearns hedge funds, High Grade
Structured Credit Strategies Master Fund and the High Grade Structured Credit Strategies
Enhanced Leverage Master Fund, ran into collateral trouble after substantial losses in April.
Merrill Lynch seized US$800 million in collateral assets and planned to sell these assets on June
18. Bear Stearns had negotiations with JP Morgan, Chase, Merrill Lynch, Citigroup and other
investors over the state of the two hedge funds. However, these negotiations did not stop Merrill
Lynch from selling the assets. Bear Stearns disclosed that the hedge funds were facing a sudden
wave of withdrawals by investors and by July, it closed the two hedge funds, wiping out virtually
all invested capital.
The widespread gravity of the valuation problems were highlighted when at the
beginning of August, BNP Paribas froze three hedge funds, stating that it is impossible to value
the assets due to a lack of liquidity in certain parts of the securitization market. The asset values
are reported to have fallen from US$3.47 billion to US$1.6 billion. Paribas stated that the funds
were invested in AAA and AA rated structures.60 In the third week of August, BNP Paribas
announced that it has found a way to value the assets of three of its funds and it allowed investors
to buy and sell assets. In the same week, the Carlyle Group put up US$100 million to meet
margin calls on a European mortgage investment affiliate, with US$22.7 billion in assets. The
group issued a statement, explaining that while 95% of the affiliates assets are AAA mortgage
backed securities with implicit U. S. government guarantees, the value of the assets has declined
due to diminished demand for the securities.
During this period, money market funds that normally purchase asset backed commercial
paper (ABCP) adopted a policy of buying only Treasuries. The yields on Treasury bills fell, as a
result of this flight to quality. This action by money market funds and other investors helped to
trigger a corporate funding crisis, with many special investment vehicles unable to roll over their
ABCP. This forced vehicles to seek funding from other sources and to sell assets. The problems
were not restricted to the U. S. ABCP market.61
The difficulty underlying the valuation of collateral and the resulting liquidity and
funding problems, affected many special investment vehicles and hedge funds. In the middle of
August, the Goldman Sachs fund, Global Equities Opportunities, lost over 30% of its value over
several days. Investors injected US$1 billion and Goldman injected US$2 billion of its own
money into the fund.62 Funds in the U. S., Canada, Europe, Australia have experienced funding
difficulties, some being forced into bankruptcy. The need to generate cash forced the sale of
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assets. This affected many quantitative hedge funds, such as Renaissance Technologies, which
fell 8.7%. Exchanges rates were affected, as funds reduced their leverage. Selling by hedge
funds and nervous investors also forced muni bond prices down.
Other players were affected. Real estate funds were hard hit due to both falling real
estate prices and the tumult in the credit markets. The average fund investing primarily in the
U.S. lost 17.2% over the first three months of the summer and were down 16.5% on the year
(Morningstar Inc). Fund redemptions have forced managers to sell assets in falling markets.
KKR Financial Holdings LLC, a real estate firm, 12% owned by Kohlberg, Kravis Roberts & Co.
reported in the middle of August that losses threaten its ability to repay US$5 billion in short term
debt. It announced plans to raise US$500 million by selling shares to Morgan Stanley and
Farallon Capital.
Merger arbitragers were also hit, with many being forced to unwind positions to offset
losses. The gap between a target’s stock price and the price the buyer has agreed to pay widened
to 68% in August, compared to a spread of 11% at the end of June (reported by a Goldman Sachs
analysis). Sowood Capital Management liquidated positions in a number of pending mergers and
went into default.63 In the fight to gain deals, banks had waived such provisions as the “market
out” clause, which allows banks to re-negotiate an underwriting deal if market conditions have
deteriorated. Banks are now having to re-negotiate deals without this weapon in their arsenal.
Home Depot delayed and re-negotiated a US$10.3 billion deal to sell its construction supply
business to private equity firms.
Asset backed structured products are difficult to value for many reasons. First, is the
general complexity of the liability structure, the cash flow waterfalls, and the different types of
collateral/interest rate triggers. Each structure is unique and computer programs used to simulate
the cash flows to the different bonds must be tailored made to each trust. Second, is the valuation
of the assets in the collateral pool. For subprime ABS trusts, this typically implies valuing a pool
of several thousand subprime mortgages with different terms and a wide diversity in the
characteristics of the borrowers. For CDOs, this implies valuation of the bonds issued by ABS
trusts; and for CDO squared structures, this implies the valuation of bonds issued by CDOs.
Compounding these difficulties, many of the asset pools are synthetic credit default swaps on
ABS, which need to be valued. Third, cash flows to trusts often depend on future values of the
collateral or the future ratings of the collateral by the credit rating agencies. This creates an
additional layer of complexity: to estimate the value today, it is necessary to estimate values in
the future or predict future credit ratings of the collateral. Fourth, is the scarcity of data about the
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nature of the different asset pools. Data on the asset pools is usually not readily available and not
updated on a regular basis.
3.9 Transparency
There are a number of different dimensions associated with the general issue of
transparency in credit markets. First, is the complex nature of the products and how this affects
both pricing and risk assessment. Many unsophisticated investors have used credit ratings as a
sufficient metric for risk assessment. Buyers of these products, such as pension funds, university
endowment funds, local counties and small regional banks do not have the in-house technical
sophistication to understand the true nature of these products, the frailty of the underlying
assumptions used in their pricing and credit rating and how they might behave in difficult
economic conditions. For risk measurement, they have relied of the rating agencies and took
comfort in the protection that a rating might give.64 The rating agencies have been unclear as to
the precise meaning of a rating for structured product bonds and the robustness of their
methodologies for such products.
Second is the lack of transparency with respect to the valuation of illiquid assets. This
lack of transparency has generated investor concerns about the robustness of posted prices in
assessing the credit worthiness of counterparties. For some funds, this is a substantial issue. For
example, in Bears Stearns High Grade Structured Credit Strategies Enhanced Leveraged fund,
over 63 percent of its assets were illiquid and valued using models – see Goldstein and Henry
(2007). This was one of the causes of the collapse of Bears Stearns.
Third, is the type of assets within a vehicle, such as the percentage of CDOs, CDOs
squared, prime, Alt-A and subprime mortgages. This basic type of information is rarely available
and has produced a market for lemons – (unsophisticated) investors are unable to observe or
unwilling to believe that funds have no exposure to the subprime market. Synapse closed one of
its high grade funds on September 3, 2007, citing “severe illiquidity in the market.” The
company stated that the fund had no exposure to the U. S. subprime market.65
Fourth, is not knowing the total magnitude of the commitments a financial institution has
given, whether it be to back stop lines of credit or loan commitments to private equity buyouts. A
vehicle that relies upon funding from, say, the commercial paper market, will buy a commitment
from a financial institution to provide funding in the event of a market disruption. Financial
institutions also offer lines of credit to firms, which can be drawn down and repaid at the firm’s
discretion. Fulfilling all such commitments could have serious impact on an institution’s
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liquidity. The level of such commitments is not known to outside investors.66 To avoid holding
all the committed capital, the institution will purchase a contract from another institution to
provide additional capital if needed. This type of contract is of questionable value if there is a
major market disruption, as the institution selling the contract will also have its own liquidity
problems.
Fifth, money market funds provide a safe haven for investors to park their money.67 In
order to retain their AAA level rating, they are generally restricted from investing in low credit
grade securities. If any of their holdings are down-graded, the fund is under pressure to sell these
holdings, incurring losses. Unless the fund has sufficient liquidity, it risks its net asset value per
share falling below one dollar, resulting in a “breaking the buck,” which could trigger investors to
exit the fund, due to concerns about the safety of their investments. It would also harm the
reputation of the fund manager. Some of the money market funds have invested in SIVs. A few
of these SIVs have been downgraded, and others are facing downgrading. Many banks have very
profitable money market franchises and have implicit commitments to these funds. It is in a
bank’s own interests to buy the fallen assets and to take the loss, rather than risk a run on their
money market funds.68 This is another form of commitment that is not reported.
Finally, many banks hold similar assets to those held by SIVs. In the arrangement
process, a bank may hold or warehouse assets until they can be securitized and sold. The extent
of these holdings is often unknown to investors, though the amount of Level 3 assets might be a
guide. If SIVs are forced to sell assets, this will drive the prices down and banks will be forced to
mark-to-market similar assets at the lower prices. Investors are uncertain as the magnitude of
potential losses the banks might be facing and this is one of the factors contributing to increased
volatility in the share prices of banks. It could cause a credit crunch and affect the whole
economy. In an attempt to avoid this type of scenario, Bank of America, Citigroup Inc. and JP
Morgan Chase & Co. held talks with the U. S. Treasury to establish a new super conduit to buy
up to US$100 billion in assets from SIVs.69 Because the conduit would be backed by a group of
banks, it was hoped that investors would have confidence in buying the fund’s commercial paper
and this could re-start the ABCP market.
3.10 Systemic Risk
Systemic risk arises if events in one market affect other markets. Many money market
managers that normally purchase ABCP abandoned the market and fled to the Treasury bill
market, causing a major increase in prices and lowering of yields. The ABCP market relies on
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the quality of the collateral to minimize the risk of non-performance by borrowers. Lenders need
assurance as to the nature of the assets and their values. In the breakdown of the ABCP market,
there have been reservations about both dimensions. Some lenders have been concerned that the
collateral contains subprime mortgages. This lack of transparency has meant that some borrowers
were unable to rollover their debt, even though they had no exposure to the subprime market.
There has also been uncertainty with respect to the value of collateral. The lack of transparency
with respect to the holdings of structured products by monolines and the associated valuation
concerns, has adversely affected many markets, such as bond auction markets and tender option
bonds, which use monolines to provide an insurance wrap.
Even under normal market conditions, many instruments are illiquid and it is difficult to
estimate a price. In the turmoil of summer, these problems became insurmountable. These
problems were illustrated by BNP Paribas decision to freeze withdrawals from three hedge funds
in the beginning of August, stating that it is impossible to value the assets due to a lack of
liquidity in certain parts of the securitization market70.
The effective closure of the ABCP market had many repercussions. For many hedge
funds, the inability to rollover debt, has forced them to sell assets and this has affected many
diverse markets. First, the collateralized debt obligation market has come under a lot of pressure
from this selling to the extent that many funds have found prices to be artificially low and some
have resorted to selling other assets. Some funds have closed trading positions by selling “good”
assets and buying “bad” assets that were shorted. This has caused prices of good assets to
decrease and of bad assets to increase. This type of price reversal has adversely affected some
“quant” hedge funds that trade based on price patterns. Hedge funds and institutional investors
reduced their leverage by unwinding carry trades.
Many SIVs have backstop lines of credit from banks. The uncertainty of the magnitude
of these possible demands has forced banks to hoard cash, making them reluctant to lend to other
banks. The three month London inter bank offered rate (LIBOR) increased by over 30 bps during
the first part of August. Compounding the banks’ funds concerns, are the commitments to
underwrite levered buyouts. The reluctance to lend and the tightening of credit standards has
affected hedge funds, availability of residential and commercial mortgages, bond auction markets
and lending to businesses.
3.11 Summary
Here we summarize in point form the factors that have contributed to the credit crisis.
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1.
A low interest rate environment that generated a search for yield enhancement.
2. The demand for high yielding assets to put into the collateral pools in order to increase
the profitability of securitization. Subprime mortgages were an ideal choice, along with
auto loans and credit cards.
3. Mortgage originators did not assume default risk of risky mortgage loans. They had little
incentive to perform due diligence. There was fraud and lax regulatory oversight.
4. To reduce capital requirements, banks employed an ‘originate to distribute’ mode of
operation. They had little incentive to perform due diligence.
5. The equity holders of CDOs, CDO squared, SIVs, DPCs sold many derivative claims. In
many cases the underlying collateral were credit default swaps written on asset backed
bonds. This implied that credit default swaps written on the same asset could appear in
many different structures. This increased the systemic risk.
6. The rating agencies did no monitoring of the raw data, even though it was common
knowledge that lending standards were declining and fraud increasing. This implied that
assumptions used to estimate the probability of default, recovery rates and default
dependence did not reflect current conditions.
7. Rating agencies were tardy in recognizing the implications of the declining state of the
subprime market for the ratings of monolines. 71
8. Rating agency incentive problem – they are paid by clients and there is limited
competition (by regulation). The rating of structured products has been very profitable
business for the agencies.
9. Monoline accepted at face value the ratings for senior tranches from the agencies and
sold insurance wraps.
10. Management of financial institutions are given bonuses based on short run performance.
They have little incentive to care about the long run consequences of their actions
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(agency-shareholder problem). Labor markets are not perfect: failure, even spectacular
failure is rarely a barrier to getting a job at another institution.
11. The new Basle II capital requirements made it attractive for banks to invest in super
senior tranches. Money markets funds are required only to invest in AAA rated assets.
Other financial institutions are regulated only to invest in investment grade assets. These
investors provided a receptive market for the AAA rated asset backed bonds.
12. The absence of complete data on the collateral pools for many structures made valuation
impossible even for sophisticated investors. It also made independent analysis of credit
ratings impossible. To an unsophisticated investor, the ratings process was not
transparent. They had to rely on the rating agencies. Regulators ignored this problem.
13. The absence of complete and timely data and concern about valuation methodologies
made investors uncertain about valuations posted by banks in their trading books.
14. The implicit commitments of banks to their SIVs and money market funds were not
reported to investors.
4
Steps to Prevent a Repeat
We have identified the major issues that have contributed to the credit crisis. In this
section we make recommendations about the steps necessary to avoid a repeat. The rating
agencies have received considerable attention, though they are only one part of the story. Other
issues have played an important role in the crisis: incentive structures, difficulties in valuing
illiquid assets, lack of transparency, lack of data, the underlying design of SIVs and structured
credit products, inadequate risk management and the failure of state and Federal regulators.
4.1 Rating Agencies
In the current crisis, we have witnessed relatively newly rated facilities having their credit
ratings changed from AAA to junk, and the tardy response of agencies to recognize the risk
arising from the holding of subprime mortgages by monolines. These observations raise the
question of the effectiveness of the methodologies used by the agencies to model loss
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distributions for portfolios of assets and the failure of the agencies to recognize the limitations of
their models in a timely manner.
Rating agencies have a long history of estimating the probability of default and the loss
given default for individual obligations. This is not the case for structured products, where there
are many additional difficult issues. As discussed by Aschcraft and Schermann (2007) subprime
ABS ratings differ from corporate debt rating in a number of different dimensions. Corporate
bond ratings are largely based on firm-specific risk, while CDO tranches represent claims on cash
flows from a portfolio of correlated assets. Thus, the rating of CDO tranches relies heavily on
quantitative models while corporate debt ratings rely essentially on the analyst judgment. While
the rating of a CDO tranche should have the same expected loss as a corporate bond for a given
rating, the volatility of loss, that is, the unexpected loss, is quite different and strongly depends on
the correlation structure of the underlying assets in the pool of the CDO.
For structured products, such as ABS collateralized debt obligations, it is necessary to
model the cash flows and the loss distribution generated by the asset portfolio over the life of the
CDO, implying that it is necessary to model prepayments 72 and default dependence (correlation)
among the assets in the CDO and to estimate the parameters describing the dependence.73 Over
the life of a CDO, individual defaults may occur at any time, implying that it is necessary to
model the loss distribution over time. This necessitates modeling the evolution of the different
factors that affect the default process and how these factors evolve together.74 This requires
assumptions about the stochastic processes that describe the evolution of the different factors,
such as interest rates and prepayment behavior, and the estimation of the parameters describing
these processes, which usually requires the use of time series data. If there are major changes in
the economy, then these parameters may change, implying that it is necessary to examine the
sensitivity of a rating methodology to parameter changes.
It is critical to assess the sensitivity of tranche ratings to a significant deterioration in
credit conditions affecting credit worthiness and default clustering. As shown in Fender, Tarashev
and Zhu (2008) the impact of shocks affecting credit worthiness on CDO tranche ratings is very
different than for a corporate bond. It depends critically on the magnitude and the clustering of
the shocks and it tends to be non-linear.
If default occurs, it is necessary to estimate the resulting loss. We know from the work of
Acharya et al (2003) and Altman et al (2005) that recovery rates depend on the state of the
economy, the condition of the obligor and the value of its assets. Loss rates and the frequency of
defaults are dependent (correlated): if the economy goes into recession, the frequency of defaults
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and loss rates increase. It is necessary to model the factors that affect the loss and the joint
dependence between the frequency of default and loss. The level of dependence will vary, in
general, with the state of the economy.
To have confidence in a model, it is necessary to have a clear definition of what a rating
means for a particular type of instrument, the factors that an agency considers when assigning a
rating and the how well a rating model performs in different economic environments. There is a
lack of clarity about what does a rating actually measure.75 Is it a measure of the probability of
default or the expected loss over some specified horizon? What is the length of the horizon? Does
a rating, say BBB, have the same meaning for asset backed securities as for corporate bonds?
To test model predictions against actual outcomes requires data.76 Unfortunately, for
many types of collateralized products, data availability is limited across instruments and does not
extend over long periods. Consequently, there is little information about the accuracy and
robustness of models over different parts of the credit cycle. To assess the credit risk of
structures such as SIVs, it is necessary to consider other risk dimensions, such as market liquidity
and valuation of collateral. These factors have been overlooked, though they affect the credit
worthiness.
The rating agencies clearly state that they do not perform due diligence on the raw data.
The current situation is analogous to accountants accepting at face value the figures given to them
by firms. There is no auditing function. The current situation is problematic. In moving
forward, if data auditing are required, then the issue of compensation both for rating and for
auditing needs to be addressed. It is not clear that regulating the originators will solve the
problem of faulty data unless there is adequate enforcement. Continuing the analogy, firms are
required to follow generally accepted accounting principles, though accounting fraud still occurs.
For the last few years, the characteristics of subprime mortgage borrowers were
undergoing major changes due to declining underwriting standards and fraud. The failure to
explicitly recognize the changing nature of the underlying data used in model estimation implied
that the probabilities of default, recovery rates, default dependence and the dependence between
default and recovery rates were poorly estimated. Models need to capture default contagion that
exists in local housing markets. There exist statistical techniques, such as data sampling,
introducing unobservable heterogeneity and different prior distributions, which have the potential
to ameliorate some of these problems.77 For collateralized structures, there is the need for more
transparency about (a) the types of models used by the agencies; (b) the assumptions about the
data used to rate a particular structure; and (c) the accuracy and robustness of the rating
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methodologies to the underlying assumptions. Current methodologies failed due to the use of
inappropriate assumptions derived from historic data for corporate CDOs with tranches much
wider than for ABS CDOs. They also failed to appropriately model both default and recovery
dependences.
To rate the commercial paper of a SIV, there are additional factors to consider. First is an
assessment of the backstop lines of support and other contingent funding in the case of market
disruptions. The rating agencies rate the contingent sources of funding available to a vehicle.
Second, for an investor to buy asset backed commercial paper (ABCP), they need to know the
nature of the assets supporting the paper and the value of the collateral. The agencies are clear
that they make no statement about valuation. Yet if the value of the collateral deteriorates, this
adversely affects the credit worthiness of the commercial paper. Thus logically, one must address
the issue of the valuation of the collateral, if one is to assess the credit worthiness of the vehicle.
There is the need to be more transparent with respect to the meaning of a rating for
commercial paper or medium term notes for structured products and investment vehicles.78 What
does a rating actually consider and what assumptions are made in reaching a rating decision? At
present the onus is on the investor in an ABCP to understand exactly what a rating means, the
underlying assumptions and data used to derive such a rating and the limitations of the rating
methodology. This is demanding a lot from investors, given the lack of transparency. Again,
there is also the need for more transparency about the methodologies used to assess the different
factors and how these considerations are incorporated to reach a final decision. There is a long
list of uninformed investors who naively interpreted an ABCP credit rating as measure of the
underlying credit worthiness, being unaware of the limitations of the methodologies.
Recommendations
1. The meaning of a rating needs to be clearly stated. For example, is a rating a measure of
the probability of timely payment? Is it a measure of the expected loss averaged over the
life of the instrument or some other horizon? If a rating is through-the-cycle, what is the
length of the cycle? How do the agencies actually calculate their numbers? To avoid
confusion, the agencies need to be explicit and attach actual numbers to their forecasts.
2. For any particular type of instrument that is being rated, there is the need for a clear
statement about the methodology used to derive a given rating and the underlying
assumptions. These have to be generally available, so that in principle the rating could be
reproduced by an independent party. At present, the information agencies make available
to non clients is quite limited. Rating agencies often state that a rating depends both on
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quantitative and qualitative factors. The quantitative part of the rating should be
reproducible by an independent party.
The ability to independently validate a rating would go a long way to reduce the effects of
conflicts of interest. Independent validation requires that data be available. We address this issue
in the next recommendation.
3. For asset backed securities, the government should sponsor an agency that collects
information on a timely basis about the collateral pools and make it available to market
participants. This will facilitate an independent party’s ability to reproduce the credit
ratings.
4. Clarity is required about the data sources used to reach a rating. Is the agency accepting
data from a third party and has the agency done anything to check if there have been
structural changes in the data sources? Has it checked the data to justify the validity of
its distributional assumptions?
4.2 Valuation
In the current crisis, one of the fundamental problems is the valuation of the securitized
tranches for mortgage assets. To value a simple credit default swap requires specification of the
probability of default of the obligor over the life of the swap and the loss if default occurs. These
probabilities and loss rates are not those estimated by rating agencies. For pricing purposes, we
need the price of risk for each factor that affects the loss distribution. The price of risk for a
factor relates the risk of loss to value. Market prices for swaps with standardized maturities of
one, three, five, seven and ten years now exist for a large number of obligors, though the market
for non-standardized maturities is still illiquid. The existence of market prices means that models
can be calibrated to match current prices. Once we can infer prices of risk for a particular obligor,
we can price non-standard swaps written on the same obligor.
For synthetic CDOs,79 valuation becomes more complicated, as it is necessary to model
default and recovery dependences among the obligors in the CDO. For each credit default swap
within the structure, the probabilities of default over the life of the CDO are inferred using the
current market prices for all the swaps on the particular obligor. It is necessary to patch together
the individual credit swaps to produce a price for the whole structure. The typical types of
models used by financial institutions are relatively simple and static in nature,80 and do a
relatively poor job of pricing all of the different tranches. Transparency in pricing and the
liquidity of the market has greatly increased following the introduction of credit indices and the
trading of tranches written on the indices. This has also facilitated models to be calibrated to the
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prices of the individual tranches of an index. However, for synthetic CDOs that do not contain
the same obligors as in an index, additional assumptions are required for pricing.
For pricing assets such as mortgages, auto-loans or credit cards, the difficulties associated
with valuation greatly increase, as there are few prices that can be used for calibration. Even
under normal conditions, markets are illiquid. The types of models used to estimate the credit
ratings of CMOs could be extended to pricing. This can be achieved by estimating the prices of
risk associated with each factor that affects default and the resulting loss. However, this requires
market prices. Mortgage related credit indices now exist, allowing the prices of risk to be
estimated. Unfortunately, mortgage portfolios may differ substantially from the characteristics
of the index, as there is wide heterogeneity across different types of mortgages. Standardization
of structures will help to improve liquidity and pricing, as recently suggested by Lagarde
(2007),81 though there are many practical difficulties with this type of suggestion. If prices of risk
cannot be estimated, another approach is to use the credit rating for the mortgage structure and
then make some heroic assumption about what yield an asset with a given rating commands. The
use of this type of model has meant that in the current crisis, as rating agencies have down-graded
assets, there have been automatic write-downs. There are two difficulties with this approach. It
assumes that ratings are both accurate and timely. The second difficulty is the nature of the
required heroic assumptions. Apart from pragmatism, there is little justification
Recommendations
1. There is a need for the simplification and standardization of instruments. Many
instruments have become too complicated, making reliable pricing or risk management
problematic.
2. For many different asset classes, the industry needs to develop markets for indices
written on standardized assets. This will help in price discovery and for pricing related
assets.
4.3 Transparency
The lack of transparency has affected financial institutions in a number of different ways.
First, banks hold or are warehousing mortgages before securitization, as well as tranches of
structural products that they are in the process of selling to investors. In the credit crisis, as the
value of credit sensitive instruments has declined, financial institutions have been forced to write
down the value of these assets. In many cases, investors have been surprised by the magnitude of
the write-downs.
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Second, is the level and diversity of commitments, both explicit and implicit, given by
banks. The first explicit type of commitment is that to underwrite levered buyouts. For the first
part of 2007, the competition was such that many banks offered to provide financing, without the
protection of an adverse market clause that gives them an escape route. The total magnitude of
these commitments was often not disclosed on a timely basis. The second type of explicit
commitment occurred when banks gave backstop lines of credit to their sponsored SIVs. A bank
will often provide a backstop line of credit, usually for a fraction of the total amount the vehicle
needs. There is a lack of clarity as to the total level of these commitments and a bank’s ability to
honor such commitments.
The first type of implicit commitment arose because of reputation concerns. Bank
sponsored SIVs are off balance sheet vehicles, created and managed by banks, who earn revenue
from the generous management fees. To qualify for off-balance sheet treatment, a bank should
not be exposed to risk. This test is usually satisfied, given the typical SIV structure. Yet in a
number of cases, banks to protect their reputation have brought vehicle assets onto their balance
sheets. The second type of implicit commitment arose because a number of banks run enhanced
money market funds that invested in subprime assets. The banks have stepped in to support the
funds in order to avoid breaking the buck, as the value of the subprime assets declined. During
2007 bank shareholders have had a series of negative surprises due to the lack of information
about the different types and magnitude of implicit commitments.
For banks, 10K statements offer little information about actual holdings of assets being
warehoused and there is a lack of clarity with respect to the total level of bank commitments.
Regulators could request that this information be reported on a regular basis. This would provide
investors with information about a bank’s exposure and the effects on valuation if downgrades
occur. A similar requirement is also needed for monolines. The recent Senior Supervisors Group,
(April 11, 2008) report surveys twenty financial firms. It found that in some cases the level of
disclosure was extensive. However, even in these cases, the level of disclosure was at such an
aggregated level, that many important details were hidden about the true nature of an institutions
exposure.
The lack of transparency in the pricing of subprime structures has been a major issue.
Illiquid assets are difficult to value even in normal markets. One way to improve pricing
transparency and liquidity is to encourage the trading of indices based on standardized baskets of
the assets. Trading in these indices would improve transparency and provide guidance for
calibrating models used for non-standard baskets of assets. The last few years have seen the
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development of such indices,82 though in some cases, the asset structures used to define the
underlying assets in the index lack transparency. There is a need for more simplicity and
transparency in design.
Recommendations
1. For banks there is the need for transparency as to the magnitude of explicit commitments
arising from lines of credit, backstop supports, and funding for levered buyouts.
2. For banks there is the need for transparency as to the magnitude of implicit commitments
that arise from reputation concerns. Examples are the implicit commitments to off
balance sheet vehicles and enhanced money market funds. A bank should state in its
annual report the consequences of bring back onto its balance sheet its off-balance
vehicles. This would help reduce the information asymmetry.
3. There is the need for greater transparency with respect to the nature of assets held by
financial institutions, especially assets that are difficult to value (level three assets).
4.4 Instrument Design
The lack of transparency and liquidity for many asset backed securities such as subprime
mortgages, auto-loans and more exotic CDO squared securities have been a major issue in the
current crisis. In the near future, we can expect investors to focus on relatively simple and liquid
products that can be easily standardized and valued.
The introduction of credit default swap indices in late 2002 enhanced the development of
the credit swap market by improving the transparency. Investors could observe bid/ask spreads
for the different tranches on the index. Indices, such as the ABX, have been introduced for the
mortgage market. However, the heterogeneity of the mortgage market means the prices of the
sub-indices are of limited help for calibrating particular mortgage structures. To improve the
pricing transparency, more sub-indices are required. For more exotic instruments, such as CDO
squared, there are two issues. First, is the identification of obligors in each of the underlying
CDOs, and second, the modeling of default dependence. Given the limited success of models for
simple CDOs, modeling a CDO squared is problematic.83 The data for all structured products
should be collected by a regulator and made available for analysis. This would be a first step to
improve the pricing transparency of such complex instruments.
New products exposed to “gap” risk have been introduced such as Constant Proportion
Portfolio Insurance (CPPI) and Constant Proportion Debt Obligation (CPDO). Both products are
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leveraged investments whose return depends on the performance of an underlying trading
strategy. Quite often positions are taken into the available credit indices such as iTraxx and CDX.
Typically, the performance of these trading strategies is exposed to “gap” risk that is not captured
with traditional option pricing models because of the continuous paths of the Brownian motion
assumed by these models. The rating of these products was initially based on flawed models, with
most of the CPDOs being subsequently downgraded with huge losses. For example, Moody’s on
November 26, 2007 announced that Tyger Notes, a CPDO based on financial credits from UBS
lost 90 percent of its value after its net asset value fell below the level that triggered its unwind.
Moody’s later on cut the rating of the other CPDOs.84
SIVs were funding medium-term and hard-to-value assets with short-term money market
securities exposing the vehicle to the risk of a market disruption.85 When banks were unable to
roll the ABCP funding these SIVs, and market liquidity had totally evaporated for subprime
related assets, banks to preserve their reputation had no other alternative, but to take back the
assets on their balance sheet. The design of the SIVs can be altered to make them less sensitive to
market disruptions. There are a number of ways to achieve this. Currently, some of the extant
short-term commercial paper gives the vehicle the option to extend the maturity of the debt.
Usage of this option could be expanded. Another type of option would be to allow the vehicle to
convert the paper into one or two year floating rate debt. The option could be contingent on the
event of a market disruption. The cost of the option would be relatively small, given that the
probability of a market disruption is small. The cost of these modifications would be to decrease
expected profits.
Recommendations
1. There is the need to demonstrate that valuation methodologies can be validated with
respect to external prices and risk management is feasible, especially for complex
instruments.
2. There is the need to design instruments that allow for market disruptions.
4.5 Regulatory Issues
The Basel based Financial Stability Forum (FSF) whose membership consist of central
bankers, regulators and finance ministers from many countries, presented to the G-7 Ministers
and Central Bank Governors at their meeting in Washington in April 2008 a set of 67
recommendations for increasing the resilience of markets and institutions going forward. Many of
these recommendations aim at improving transparency in financial markets, regulatory oversight
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and coordination across regulatory bodies at the national and international levels. Among the
proposals are increased capital requirements for structured credit products and the trading book to
explicitly capture default and event risk of credit exposures held in the trading book, faster
disclosure of losses by banks and increased cross-border monitoring of banks by regulators.
However, there are a number of issues at the heart of the current credit crisis that need an urgent
regulatory response.
First, the lax lending standards over the last few years have been a major contributor to
the current crisis. Both regulators and risk managers ignored the implications. A decline in
underwriting standards for subprime mortgages (and also auto-loans and credit cards) implied that
the probability of default for subprime borrowers and that the default dependence increased,
while recovery rates decreased. This, in turn, lowered the value of structures containing subprime
mortgages. There needs to be regulatory requirements for the random sampling of the raw
mortgage data and the methodologies used to generate the multi-period loss distributions need to
be flexible enough to incorporate the changing regime nature of the data.
In response to the credit crisis, there has been a rush to introduce new laws regulating
lending standards. However, without effective enforcement mechanisms such efforts will be of
little value. The responsibility for enforcement needs to be clearly defined, especially given state
and fragmented federal divisions. To motivate financial institutions that sell structured products
to undertake the appropriate due diligence, they could be required to hold a specified percentage
of the equity portion of the structures they sell to investors. This way they bear the direct costs
from mispricing due to inappropriate assumptions about the nature of the loss distribution. For
example, if a bank sets up a special purpose vehicle, it is required to purchase and hold a
specified percentage of the equity.
Second, the issue of counterparty risk has arisen at two levels. Many banks had put
options that allowed them to put back mortgages to originators in the case of delinquency. In a
number of cases when banks attempted to exercise this option, the originators did not have the
assets to reimburse the banks. The credit derivative market is an over-the-counter market,
implying that there is always counterparty risk. In the current credit crisis, the ability of some
counterparties to honor their commitments has been called into question.
While banks keep track of their counterparty exposures, the determination of the value of
the total exposure (after netting) to a counterparty and the posting of collateral has been based on
relatively simple forms of rules. The reliance both on credit ratings as a measure of the risk of a
counterparty and the valuation of illiquid assets have been contributing factors to the crisis. The
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rating agencies have done a poor job in assessing on a timely basis the credit worthiness of many
of the counterparties and the valuation of illiquid assets is difficult even in normal times. Both
banks and regulators have failed to recognize that a credit event that adversely affects a bank may
also adversely affect both the credit worthiness of a counterparty and the value of the bank’s
collateral. Moving forward, there is a need to understand and model the dependence between the
valuation of the cash flows from a counterparty and its ability to pay, what is known as “wrongway” counterparty credit exposure. Regulators should ensure that methodologies adequately
account for this type of dependence.
Centralized clearing houses (CCHs) offer a potential way to localize counterparty risk.
All over-the-counter trades would be cleared through a CCH. The CCH must have sufficient
capital, monitor its exposure to each customer and request the posting of collateral. If a party
fails, such as Bears Stearns, the CCH bears the counterparty risk for all the OTC contracts.
Third, banks have many implicit commitments that do not appear on the balance sheets.
For example, some banks have received managerial fees from hedge funds and SIVs and
provided lines of credit. Some banks have used their name to market enhanced money funds. In
these cases, it was known that the bank had implicit commitments. It is not surprising, and should
have been expected, that many banks to protect their reputations brought assets on to their
balance sheets, adversely affecting their capital and forcing some banks to raise additional capital.
Regulators should request that these implicit commitments be recognized for capital calculations
and that these contingencies given explicit recognition in Value-at-Risk measurements. For
practical implementation, regulators should be ready to specify some minimum probability of
occurrence. Whether it is desirable to hold capital against these commitments is another issue.
There are two types of contingencies. The first type of contingency is the case of a vehicle
having refinancing problems that are isolated to the particular vehicle and the bank transferring
assets onto its balance sheet. The second type of contingency is the case of a general market
disruption. To hold capital against this type of event could be prohibitive. Explicit and implicit
commitments should also be reported in the bank’s accounts, so investors know of potential
future liabilities.
Fourth, the requirement that assets in the trading book be marked-to-market (or model)
has come under attack from some bankers.86 The central issue is the belief that in the current
crisis, market or model prices do not reflect the true value of an asset and consequently
companies are being forced to recognize losses on assets they had no intention of selling. In the
current crisis, companies have recognized huge write-downs, causing investors to become
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increasingly concerned about the credit worthiness of financial institutions, which have been
forced to raise capital at unfavorable prices.87
The valuation of illiquid assets is difficult under normal markets conditions and
problematic when markets are in turmoil. In the current crisis, there was a failure to adjust
distributional assumptions due to misrepresentation of the underlying risk associated with
subprime borrowers. For assets recorded in the banking book, a loss reserve is required. The
magnitude of the reserve is usually based on the expected loss over the next year. In general, in
the current crisis this has been under estimated, given the inappropriate distributional
assumptions. If markets are mispricing assets in the current crisis, it is probably due to the lack of
transparency with respect to the nature of the assets. Investors need to assess the value of an
institution’s assets. The focus of the debate should be on the issues of transparency of the assets
held by institutions and the valuation of these assets.
Fifth, the systemic nature of the crisis has arisen because of widespread ownership of
structures containing subprime and the circular dependence between refinancing and collateral
valuation. Regulators failed to recognize the existence of positive feedback mechanisms and to
understand their implications for the financial system.88 If asset values decline, ability to
refinance declines, valuation of counterparty collateral declines, the value of monoline assets
declines and the value of the guarantees given by monolines declines. Regulators were blind to
the impending crisis. To avoid a repeat, there needs to be more transparency as to the nature of
assets held by different institutions. To achieve this will require increased cooperation of
regulators across national boundaries. There is also the need to recognize feedback mechanisms
explicitly and understand their implications for the financial system.
Many financial institutions failed to anticipate the liquidity risks associated with some of
their businesses. Regulators need to understand the risks that can be caused by liquidity and
require that these risks be formally recognized in measuring the risk of an institution.
Rating agencies failed to understand the risks arising from structured products. Given the
regulatory importance attached to ratings, the onus is on regulators to monitor the rating agencies
with respect to data quality, methodologies and rating designations.
Recommendations
1. Minimal Federal lending standards are required across all states in order to avoid the
problems arising from lobbyist pressuring state lawmakers to have state laws relaxed.
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2. There is the need for compulsory random sampling of mortgage lending practices and
mortgage delinquency rates, especially in major states. The responsibility for such duties
must fall to an independent body.
3. Originators should be required to hold a randomly selected number of mortgages from
each mortgage class. Arrangers should be required to hold a specified percentage the
equity tranche of any structure that they sell.
4. In cases where a counterparty posts collateral, regulators need to consider the effects of
“wrong-way” counterparty credit exposure in determining capital requirements. They
also need to recognize the effects of pro-cyclicality in stress testing and scenario analysis.
5. Fair value accounting has come in for criticism due to its pro-cyclical nature. A possible
solution is to allow investment banks to place an asset either in the trading book or the
bank book. This decision is made at the time the bank buys the asset. There is the need
for some rules to avoid cherry picking by banks – that is banks cannot keep on switching
an asset back and forth as market conditions change.
6. For financial institutions that are of a size or importance such that their failure threatens
the stability of the financial system, there is the need for consistent regulation across such
institutions.89
7. The fragmented regulator system both at the Federal level and at the state level needs to
be improved.90
8. Regulators need to monitor the rating agencies with respect to data quality,
methodologies, and the efficacy of their prediction. The inherent conflicts of interest
between the rating agencies and their clients needs to be addressed.91 The ability to
perform independent validation of ratings would go a long way to reduce the effects of
possible conflicts of interest, which are impossible to eliminate.
9. Centralized clearing houses (CCHs) should be used to reduce and localize counterparty
risk.
4.6 Risk Management Issues
The Senior Supervisors Group issued a report in March 2008 that identifies risk
management practices that differentiate financial institutions that have been able to weather
relatively well the financial market turmoil, from those that did not perform well and have been
exposed to large credit write-offs. Firms that performed relatively well:
- adopted a comprehensive view of their exposures: they shared quantitative and
qualitative information more effectively across the organization so that they were able to identify
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very early the sources of significant risk and had more time to evaluate the appropriate actions to
be taken; these firms have risk management committees that meet on a weekly basis to discuss all
significant risk exposure across the firm, and include senior management (CEO, CFO, CRO,
COO,..) and the heads of business lines as well as legal and compliance officers, all as equal
partners;
- had in place rigorous internal processes to value complex and potentially illiquid
securities: they had independent in-house expertise to assess the credit quality of structured credit
assets and were not relying only on the assessment of credit rating agencies;
- enforced active controls over the consolidated organization’s balance sheet, liquidity
and capital positions: they aligned the treasury functions more closely with risk management
processes, incorporating information from all businesses in global liquidity planning, including
actual and contingent liquidity risk; these firms had in place internal pricing mechanisms that
provide incentives for the business units to better control balance sheet growth and ensure that
contingent liquidity risk does not outweigh expected returns;
- relied on a wide range of risk measures: they had adaptive risk measurement processes
and systems that could rapidly alter underlying assumptions in risk measures to reflect current
circumstances; in particular, they complemented VaR measures with forward-looking stress
testing;92 stress tests specially designed to allow firms to estimate the economic benefits of
diversification and the impact of correlation risk in stressed markets. Exhibit 2 discusses “cliff”
effects or strong non-linearities that characterizes the risk of subprime CDO tranches, and limit
the usefulness of VaR measures under some circumstances.
The report also emphasizes the role of senior management to articulate the strategy of the
firm that will increase its franchise value. Imbedded within this responsibility is the task of
finding the right balance between the desire to develop new businesses and the risk appetite of the
firm. In particular, senior management plays a critical role in identifying and understanding
material risks and acting on that understanding to mitigate excessive risks. Internal
communication across the firm is also critical to performance in stressed market conditions. The
existence of organizational silos in the structures of some firms appeared to be detrimental to the
firms’ performance during the turmoil. Firms that avoided significant losses cited a degree of
integration among the liquidity, credit, market and finance control structures. Firm-wide risk
management has become a necessity to keep pace with the growth of risk taking.
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Finally, compensation has been cited as a major issue in the current credit crisis. In
particular, the incentive structure tied loan originator revenues to loan volume, rather than to the
quality of the loans to be securitized. There is a need to better align compensation and other
incentives with the interests of the investors and of the shareholders of the firm, and to find the
appropriate balance between short-run and long-run performance, and between individual
business unit goals and the firm-wide objectives. The originate-to-distribute business model has
created incentives for both firms and individuals that have conflicted with sound underwriting
practices, risk management best practices and the interest of investors and shareholders.
Recommendations
1. Firms should adopt a comprehensive firm-wide risk management and share quantitative
and qualitative information in risk management committees that meet frequently and
include senior management as well as heads of business lines, legal and compliance
officers, all as equal partners.
2. Rigorous internal processes should be put in place to value complex and illiquid
securities and internal credit quality assessment should complement external ratings.
3. The treasury functions should be closely aligned with risk management to plan and
control balance sheet, liquidity and capital positions.
4. Traditional Value-at-Risk measures should be complemented by forward-looking stress
testing to capture the impact of severe market shocks.
5. The incentive and compensation system should be reviewed to better align the interests of
all the participants in the securitization chain with the interests of the investors and
shareholders of the firm. The incentive compensation scheme should be closely related to
long-term, firm-wide profitability.
5
Summary
Securitization allows banks to move assets off their balance sheets, freeing up capital and
spreading the risk among many different players. These are real benefits. Federal Reserve
Chairman Ben Bernanke said at the opening meeting in April 2008 of the G-7 in Washington that
failures in the so-called “originate-to-distribute” model of credit extension were the root of the
current crisis. It broke down at a number of key points, including at the stages of underwriting,
credit rating and investor due diligence. Financial institutions that had bought structured credit
products coming from the securitization of subprime loans did not have adequate risk
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management or liquidity plans in place. Chairman Ben Bernanke also said “these problems
notwithstanding, the originate-to-distribute model has proven effective in the past and with
adequate repairs could be so again in the future”.
In this paper, we have identified many of the factors that have contributed to the crisis,
from the search for yield, fraud, agency problems resulting in lax underwriting standards,
incentive issues, failure to identify a changing environment, poor risk management by financial
institutions, lack of transparency, the limitation of extant valuation models and the failure of
regulators to understand the implications of the changing environment for the financial system.
The paper addresses the different issues and offers suggestions on how to move forward.
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Appendix A
Biggest losses/write-downs since the beginning of 2007, in billions of US$ as of April 2008
(Source: Bloomberg)
Citigroup
$40.9
UBS
$38
Merrill Lynch
$31.7
Bank of America
$14.9
Morgan Stanley
$12.6
HSBC
$12.4
JP Morgan Chase
$9.7
IKB Deutsche
$9.1
Washington Mutual
$8.3
Deutsche Bank
$7.5
Wachovia
$7.3
Crédit Agricole
$6.6
Credit Suisse
$6.3
RBS
$5.6
Mizuho Financial Group
$5.5
Canadian Imperial Bank of Commerce
$4.1
Société Générale
$3.9
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Exhibit 1
Central Banks Interventions
European Central Bank
August 9, Euro 95 billion (US$130 billion)
August 10, Euro 61 billion (US$84 billion)
U. S. Federal Reserve
August 9, US$24 billion
August 10, US$38 billion
Bank of Canada
August 10, C$1.64 billion (US$1.55 billion)
Bank of Japan
August 10, Y100 billion (US$8.39 billion)
Swiss National Bank
August 10, SF 2 -3 billion (US$1.68 -2.51 billion)
Reserve Bank of Australia
August 10, A$4.95 billion (US$4.18 billion)
Monetary Authority of Singapore
August 10, S$1.5 billion (US$0.98 billion)
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Exhibit 2: “Cliff” effects or non-linearities in the risk of subprime CDO tranches
Banks and rating agencies have based their risk assessments on market assumptions
which didn’t reflect the severity of the current environment after the housing market started to
deteriorate and market liquidity evaporated. It has long been suggested to complement standard
risk analyses based on “normal market conditions”1 by “stress-testing” methods and “scenario
analysis” which take into account liquidity risk and other complexities in order to ensure that
banks are aware of the potential losses they might incur in highly unlikely but plausible
scenarios.2 It is well known that Value-at-Risk (VaR) models do not accurately capture “gap
risk”, i.e., extreme market events. It is clear that if the term structures of default probabilities, the
losses given default and the default correlations of the mortgage bonds in the pool of the
subprime CDOs, had been reasonably stressed we would have known the extent of the potential
losses. Traditional Value-at-Risk risk measurement models are static in nature and do not capture
the impact on potential losses of limited liquidity and complex non-linearities embedded in
structured credit products.
In particular, the nature of the risks involved in holding a triple-A rated super-senior
tranche of a subprime CDO was completely missed by all the players: rating agencies, regulators,
financial institutions and investors. Subprime CDOs are in fact CDO squared as the underlying
pool of assets of the CDO is composed of subprime MBS bonds that are themselves tranches of
individual subprime mortgages. A typical subprime trust is composed of several thousand
individual mortgages, typically around 3 to 5,000 mortgages for a total amount of approximately
a billion dollars. The distribution of losses of the mortgage pool is tranched into different classes
of MBS bonds from the equity tranche, typically created through over-collateralization, to the
most senior tranche rated triple-A. A typical subprime CDO has a pool of assets composed of
MBS bonds rated double-B to double-A, with an average rating of triple-B. The problem is that
the initial level of subordination for a triple-B bond is relatively small, between 3 and 5 percent
and the width of the tranche is very thin 2.5 to 4 percent maximum. As prepayments occur the
level of subordination of the lower tranches increase, in relative terms, and can reach 10 percent
over time. Assuming a recovery of 50 percent on the foreclosed homes, means that a default rate
of 20 percent on subprime mortgages, which is realistic in the current environment, will most
likely hit most of the triple-B tranches. Moreover, it is also most likely that in the current
downturn in the housing market and recessionary economic environment, the loss correlations
2
See, for example, Crouhy, Galai and Mark (2006).
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45
across all the triple-B tranches will be close to one. As a consequence, if one triple-B tranche is
hit, it is most likely that most of the triple-B tranches will be hit as well during the same period.
And, given the thin width of the tranches, it is most likely that if one MBS bond is wiped out,
they all will be wiped out at the same time, wiping out the super-senior tranche of the subprime
CDO. In other word, we are in a binary situation where either the cumulative default rate of the
subprime mortgages remains below the threshold that keeps the underlying MBS bonds
untouched and the super-senior tranches of subprime CDOs won’t incur any loss, or the
cumulative default rate breaches this threshold and the super-senior tranches of subprime CDOs
could all be wiped out.
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*
We gratefully acknowledge comments from Steve Arbogast, William Dellal, Darrell
Duffie, Paul Embrechts, Tom George, Rajna Gibson, Dan Jones, Arthur Maghakian and Lee
Wakeman. We would like also to thank Stephen Figlewski, the editor, for constructive and
helpful comments.
1
The term “subprime” refers to mortgagees who are unable to qualify for prime mortgage rates. Reasons
for this include poor credit histories (payment delinquencies, charge offs, bankruptcies, low credit scores,
large existing liabilities, high loan to value ratios).
2
In April 2008, the International Monetary Fund (IMF) said that total financial losses stemming from the
housing turmoil and the global credit crunch, including the securities tied to commercial real estate and
loans to consumers and corporates, may reach US$945 billion over the next two years, with US$565 billion
directly related to the subprime crisis. And losses at financial institutions are likely to be saddled with half
the potential losses, or about US$440 to US$510 billion.
3
The US$300 billion in losses related to the subprime crisis compares to about US$170 billion in losses for
the savings and loan crisis in the 1980s and early 1990s.
4
Appendix 1 shows the credit losses and subprime related write-downs since the beginning of 2007 at
major banks worldwide, based on data compiled by Bloomberg. Early 2008, AIG’s auditors forced the
insurer to lower the value of credit-default swaps it holds by an estimated amount of US$4.88 billion.
Credit Suisse also announced in February that it had to write-down US$2.85 billion of previously mismarked structured credit products.
5
To smooth the deal, the Fed has taken the unprecedented step of providing US$30 billion in financing for
Bear’s less liquid assets. The Fed is assuming responsibility for managing the assets and assumes the risk
of those assets declining in value, except for the first billion which will have to be absorbed by JP Morgan
Chase, and the profit if they rise in value.
6
These rates, in turn, affect monthly payments on millions of credit cards and mortgages in Europe and the
U.S.
7
As an alternative to raise more capital banks are trying to shrink their balance sheet by selling loans at a
discount. Citigroup negotiated (April 18, 2008) with a group of leading private equity firms (Apollo,
Blackstone and TPG) the sale of US$12 billion in leverage loans at a discount that could come in at about
90 cents on the dollar.
Anxiety is such that even some dedicated free-market spirits, such as Nobel laureate Myron Scholes,
declared to the French newspaper, La Tribune (January 24th, 2008) that a concerted political effort has
become necessary. In addition to sovereign funds, the U.S. government may have to step in to recapitalize
some of the large financial institutions subject to large losses to ensure that they can keep financing the
economy.
8
For example, funding for Citigroup, one of the hardest hit by the credit crisis, has risen from 12 bps to 1
percentage point over Libor, while the cost of borrowing for Merrill Lynch has climbed from to 1.50
percentage point over Libor from 20 bps. Investors believe there is an increasing probability of default for
banks. The iTraxx Senior Financial Index that tracks the cost of insuring the senior debt of a portfolio of 25
European banks and insurers has increased from 8 bps to 57 bps.
9
The credit crisis has caused credits spreads to increase, especially for junk bonds. Some highly levered
companies have been forced to postpone new debt issues.
10
The leverage loan market in February 2008 is starting to show signs of weakness as UBS and Credit
Suisse announced the write down of a combined US$400 million in the value of leveraged loans as part of
their fourth-quarter 2007 earnings report. Some analysts expect as much as US$15 billion in leveraged-loan
related write-downs at commercial and investment banks in the first quarter of 2008.
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11
Cf. iTraxx Europ e crossover index. It closed at 510 bps on February 6, which means that the annual cost
of insuring 10 million euros worth of high-yield debt against default over 5 years is 510,000 euros. In the
U.S., the HiVol index of the 30 riskier investment grade credits of the 125 names composing the CDX
index reached almost its peak on February 6, at 271 bps.
12
According to a recent report by Altman and Karlin (2008) default rates were near-record low and
recovery rates were near record high in 2007 for high-yield bonds. Default rates fell to just 51 bps, the
lowest since 1981. According to S&P the default rate on leveraged loans decreased again in 2007 to just 26
bps, down from 1.1% in 2006 and 3% in 2005. Default losses on high yield bonds were just 20 bps in 2007
based on an average recovery rate of 67%. One measure of the potential increase in defaults going forward
is the distress ratio, i.e., bonds yielding more than 10% above Treasuries. This ratio increased dramatically
to 10.4% as of year-end 2007 from record low levels just six months earlier, and from 1.7% at the end of
2006. Altman forecast a default rate for high yield bonds of 4.6% in 2008 and 5% in 2009, a significant
increase from the current default rate of 51 bps.
13
Items have been drawn from many different sources: Business Week, Financial Times (London), New
York Times, Wall Street Journal, Bloomberg and the Federal Reserve.
14
The Fed funds rate was 1% in June 2003. It started to slowly increase in June 2004, and was 5.25% by
June 2006. It was reduced to 4.75%, September 18, 2007.
15
In the U. S. 50 million, or two-thirds of homeowners currently have mortgages, with 75.2% being
financed with fixed rate mortgages and the remaining 24.8% with adjustable rate mortgages (ARMs).
These figures come from the Mortgage Bankers Association, August 15, 2007.
16
Subprime loans grew from US$160 billion in 2001 (or 7.2% of new mortgages) to US$600 billion in
2006 (or 20.6% of new mortgages).
17
For a comparison of prime and subprime mortgages, see Agarwal (2007)
18
See Duffie (2007) for a discussion about credit risk transfer innovations.
According to Bank for International Settlements (BIS) the notional amount outstanding of CDSs (Credit
Default Swaps) was US$58 trillion end of December 2007 while it was only US$14 trillion at the end of
2005. However, according to ISDA, the net exposure to the banking system is “only” US$1 trillion after
netting.
19
20
Doms, Furlong and Krainer (2007) find a negative correlation between house prices appreciation and
subprime delinquency rates. They also show that the rate of change in the price appreciation affects the
delinquency rate.
21
The Mortgage Bankers Association defines delinquent as having one or more payments over due.
22
These figures are given in the press release of the Mortgage Bankers Association (March 13, 2007).
23
The economy started to change during 2004. First, mortgage rates started to increase, as the Federal
Reserve increased the Fed Funds rate and second, house price appreciation decelerated. There are many
factors that cause delinquency in the mortgage markets, major candidates being: job loss, unanticipated
medical expenses, divorce and rising mortgage expenses. House prices can also affect the default decision.
If house prices are falling, this can affect this decision in two ways. First, it limits the ability to re-finance
and second, it can cause the home owner’s equity to become negative if the initial equity stake was small,
as is often the case for subprime mortgages. Since the middle of 2005, the rate of house price appreciation
has been continuously decreasing. There has been wide variation across the country, with California,
Florida Michigan, Massachusetts and Rhode Island having price depreciation. Consequently, there has been
wide variation in subprime delinquency rate across different metropolitan areas. (See the report from the
Office of Federal Housing Enterprise Oversight – August 30, 2007)
24
This phenomenon was exacerbated by the decline in subprime mortgage rates starting in 2004 due to
increase price competition. This, along with the Federal Reserve increasing interest rates, reduced the
profitability of lending. To offset this decrease, some originators reduced standards – see Coy (2007).
Credit Crisis
Crouhy, Jarrow and Turnbull
51
Evidence of loosening underwriting standards was first noted in 2005 in the Office of the Comptroller of
the Currency’s annual survey of underwriting practices at national chartered banks.
25
We will subsequently discuss why the CDO bonds were mis-rated. Briefly, the rating methodology did
not reflect current market conditions, and there was an incentive problem in the way rating companies were
compensated for rating assignments.
27
See Morgenson (2007).
28
Lenders were far too willing to lend as evidenced by the creation of new types of mortgages, known as
“affordability products” that required little or no down payment, and little or no documentation of a
borrower’s income, the last ones being known as “liar loans”. Liar loans accounted for 40 percent of the
subprime mortgage issuance in 2006, up from 25 percent in 2001. The Federal Reserve issued three cease
and desist orders due to mortgage related issues in the last four years: Citigroup Inc. and CitiFinancial
Credit Company (May 27, 2004); Doral Financial Corporation (June 16, 2006); R&G Financial
Corporation (June 16, 2006). Ameriquest Mortgage Company (Aegis Mortgage Corporate and associated
companies) set up a US$295 million Settlement Fund to compensate borrowers for unlawful mortgage
lending practices.
The state of the subprime market also attracted attention to industry practices in mortgage origination. The
declining underlying standards and fraud is noted by Cole (2007) and Bernanke (May 17, 2007).
Morgenson (2007) identified some of the techniques used by lenders to increase subprime mortgages
originations. These were often not in the best interest of the borrower.
29
In 2007, the Federal Bureau of Investigation was looking at over 1,200 fraud cases compared to 818
cases in 2006. In 2006, they obtained over 204 mortgage fraud convictions, generating US$388 million in
restitution and US$231 million in fines – see Davies (2007).
30
Consequently, these waterfall payment structures are often complex and difficult to model for risk
management purposes.
31
Some of the material in this section draws from the publicly available information supplied by Moody’s,
S&P and the testimonies given by Michael Kanef, Managing Director, Moody’s Investors Services (2007)
and Vickie Tillman, Executive Vice President of S&P (2007).
32
Fitch (2008) reports numbers for the year 2007. Transitions from investment to speculative grade,
including default, for U.S. structured finance show a dramatic increase.
33
Most of the US$2.5 trillion sitting in the money market funds is invested in such assets as U.S. Treasury
bills, certificates of deposit and short-term commercial debt. In the recent low interest rate environment
these funds have also invested in triple-A super-senior tranches of CDOs and triple-A rated ABCP, in order
to increase the yield generated by these funds.
34
Rating agencies earn hefty fees for rating structured credit securities. In 2006, Moody’s reported that 43
percent of total revenues came from rating structured notes.
35
See Partnoy (2006). The conflict between incentives and reputation is illustrated by the recent disclosure
by Moody’s (July2, 2008), that management failed to inform investors on a timely basis that a computer
program used to rate constant proportional debt obligations contained an error. Consequently, a number of
credit ratings were over estimated by several notches.
36
In testimony to Committee on Banking and Urban Affairs, both agencies stated that they accepted the
raw data without any form of checking- for Moody’s see Kanef (footnote 3, 2007) and for S&P see Tillman
(P7, 2007).
37
This pro-cyclicality in CE has the potential to amplify the housing cycle. See Ashcraft and Schuermann
(2007). A rating that is “through the cycle” means that it under estimates the true probability of default in a
recession and over estimates it in an expansion.
38
Some hedge funds aware of the problems in the subprime markets (these were public knowledge) and the
failure of rating agencies to incorporate such information into their ratings, anticipated significant
downgrades and declining prices.
39
To some extent this should have been mitigated by originators having to repurchase delinquent loans
within a few months of origination (“early payment default” clause). However, as some of the brokers were
experiencing financial difficulties and even in some cases filed for bankruptcy, this did not occur, leading
to even greater losses on the underlying asset pools. For example, Merrill Lynch demanded in December
Credit Crisis
Crouhy, Jarrow and Turnbull
52
2006 that ResMae mortgage Corp. which sold it US$3.5 billion in subprime mortgages, buy back US$308
million of loans where the borrowers had defaulted. ResMae said that those demands “crippled” its
operations, in its filing for bankruptcy protection in February 2007. Accredited Home Lenders Holding
reported a loss of US$37.8 million due to repurchase of bad loans (February, 2007).
40
In June 2004, New Jersey’s Assembly and Senate passed bills that rolled back parts of the earlier law,
including the “tangible-net-benefit rule” that required lenders to prove that a refinancing of any home loan
less than five years old would provide a “tangible-net-benefit” to the borrower. Thousand of New Jersey
homeowners subsequently refinanced existing mortgages or took new loans with Ameriquest before the
subprime market tanked. Many of these loans are now in foreclosure.
41
This section draws on material given in Polizu (2006).
42
The defeasance mode is the orderly wind-down by the manager of the portfolio. The enforcement mode
occurs if the trustee undertakes the wind-down.
43
Capital notes are subordinated to senior creditors and rank pari passu with all other capital notes
outstanding. Capital notes typically have a fixed maturity date. Each year the maturity is automatically
extended for a further year, unless the investor stops the automatic extension. This mechanism is termed
the “rolling capital notes”. Capital notes usually receive some minimum rate, payable at pre-specified
dates. The intention of the manager is to create excess spread above this minimum rate. Profits are shared
between the manager (performance fees) and the investor (known as an additional interest amount).
Leverage for a SIV is defined as the ratio of senior debt (ABCP plus MTNs) to capital notes. Typical
leverage varies in the 12-14 range.
44
A variant of a SIV is the SIV-Lite structure. In these types of vehicles, capital has a finite maturity. The
vehicles typically hold residential mortgage backed securities and home equity backed securities. The
fixed maturity implies that at launch, the maximum permitted leverage is fixed through the life of the
vehicle. This is not the case with a SIV.
45
In the case of K2, Dresdner does not anticipate to make substantial losses as its assets are entirely
investment grade and do not contain any exposure to subprime mortgages and related structured credit
products.
46
In the event of a bond defaulting, the monoline agrees to make whole interest and principal payments on
their respective due dates.
47
The only exception was ACA which was rated single-A and which guaranteed US$26.6 billion of CDOs
backed by subprime mortgages. As long as the monoline maintains its single-A rating, the counterparties
don’t require the monoline to post collateral even if the value of the securities it insured fell in value.
48
As mortgage delinquencies rose, so did paper losses. In November, the monoline CIFG, which had
exposure of approximately US$6 billion to the US subprime market, received a US$1.5 billion injection
from two French banks. After the injection, Fitch re-affirmed CIFG AAA ratings. MBIA and AMBAC
wrote assets down by a combined US$8.5 billion in the third quarter of 2007. There is now a general
market concern that monolines have insufficient resources to honor their commitments. Recently MBIA
added US$3.5 billion in write-downs on its credit derivatives portfolio for the fourth quarter of 2007 and a
US$2.3 billion fourth quarter loss. MBIA has raised about US$2.5 billion in capital since November and
has plans for more, possibly involving obtaining reinsurance on portions of its portfolio. Fitch recently cut
its triple-A rating to double-A on AMBAC, Security Capital Assurance and FGIC, citing their failure to
raise capital. Fitch also put the triple-A rating of CIFG on negative watch, just weeks after affirming its
rating. In March, Moody’s, then S&P and Fitch, downgraded CIFG from triple-A to single-A plus and
rating agencies are now questioning the long-term viability of CIFG as a guarantor as shareholders have
declared they may not be prepared to recapitalized the monoline a second time. AMBAC benefited from a
capital infusion of US$1.5 billion, which allowed it to maintain its triple-A rating.
ACA might be the first monoline to file for bankruptcy. S&P slashed ACA rating to CCC, a low
junk level, from A in December 2007. The stock of ACA was delisted from the New York Stock Exchange
last December and ACA is now on a run-off mode.
MBIA and AMBAC were downgraded to AA rating status in June, 2008.
Credit Crisis
Crouhy, Jarrow and Turnbull
53
49
There is concern that banks might have to write down an additional US$40 to US$ 70 billion consecutive
to the downgrade or the bankruptcy of monolines.
50
A potential bailout of FGIC, the third biggest municipal bond insurer in the U.S. with about US$315
billion of insured bonds outstanding, is being led by Calyon, the investment banking unit of France’s Credit
Agricole. Other bank in the consortium include UBS, Soc Gen, Citigroup, Barclays and BNP Paribas.
51
According to Eliot Spitzer speed to resolve the monoline recapitalization issue is critical as the
diminishing confidence in the monoline to meet their obligations has already hurt markets like the auctionrate securities. Just before Eliot Spitzer injunction, the auction-rate securities market, a US$330 billion slice
of the municipal bond market shut down. (These securities are also issued by student loans authorities,
museums and many others.) Investors stopped buying securities at regular municipal auctions because they
were concerned about the fate of the bond insurers who guarantee around 80 percent of the entire market.
The Port Authority of New York and New Jersey found itself paying a rate of 20 percent on US$100
million of its debt, almost quadruple its cost a week before. Auction bonds are initially sold as long-term
securities but are effectively turned into short-term securities through auctions where interest rates are
determined by bidding that typically occurs every 7, 28 or 35 days. When there are not enough buyers, the
auction fails and bondholders who wanted to sell are left holding the securities. Rates at failed auctions are
set at a level spelled out in official statements issued at the initial bond sale.
52
It is not clear that this will help monolines keep their current credit ratings.
The plan advanced by William Ackman did directly address this issue.
54
In the U. S. banks are required to have minimum level of reserves on average for a two week period,
known as a “maintenance period.” If a bank has excess reserves, it can lend then in the Fed funds market
and if insufficient reserves, it can borrow in the Fed funds market. The Fed adds and drains credit from the
market, so as to keep the effective Fed funds rate (the actual rate that banks borrow or lend) near to the
target official Fed funds rate.
53
55
This facility was used the first time by Lehman in April 2008. Lehman shifted around US$2.8 billion in
loans, including some risky LBOs it had been unable to sell, into a new investment vehicle it named
“Freedom” which issued debt with 20% subordination that was assigned a single-A rating by rating
agencies and therefore was eligible as collateral at the PDCF of the Fed.
56
The decision to close one of the Synapse funds apparently arose due to the failure to reach agreement
with its prime broker, Barclays Capital, about the valuation of assets held by the fund. The fund did not
hold subprime mortgages. See Davies, Hughes and Tett (2007).
57
See the Statement of Financial Accounting Standards, rules SFAS 157 and SFAS159.
58
Price is defined as the amount that would be received to sell an asset or paid to transfer a liability.
59
For a recent discussion and references to extant literature, see O’Brien (2005).
60
It was not clear what assets these structures held.
61
In the second week of August, Coventree, a Canadian investment firm could not sell US$229 million of
commercial paper. It shares fell by 80% before trading was stopped. Three days later, in the asset backed
commercial paper market, 17 Canadian issuers failed to sell short term debt and sought financing from
banks and the market closed down. The funds had backstop lines of credit. However, the criterion for
usage is more restrictive in Canada than the U. S. It requires a general market disruption. As some funds
could still roll over their ABCP, some banks took this as evidence that there was no general market
disruption and refused to honor their commitments, triggering the funding crisis in Canada. In Europe and
Australia, many special investment vehicles reported problems. For example, in Europe Mainsail II, an
affiliate of Solent Capital Partners (London) and Synapse Investment Management and in Australia, Ram
Home Loans, all reported problems in rolling over the asset backed commercial paper.
62
The fund agreed to waive its annual management fees.
Sowood played credit spread vs. equity prices and was crushed when spread widened while equity
markets didn’t fall.
63
Credit Crisis
Crouhy, Jarrow and Turnbull
54
64
King County officials bought US$53 million in Mainsail commercial paper, when rated AAA by S&P. It
is now rated B. An official from the county is quoted as stating “we rely heavily on that (the rating)” – see
Henry (2007). Words in italic have been added.
65
SachsenLB had asked for the return of its investment in the fund. Synapse was unable to find alternative
funding.
66
Some institutions do disclose the aggregate amount of such commitments. However, at this level of
aggregation, the investor does not know the types of firms or individual levels of support provided by the
bank.
67
The size of U. S. money market funds is approximately US$2.70 trillion, according to the Institute of
Money Market Fund Association.
68
Credit Suisse recorded a third quarter loss of US$128 million after removing assets from one of its
money market funds. At the beginning of summer, it had money market assets of US$25.5 billion and six
months later these had sunk to approximately a quarter of that size. In November 2007, it transferred
approximately US$6 billion of the remaining assets onto its balance sheet to meet redemption claims. In
December 2007, Columbia Management, a unit of Bank of America, closed its Strategic Cash Portfolio
after withdrawals reduced the fund from US$40 billion to US$12 billion. Prior to the shut down, the bank
had provided US$300 million in support.
69
It is unclear how the fund would have avoided this issue, if assets are purchased at market prices. At the
end of the year, the three major banks abandoned the idea of the fund. It had met with a lukewarm
response from other investors.
70
The asset values are reported to have fallen from US$3.47 billion to US$1.6 billion. Paribas stated the
funds were invested in AAA and AA rated structures.
71
The problems of rating credit related structures are currently illustrated by the ratings assigned to the
monoline CIFG. S&P give it an investment grade A+ (negative), while Moody’s a Ba1 and Fitch a near
default rating of CCC (June 8, 2008).
72
Prepayments of principal include both voluntary and involuntary (default) prepayments. Voluntary
prepayments depend strongly on the path followed by interest rates. Interest rate risk is a key source of
uncertainty in the analysis of cash flows.
73
There are many different types of factors that influence default dependence. For example, if the local
economy deteriorates, then defaults might increase or if a particular sector of the economy deteriorates,
then this will adversely affect obligors within the sector.
74
The recent work of Chava, Stefanescu and Turnbull (2007) examines the multi-period loss distribution
for single corporate assets.
75
See Nomura (2006) for a discussion about bond rating confusion. The issues also extend to municipal
bond ratings.
76
See Deventer (2007).
77
See the recent papers by Duffie, Eckner, Horel and Saita (2006) and Chava, Stefanescu and Turnbull
(2007).
78
The same issue has been raised about the rating for municipal bonds compared to corporate bonds, as
both default and recovery rates are quite different for the same rating.
79
Synthetic CDOs are structures that contain credit default swaps.
80
Schőnbucher (2003, chapter 10) provides a clear introduction to this topic.
81
C. Lagarde is France’s minister of economy, finance and employment.
Examples of such indices are the CDX and iTraxx for synthetic CDO structures, LCDX for loans, ABS
for asset backed securities and CMBX for commercial mortgage backed securities.
83
See Jarrow, Mesler and van Deventer (2007).
84
The size of the CPDO market is only approximately US$3.5 billion.
82
Credit Crisis
Crouhy, Jarrow and Turnbull
55
85
This was also the root of the problems with the British bank Northern Rock Pic, that caused the first
bank run in 140 years in Britain.
86
Adrian and Shin (2008) argue that mark-to-market accounting can cause pro-cyclicality.
87
One recent proposal is for auditors to estimate the maximum losses for a financial institution and
recognized these losses in the profits – see Guerrera and Hughes (March 14, 2008). Given that auditors
have in general even less expertise than credit rating agencies at making such estimates and rating agencies
have done a poor job in the current crisis, investors will be forced to rely on their own estimates without the
benefit of market opinion. The outcome may be a “market for lemons” with even greater declines in asset
values than under the mark-to-market framework.
88
The recent U.K. House of Commons Treasury Committee Report on the failure of the Northern Rock
Bank notes the failure of the regulators to recognize the implications of positive feedback mechanisms.
89
The head of the New York Federal Reserve has recently suggested such a plan (June 9, 2008).
The recently announced framework from the Treasury Department represents a start of this difficult
process (March 31, 2008).
91
A start has been made by the New York Attorney General (June 4, 2008). The agreement requires rating
agencies to be paid for any preliminary work they do, irrespective of whether they are selected to give a
final rating. This will help provided there are at least two agencies employed and the details are made
public.
90
92
VaR measures perform well under normal conditions but are unable to capture severe market shocks.
Credit Crisis
Crouhy, Jarrow and Turnbull
56
How the Week's Wild Selldown Went Down - WSJ.com
1 of 2
http://online.wsj.com/article_print/SB121582344487147875.html
July 12, 2008
How the Week's Wild Selldown Went Down
By AARON LUCCHETTI
July 12, 2008; Page A8
For investors in Fannie Mae and Freddie Mac this week, the philosophy
was sell first, ask questions later.
The two companies' wild week -- Fannie's shares tumbled 45%, while
Freddie's sank 47% -- started when Lehman Brothers analyst Bruce
Harting and a colleague raised questions about how much capital the two
companies might need.
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Mr. Harting was an unlikely spark for the fire that erupted. In April, he upgraded both Fannie and
Freddie shares to "overweight." In addition, his employer's own shares have been battered by unfounded
rumors that some big clients were scaling back their dealings with the investment bank.
The Lehman report, released Monday, aired the possibility that Fannie and Freddie would need to raise a
staggering $75 billion if a new accounting rule being contemplated went into effect. The report also made
it clear that the accounting change probably wouldn't be applied to the two mortgage giants.
"It's in no one's interest" for Fannie and Freddie "to be saddled with overwhelming capital requirements
at a time when the market needs" them to buy mortgages, Mr. Harting concluded.
But the worst-case scenario gripped Wall Street, especially investors whose confidence in the stock
market has eroded with the cascading write-downs, losses and capital infusions announced by banks and
securities firms since the credit crisis erupted last summer.
Financial-stock investors have become increasingly fixated on the Bear Stearns Cos. scenario, in which
the federal government arranged a shotgun marriage with J.P. Morgan Chase & Co. that bailed out
bondholders but forced equity holders to swallow horrific losses on their Bear stakes.
The Lehman report thrashed Fannie and Freddie shares. Then the two stocks took another beating after
former St. Louis Federal Reserve President William Poole said the two companies might need a
government rescue.
On Friday, Treasury Secretary Henry
Paulson released a statement saying the
government's focus was on supporting
Fannie and Freddie in their current form.
While that helped the two stocks rebound,
investors remain stuck on Fannie and
Freddie's need to raise capital, with the
only unanswered questions being how
much and from whom.
7/13/2008 3:46 PM
How the Week's Wild Selldown Went Down - WSJ.com
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A Lehman spokeswoman said Mr. Harting
wasn't available for comment. He followed
mortgages, thrifts and financial-services
companies since the savings-and-loan crisis
of the 1980s. In 1996, Mr. Harting joined
Lehman after stints at Salomon Brothers
and Kidder Peabody & Co. In 2000, his
recommendations of Fannie and Freddie shares helped him earn third place in The Wall Street Journal's
annual survey of best Wall Street stock analysts.
When he upgraded Fannie and Freddie in April, Mr. Harting cited the Fed's moves at the time to shore up
confidence, setting price targets of $46 for Fannie and $45 for Freddie. Since then, shares of Fannie have
plunged to $10.25 from $30.19, and Freddie has fallen to $7.75 from $26.97.
The upgrade "has proven wrong or much too early in this market," he acknowledged in Monday's report.
Lehman shares fell 17% Friday and 37% for the week.
Write to Aaron Lucchetti at aaron.lucchetti@wsj.com1
URL for this article:
http://online.wsj.com/article/SB121582344487147875.html
Hyperlinks in this Article:
(1) mailto:aaron.lucchetti@wsj.com
Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved
This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our
Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones
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•
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•
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Mortgage Giants Face Pressure Over Capital Jul. 11, 2008
Today's Markets Jul. 11, 2008
The Price of Fannie Mae Jul. 10, 2008
McCain Open to Bailouts for Fannie and Freddie Jul. 10, 2008
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Why Fears About Fannie And Freddie Are Growing Jul. 11, 2008 npr.org
Questions and answers about Fannie, Freddie Jul. 11, 2008 usnews.com
Washington, Wall St. weigh Fannie, Freddie help Jul. 11, 2008 news.yahoo.com
Fed May Offer Lifeline for Freddie, Fannie Jul. 11, 2008 npr.org
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7/13/2008 3:46 PM
SEC Curbs Shorting of GSE Stocks, Considers Limits for Wider Market...
1 of 2
http://online.wsj.com/article_print/SB121614248005255151.html
July 15, 2008 3:44 p.m. EDT
SEC Curbs Shorting of GSE Stocks,
Considers Limits for Wider Market
By KARA SCANNELL
July 15, 2008 3:44 p.m.
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WASHINGTON--The Securities and Exchange Commission announced an
emergency action aimed at reducing short-selling aimed at Wall Street
• See a sample reprint in PDF
format.
brokerage firms, Fannie Mae and Freddie Mac, and will immediately
• Order a reprint of this article now.
begin considering new rules to extend new requirements to the rest of the
market.
MORE
to Senate Finance
SEC Chairman Christopher Cox said the SEC would institute an emergency • Cox testimony
1
Committee
order requiring any traders to pre-borrow stock before shorting Fannie Mae
and Freddie Mac, the embattled government-sponsored entities that own or
back more than half the nation's mortgages. It would also apply to the stocks of Lehman Brothers,
Goldman Sachs, Merrill Lynch and Morgan Stanley. The order is a near-term fix and will expire in 30
days.
Mr. Cox said the SEC "will undertake a rulemaking to address the same issues" across the market.
The move will likely limit short-selling for the two mortgage entities, which have seen their stock prices
fall sharply in recent weeks. Wall Street has been calling for the SEC to address short-selling, which
some believe is contributing to market volatility and could be used to manipulate shares of financial
stocks.
It comes as short-interest, or the amount of outstanding short positions, is at an all-time high for NYSE
Euronext-listed stocks.
Short-selling, a legitimate trading strategy geared to profit from falling stock prices, has long been a
lightning rod issue, so changes that cover the entire market will likely be hotly debated. Companies have
complained that short-sellers target their stocks with the purpose of driving them down, while
short-sellers have been credited with identifying a company's true market value.
Under current rules, a short-seller must locate shares to borrow, which are later replaced with stock
bought at a lower price. Some market watchers have been concerned that traders were borrowing the
same shares from the same lender over and over, and driving down stock prices.
Under the emergency order, traders will be required to borrow the stock and the lender would then take it
out of the market and not allow other traders to use it to satisfy requirements that they've located stock.
Write to Kara Scannell at kara.scannell@wsj.com2
URL for this article:
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7/15/2008 3:55 PM
SEC Curbs Shorting of GSE Stocks, Considers Limits for Wider Market...
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Hyperlinks in this Article:
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(2) mailto:kara.scannell@wsj.com
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This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our
Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones
Reprints at 1-800-843-0008 or visit www.djreprints.com .
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Related Web News
•
•
•
•
Fannie, Freddie, bank shares plunge Jul. 15, 2008 reuters.com
U.S. stocks shed gains as Fed-bailout rally fades Jul. 14, 2008 marketwatch.com
U.S. stocks shed gains as Fed-bailout rally fades Jul. 14, 2008 marketwatch.com
Stocks tumble on Fannie, Freddie, oil Jul. 11, 2008 news.yahoo.com
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Auction-Rate Crackdown Widens - WSJ.com
1 of 5
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July 25, 2008
PAGE ONE
Auction-Rate Crackdown Widens
UBS Faces New Charges in New York, as
Scrutiny of Wall Street's Role Intensifies
By LIZ RAPPAPORT
July 25, 2008; Page A1
The state of New York on Thursday joined a widening array of prosecutors
and customers accusing Wall Street firms of wrongdoing in efforts to hold
together the $330 billion auction-rate securities market before it collapsed
in February.
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State Attorney General Andrew Cuomo filed civil fraud charges against UBS AG, accusing the firm of a
"multibillion-dollar consumer and securities fraud," and demanding that the firm pay back its profits from
the business, make investors whole and pay damages.
A spokeswoman for UBS said, "We will
vigorously defend ourselves against this
complaint."
The New York attorney's case echoes a
similar case brought against UBS by
Massachusetts officials and many private
cases and arbitration claims filed against
UBS and other prominent firms in recent
months.
The firms are accused of pushing risky
securities on retail and corporate customers
with misleading sales tactics, even as the
market for those securities was falling
apart. When the collapse came, many
customers faced losses or were stuck with securities they couldn't sell.
Wall Street firms themselves have suffered immense losses and faced litigation resulting from their
activities in other kinds of troubled financial instruments -- most notably mortgage-backed securities.
Their auction-rate problem could prove a smaller financial scar than the hundreds of billions lost in
mortgage-backed securities, but a big loss to Wall Street's reputation.
The victims in the auction-rate cases range from individual investors to big corporations. Some 250
public companies held these instruments, as did tens of thousands of individuals. The companies -ranging from 3M Co. to Texas Instruments Inc. -- have on average written down the value of these
holdings by 12% in the past few months, according to Pluris Valuation Advisors LLC, a company that
helps corporations value illiquid securities. Applied across the whole $330 billion market -- which since
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February has gotten substantially smaller -- that would amount to roughly $40 billion of losses.
Auction-rate securities -- issued by municipalities, student-loan companies, charitable organizations and
others -- are long-term securities that Wall Street engineered to have short-term features. Their interest
rates reset at weekly or monthly auctions run by Wall Street firms. The firms promised individual
investors and corporate clients that the frequent auctions made these securities as safe and liquid as cash
because they would always be easy to sell quickly.
A Common Allegation
At the root of these cases is a common allegation: As problems mounted in these auctions and their own
inventories of these securities became bloated, Wall Street firms worked aggressively to push the
instruments out of their doors and into the hands of clients, playing down the severity of the problems
rippling through the market.
The action, Mr. Cuomo and others charge, helped to contain their own losses but left their customers with
beaten down, illiquid investments.
The New York complaint also alleges that several high-ranking UBS executives, whom the New York
attorney didn't name, sold roughly $21 million of their own auction-rate securities holdings amid the
turmoil. Some 50,000 UBS customers were left holding $37 billion worth of the struggling investments,
the complaint says.
MORE
• Read the lawsuit1 filed Thursday in state court.
• Cuomo Readies UBS Civil Suit2
07/23/08
• Auction-Rate Probe Grows Over Clarity From
Brokers3
07/09/08
Karina Byrne, a UBS spokeswoman, said, "UBS does not
believe that there was illegal conduct by any employee." After
an internal investigation into personal sales of auction-rate
securities, "we have found cases of poor judgment by certain
individuals and are evaluating appropriate disciplinary
measures for these individuals," she said.
• UBS Faces State Suit on Auction Securities4
06/27/08
"It is frustrating that the New York Attorney General has filed
this complaint while we have been fully engaged in good-faith
negotiations with his office to bring liquidity to our clients
holding auction-rate securities," she added.
UBS is at the center of many of these allegations, but it isn't alone. Investigators from 10 states showed
up at the offices of Wachovia Corp.'s St. Louis brokerage offices last week to get documents and conduct
interviews in a dramatic escalation of their probe into its auction-rate activities. Wachovia said it, like
others, is responding to inquiries from regulators.
State attorneys are also probing the activities of Merrill Lynch & Co., Citigroup Inc. and others. Merrill
Lynch and Citigroup declined to comment.
The securities are backed by pools of other financial instruments, such as student loans, ultra-safe
municipal bonds or complex subprime-mortgage debt. Even the safe municipal bonds were drawn into
the unfolding mortgage crisis because they were backed by struggling bond insurers with exposure to
mortgage debt.
Stepping In
In normal times, when weekly auctions of auction-rate securities failed to generate sufficient demand,
Wall Street firms stepped in to support the market, buying the instruments themselves. But as they
became strained by other problems, Wall Street firms stopped supporting the market with their own bids.
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By February, nearly every auction wasn't drawing enough buyers and the securities suddenly became
illiquid, impossible for investors to cash in.
In February, the market for auction-rate
securities collapsed when the big dealers in
the market -- including UBS, Citigroup,
Merrill and others -- stopped supporting
struggling auctions, leaving investors
unable to sell. Many companies have had to
mark down their value, individuals have
been stuck unable to access cash, and
issuers of the instruments have had to pay
higher interest rates or find a new way to
raise money.
Before it fell apart, Wall Street firms raised
some brokers' commissions to get the
securities out the door. Merrill Lynch
published reassuring research just days before it pulled out of the market. At UBS, executives mobilized
its financial advisers to sell the securities to institutional and retail investors, many of whom have since
filed complaints alleging UBS and others offered sugar-coated assurances in the months leading up to the
February collapse.
One example unearthed in the Massachusetts investigations: Last November, Edward Hynes, an
institutional sales manager at UBS, was preparing for a conference call with salespeople who worked
directly with investors. In an email to three colleagues who would be leading the call, he laid out a
strategy for the message that salespeople should take to UBS clients, according to documents filed by the
state of Massachusetts against UBS.
"We need them to walk out and believe that this is a strong credit w [sic] strong UBS commitment to
support the liquidity," Mr. Hynes wrote in an email to several colleagues about auction-rate securities
backed by student loans, according to the Massachusetts case. At the time, the market was still a few
months away from breaking, but cracks were already showing up. Mr. Hynes isn't named in the New
York complaint.
People familiar with the email say the call would have been with institutional salespeople, not retail
investment advisers.
"We are not going to address specific emails taken out of context," said Ms. Byrne in a statement. "UBS
has acted in clients' best interests in this matter."
Another example involves a lawsuit filed early in June by Latham, N.Y., energy company Plug Power
Inc. The company claims UBS assured Plug Power's chief financial officer, Gerry Anderson, in a
conversation in October that auction-rate securities backed by student loans were safe and liquid, despite
spikes in their interest rates that suggested otherwise.
Plug Power Inc. had bought $62.9 million in auction-rate securities backed by pools of student loans
starting in 2005, comprising 44% of its total investment portfolio, according to the complaint. The claim
alleges UBS put Plug Power into more student-loan auction-rate securities throughout the fall, after the
CFO expressed concern.
UBS declined to comment on the lawsuit.
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Incentive to Sell
Wall Street firms started raising commissions paid to some brokers at outside dealers who sold the
securities to clients, an action that might serve as an enticement to them to sell more.
On Nov. 2, 2007, for example, Credit Suisse's short-term trading desk sent out an email informing its
salespeople that Citigroup was increasing its commissions to outside dealers from 0.15 of a percent of the
security sold to 0.20 of a percent on certain of its auction-rate securities, according to a person familiar
with the email. By the start of January, their commissions on all types of Citigroup's auction-rate
securities rose to 0.15 of a percent, instead of 0.1, says the person.
Citigroup and Credit Suisse both declined to comment.
Wall Street analysts also put out reassuring research just days before the auction-rate market hit a
breaking point. For example, investigators are looking at one Merrill Lynch note that went out days
before the market collapsed, according to people familiar with several investigations.
The note refers to problems in a $60 billion slice of the auction-rate securities market that was issued by
closed-end mutual funds, called auction-rate preferred securities. These auctions were faltering by the
end of 2007 as well.
"Auction yields still attractive despite spread compression," reads one bullet point of the report,
published by analyst Kevin J. Conery on Feb. 8. It touted the bonds, saying they yielded at least 0.45
percentage points more than other types of bonds. "We continue to be impressed by the auction market's
resiliency in the face of challenging times," the report said.
The inside of the report notes "noise around failed auctions," but goes on to highlight ways investors can
invest in the market most safely, and states that securities issued by closed-end mutual funds are "still"
viewed by the firm as "the conservative's conservative investment."
By Feb. 13, Merrill and UBS had stopped supporting the market.
A call to Mr. Conery was directed to Merrill's press office. "The research report was fair and balanced,"
says Mark Herr, a Merrill Lynch spokesman, in a statement. "Our analyst struck the right balance
between sounding cautionary notes and concluding that there were insufficient alarms to herald the
imminent and unprecedented collapse of the ARS market."
Write to Liz Rappaport at liz.rappaport@wsj.com5
URL for this article:
http://online.wsj.com/article/SB121691395589381297.html
Hyperlinks in this Article:
(1) http://online.wsj.com/public/resources/documents/UBS-07242007.pdf
(2) http://online.wsj.com/article/SB121677389287975701.html
(3) http://online.wsj.com/article/SB121556066791337507.html
(4) http://online.wsj.com/article/SB121448893794407103.html
(5) mailto:liz.rappaport@wsj.com
Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved
This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our
Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones
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UBS to Buy Back up to $3.5 Billion in Securities Jul. 16, 2008
Breaking News: Cuomo Announces Big Suit Against UBS Jul. 24, 2008
Cuomo v. UBS: Gotham Set to Host Auction-Rate Securities Party Jul. 23, 2008
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New York sues UBS, alleges auction-rate fraud| U.S Jul. 25, 2008 reuters.com
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7/25/2008 1:16 PM
UBS to Pay $19 Billion As Auction Mess Hits Wall Street - WSJ.com
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August 9, 2008
PAGE ONE
DOW JONES REPRINTS
UBS to Pay $19 Billion
As Auction Mess
Hits Wall Street
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By LIZ RAPPAPORT and RANDALL SMITH
August 9, 2008; Page A1
A once-obscure corner of the bond market is triggering one of the messiest Wall Street
scandals in years -- and potentially the largest mass bailout of American individual
investors ever.
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On Friday, facing allegations of wrongdoing over its sales of so-called auction-rate securities, UBS AG agreed to buy
back from investors nearly $19 billion of the investments as part of a settlement with federal and a group of state
regulators. It will start buying from individuals and charities in October and from institutional clients in mid-2010.
MORE
• Massachusetts's Top Regulator to Pursue
Complaint Against Merrill1
08/08/08
• Citi, Merrill to Pay $17 Billion to Defuse
Auction-Rate Case2
08/08/08
• Morgan Stanley Settles Auction-Rate Probe3
08/07/08
UBS was the third major firm this week to vow to buy back the securities,
which allegedly were improperly sold as higher-rate equivalents for super-safe
money-market funds.
UBS, Merrill Lynch & Co. and Citigroup Inc. have committed to taking
back a total of more than $36 billion of the instruments. Other financial firms
are expected to follow suit.
• Citi's Deal May Pressure Other Firms4
08/07/08
Auction-rate securities are a kind of debt that soared in popularity in recent
years. They let issuers such as municipalities and student-loan organizations
borrow for the long term, but at lower, short-term interest rates. The rates
reset at periodic auctions, hence the name. Wall Street sold more than $330 billion of these securities to more than
100,000 individuals and other investors.
State regulators from Massachusetts and New York have sued Merrill Lynch and UBS for civil fraud, with the UBS case
now settled. Regulators from several states have also shown up on Wachovia Corp.'s doorstep demanding documents; the
bank says it is cooperating. A New York state official has accused Citigroup of destroying documents, a charge Citi has
denied. Federal prosecutors are preparing to file criminal charges against two former Credit Suisse Group brokers who
allegedly lied to investors about auction-rate securities.
It's rare that Wall Street firms make good on client losses, and the size of the auction-rate payments is unprecedented.
But a review of several recent regulatory cases reveals the legal pressure facing Wall Street, and shows that some
authorities believe the auction-rate market, which was created in the mid-1980s, got out of control.
Regulators say that financial firms, at various times, secretly propped up failed auctions; misled investors on the safety of
the securities; pressed brokers and research analysts to sell the very securities executives were trying to unload; and
resisted client demands for relief.
'No Real Control'
"It was kind of like a Moroccan bazaar," William Galvin, secretary of the Commonwealth of Massachusetts, said in
describing the way Wall Street sold auction-rate securities. "There was no real control, no warranty, no worry about
backing up what you said."
Wall Street executives say the auction market functioned smoothly for more than 20 years, and only buckled this year
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under the stress of a credit crunch that limited their ability to provide support. As a Merrill official put it Friday, its
brokers believed such securities were "good investments" for clients seeking higher short-term returns in exchange for
some risk the assets couldn't quickly be resold.
The auction-rate scandal has hit tens of thousands of American investors, such as Ken Pugh, a 60-year old retiree in Fort
Lauderdale, Fla., who formerly supervised the delivery-truck operations for the Sun Sentinel newspaper.
Mr. Pugh has $350,000, or his entire life's retirement savings, in auction-rate securities in an account at Bank of America,
$300,000 of which are backed by student loans; his statement puts a zero in the column for the value of the $350,000.
The zero, said a person familiar with the firm, is meant to be read as "not available." Bank of America footnotes
statements to notify clients that the securities they hold are not worthless but are illiquid and not easily valued.
"I'm not a financial wizard, that's all I know," says Mr. Pugh. "I took their word for it, and like a dope, this is where I
am." Mr. Pugh says he was told the securities were "28-day CDs."
He has gone back to work at an environmental services company for extra cash to live on until he "gets some restitution,"
he says. "All the stuff my wife and I planned on doing, we can't."
Mr. Pugh has filed an arbitration claim against Bank of America. Bank of America says it "does not comment on client
relationships."
Regulators and prosecutors have alleged several kinds of abuses in the auction-rate market, detailed in regulatory cases
and investigations. One allegation is that brokers secretly propped up failed auctions.
Interest rates were supposed to be reset by weekly or monthly auctions, at which investors could cash out if they wanted
to. Until the market collapsed in February, investors got the impression there was heavy demand for the securities
because the auctions went off without a hitch. They weren't told how often Wall Street dealers stepped in to support the
auctions with their own bids.
UBS submitted such bids in all of its auctions, according to Massachusetts regulators, who said the Swiss firm acted to
prevent auction failures in no less than 69% of its 57,436 auctions between January 2006 and February 2008.
In an email to UBS executives last Dec. 15, David Shulman, who ran UBS's auction-rate desk, questioned whether the
firm should continue to submit bids to support auctions.
In the email, Mr. Shulman acknowledged that investors expected UBS to make sure the auctions ran smoothly, even as
he and others behind the scenes contemplated halting their bids entirely. "Retail clients have -- I am confident been told
that these are 'demand' notes...and will be redeemed at par on demand," Mr. Shulman wrote. While there is no formal
obligation to cash out clients at par, he added, "the moral obligation runs very deep."
UBS said it didn't intentionally hide the risks of auction-rate securities, and sold them "appropriately" to individuals for
20 years. UBS said it supported auctions "longer than any other major firm," and its inventory doubled while the number
of issues in individuals' accounts declined.
A lawyer for Mr. Shulman said his emails were "taken largely out of context" and that Mr. Shulman was attempting "to
be part of the solution, and was not part of the problem."
At Merrill, Massachusetts regulators allege, market-supporting bids by the firm "conceal[ed] the true level of investor
demand and created a false impression that there were deep pools of liquidity in the auction market." Merrill says few
auctions failed before 2008 and that it disclosed that risk and the possible withdrawal of its support bids to investors.
Another allegation by regulators is that some brokers
misled investors on the safety of the securities.
Customers often were told that the securities, which had
higher interest rates than rock-solid certificates of deposit,
were just as safe and easily sold. They weren't told that the
auctions could fail and leave them without the ability to
sell.
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'Other Cash'
Merrill categorized auction-rate securities as "other cash"
on its brokerage statements. Its marketing materials noted
that 92% of issues had a top triple-A rating. But, according
to Massachusetts investigators, clients say they weren't told
the auctions might fail if Merrill withdrew from making
bids. Merrill said that while online statements listed
auction-rate securities as cash, its "official monthly
statements" listed them as "securities," and that most were in fact triple-A.
Some UBS brokers testified to the New York attorney general's office that even they didn't realize the auctions could fail.
UBS executives testified that brokers never received any training on how auction-rate securities worked.
UBS says investor guides citing resale risks and the auction process were available online. The firm says it changed its
classification of auction-rate securities at the suggestion of an industry group as a result of this year's market difficulties.
Also, regulators say brokers were paid unusually rich commissions to sell the securities. In some cases, they say, brokers
received high commissions for a product that appeared to offer high returns but held hidden risks.
The brokers and firms typically shared commissions of 0.25% of the securities sold -- compared with 0.05% for Treasury
securities and zero for plain-vanilla money-market funds. Merrill sometimes offered extra commissions, at times up to a
total of 1%. Merrill says commissions "didn't change" brokers' approach to auction-rate securities.
To help sell the securities as the market's problems intensified, Citigroup and brokerage firm RBC Dain Rauscher last
winter raised commissions to outside brokers for selling Citi's and Dain Rauscher's auction-rate securities inventory,
according to emails sent from a Credit Suisse trading desk to Credit Suisse brokers. Dain Rauscher didn't return calls for
comment.
Commissions on auction-rate securities were "much higher than for any other equivalent securities," says auction-rate
specialist Joseph Fichera, chief executive of Saber Partners LLC, a financial consultant.
State regulators also point to the ways financial firms pressed brokers and research analysts to pitch the securities.
Merrill bond analyst Martin Mauro prepared a research report on last Aug. 22 warning of the dangers of auction-rate
securities. It said investors "need to rely on other buyers in the market to redeem the securities at par."
Altered Report
The report was never published, Massachusetts regulators say, because Frances Constable, who ran Merrill's
auction-rate-securities desk, shut it down. "It may single handedly undermine the auction market," she emailed two other
Merrill employees later that day, according to a complaint filed by the regulators. The regulators say Ms. Constable
demanded that the analyst retract and rewrite the report, which appeared the next day with language added that rising
rates made the securities "a buying opportunity."
Merrill said the retraction demand didn't change the analyst's views but merely resulted in "a longer, fuller and clearer
version." The firm said its research reflected that auction-rate securities offered "higher returns in exchange for less
liquidity." Merrill said its employees weren't available to comment.
As the credit crunch developed, financial firms faced pressure to reduce their own holdings of the securities. UBS's
holdings of them, for instance, soared through an internal limit of $2.5 billion last September, reaching $11 billon by the
time the market froze up this February.
UBS's Mr. Shulman told colleagues on Aug. 22 that he was encouraging UBS brokers "to move more product through
the system." But that same day, he sold personal holdings of auction-rate holdings worth as much as $475,000. He sold
the last of his personal auction-rate holdings by mid-December, according to the Massachusetts complaint.
The reason, he told Massachusetts investigators, was that some auctions had already failed, and they exceeded his own
"risk tolerance." UBS management brought up auction-rate securities in 15 calls with its brokers between August 2007
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and February 2008.
Mr. Shulman was one of the UBS executives alluded to, but not charged, in a civil complaint by New York State
Attorney General Andrew Cuomo. Mr. Shulman was named but not charged in the Massachusetts regulatory complaint
for selling his own stake in auction-rate securities in August.
UBS said that, after its own internal probe, it "found cases of poor judgment" but not illegality by certain individuals, and
is "evaluating appropriate disciplinary measures." UBS placed Mr. Shulman on administrative leave in July. Mr.
Shulman's lawyer declined to comment on the securities sale.
Brokers at Credit Suisse allegedly misled customers about the safety of auction-rate issues by falsely calling them
"student loan" securities, according to a civil suit filed Wednesay. The plaintiff, Geneva chip maker STMicroelectronics
NV, was filed Brooklyn federal court and seeks $415 million in damages. Federal prosecutors in Brooklyn, N.Y., are
preparing to file criminal charges against two former Credit Suisse brokers whose clients included the chip maker,
according to people familiar with the matter.
Credit Suisse said the brokers resigned in September after the firm "detected their prohibited activity," and that the firm
has been assisting authorities. Credit Suisse said clients were given accurate trade confirmations and brokerage-account
statements. As for the action filed by ST Microelectronics suit, a spokesman for Credit Suisse said it "declines to
comment on meritless lawsuits."
It isn't clear how much in losses Wall Street firms ultimately will record by taking auction-rate securities back on their
books. That will depend on if, when and how much the market recovers.
In UBS's Friday settlement, the Swiss bank agreed to buy back $8.3 billion in securities from individuals and charities
and $10.3 billion later from institutions. It also has agreed to lend money to holders of the securities at 100% of their par
value if they preferred.
On Thursday, Merrill agreed to buy back about $10 billion from about 30 ,000 investors, and Citigroup agreed to buy
back about $7.3 billion from about 40,000 investors.
Write to Liz Rappaport at liz.rappaport@wsj.com5 and Randall Smith at randall.smith@wsj.com6
URL for this article:
http://online.wsj.com/article/SB121820203736224137.html
Hyperlinks in this Article:
(1) http://online.wsj.com/article/SB121823095152225497.html
(2) http://online.wsj.com/article/SB121811899419820631.html
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(4) http://online.wsj.com/article/SB121806922599718905.html
(5) mailto:liz.rappaport@wsj.com
(6) mailto:randall.smith@wsj.com
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RELATED ARTICLES FROM ACROSS THE WEB
Related Articles from WSJ.com
•
•
•
•
Massachusetts's Top Regulator Galvin Will Pursue Complaint Against Merrill Aug. 08, 2008
Merrill Offers to Buy Back Securities Aug. 07, 2008
UBS to Cash Out of ARS Party, Will Buy Back $19.4 Billion Worth Aug. 08, 2008
Cuomo’s Threat of a Suit Could Net First Settlement in ARS Party Aug. 06, 2008
Related Web News
•
•
•
•
Unlocking the Auction-Rate Mess - Barrons.com Aug. 09, 2008 online.barrons.com
Banks line up to make investors whole Aug. 08, 2008 money.cnn.com
UBS to settle securities case for $19.4B Aug. 08, 2008 npr.org
2 Banks Buying Back $17 Billion in Securities - NYTimes.com Aug. 08, 2008 nytimes.com
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8/9/2008 8:49 PM
Credit Crisis Strains Government's Options - WSJ.com
http://online.wsj.com/article_print/SB122117886133526039.html
September 12, 2008
DOW JONES REPRINTS
Credit Crisis Strains
Government's Options
By JON HILSENRATH, DAVID ENRICH and DEBORAH SOLOMON
September 12, 2008; Page A1
A year into a credit crisis that started with troubled mortgages to sketchy
borrowers, the financial system is reeling once again, casting a pall over a
widening array of financial institutions just days after history-making efforts
by policy makers to contain the problem.
QUESTION OF THE DAY
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With the share prices of Lehman Brothers Holdings Inc.,
Merrill Lynch & Co. and other financial firms on a roller
coaster, the crisis could be entering a critical stage.
The Federal Reserve has already slashed interest rates to counteract a deepening credit freeze and
instituted its broadest expansion of lending facilities since the Great Depression to keep financial markets
functioning. Over the weekend, the nation's two main mortgage finance firms -- Fannie Mae and Freddie
Mac -- were placed under government control.
Federal officials and market players are struggling with the same issues: Why haven't the steps taken so
far calmed the system? What can policy makers do next? Should the U.S. government let a big institution
fail rather than stage another potentially costly bailout?
Lehman, one of Wall Street's last big independent firms, saw its stock plunge 42% a day after the
company unveiled a plan to shrink itself as a way to ride out the crisis. It is now in talks to be sold
altogether, though it's not clear there will be takers.
The Federal Reserve and Treasury Department have been working with Lehman to help resolve its
troubles, including talking to potential buyers, according to people familiar with the matter. A rescue like
those of Fannie, Freddie and Bear Stearns Cos. isn't currently expected, but much can change in the days
ahead.
Merrill Lynch shares were down 17% to $19.43 a share Thursday. Washington Mutual Inc., the nation's
largest savings and loan, which replaced its CEO this week, came under heavy selling pressure early in
the day. After dipping below $2, the stock rallied to gain 51 cents to finish at $2.83 in 4 p.m. New York
Stock Exchange Composite trading. The stock is still down 34% since Monday.
In some ways, broader financial markets
are taking the latest drama in stride, a cause
for some reassurance. The Dow Jones
Industrial Average has traded in a range
between 11200 and 11800 since July.
Though the Dow is down for the year,
stocks in Europe and Asia have performed
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much worse.
Among the reasons for optimism: Falling oil
prices could eventually provide relief to
consumers and a stronger dollar has taken
pressure off inflation. U.S. officials hope
that the rescue of Fannie and Freddie will
help lower mortgage rates, and financial
firms have already raised billions of dollars
of fresh capital.
But other measures of financial conditions
are as bad as they were back in March,
when the Fed and Treasury arranged the
abrupt takeover of Bear Stearns by J.P.
Morgan Chase & Co. For instance, junk
bonds now yield 8.55 percentage points
more than safe Treasury bonds, a spread
that is about as wide as it was in March.
These spreads widen as investors become
more fearful about risk.
Banks are also finding it more costly to fund themselves. Wells Fargo & Co. of San Francisco, which has
weathered the crisis better than most peers, was forced this month to promise higher-than-expected yields
on debt securities it issued in order to lure nervous investors. Last month, Citigroup Inc., American
International Group Inc. and American Express Co. all faced weak demand for bond issuances that
pushed up the yields they had to pay.
"The market has no tolerance for uncertainty," says Laurence Fink, chief executive of money manager
BlackRock Inc.
Three problems are behind the latest wave of trouble.
First, the economy shows signs of weakening as stimulus from federal tax rebates wears off. A survey of
51 economists for The Wall Street Journal projects that consumer spending will contract in the third
quarter for the first time in 17 years. Lower energy prices are helping, but might not be enough to counter
the heavyweights of the housing crunch and job cuts.
Second, households and financial institutions aren't finished with a painful process known as
deleveraging, in which they reduce their reliance on debt.
Home Prices
These two processes -- deleveraging and soft consumer spending -- can feed on each other, something
economists call an adverse feedback loop. Deleveraging puts downward pressure on home prices. That, in
turn, forces financial institutions to deleverage more. In the same way, falling home prices squeeze
households, which forces them to cut back on spending and puts off a housing recovery, further weighing
on home prices.
Federal Reserve Vice Chairman Donald Kohn made note of these feedback effects in comments on the
housing market Thursday. Despite some signs that home prices were stabilizing recently, he noted that
mortgage conditions were getting tighter, which could ultimately weigh on prices. "In my view, the jury is
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still out on whether housing prices are close to finding a bottom," he said.
The government's many interventions have been designed to break this feedback cycle. But such efforts
increasingly show signs of running up against their limits. "There's no trend of improvement. It's not
improving even slowly," says Laurence Meyer, a former Fed governor and now vice chairman of
Macroeconomic Advisers LLC, an economic-forecasting firm.
Raising Capital
A third wrinkle is that financial firms are having an increasingly hard time raising the capital they need to
hasten the process of deleveraging. In the past year, sovereign-wealth funds and others have poured
billions of dollars of fresh capital into Lehman, Merrill Lynch, Citigroup and others.
Stung by mammoth losses on those investments, many investors are now balking. Sovereign-wealth funds,
many of them facing criticism at home over the investments, have stayed on the sideline as Lehman and
other firms have struggled to raise capital.
In the Middle East, some sovereign-fund managers say their portfolios are now heavy on U.S. and
European holdings after the recent buying spree. They're scouting for opportunities elsewhere, such as
India, Asia and closer to home.
Private-equity firms face different hurdles. If they own too much of an institution that accepts deposits,
they would open themselves to federal regulation as bank-holding companies. The rules limit them to less
than 25% of the voting stock of a regulated depository institution.
Since April's large cash infusions into Washington Mutual Inc. and National City Corp., private-equity
firms -- with some $450 billion in untapped funds, according to London-based data provider Preqin -haven't made any major investments in capital-starved banks.
Executives from such firms as Carlyle Group and Blackstone Group have been using the credit crunch to
lobby the Office of Thrift Supervision and the Federal Reserve to allow them to own bigger stakes of
financial firms without having to face regulation.
"At some point, that flow of capital to financial institutions will dry up, and we'll still have most of the
issues for regional banks, in terms of defaults and credit problems, still ahead of us," Blackstone President
Tony James said last month. "So maybe I'm giving an advertisement for our own business, but I think that
the economy would be well suited to find ways to bring private-equity capital into the financial sector."
The recent government rescues may have backfired by making investors more wary of investing in
capital-hungry firms. In the cases of Bear Stearns, Fannie and Freddie, federal officials' strategy was to
protect debtholders. But their interventions were also clearly designed to not bail out stock investors.
Now stock investors are worried that they could be wiped out if they pump money into firms that could
fail. "It seems unthinkable to intervene for the benefit of shareholders," says Mr. Meyer of
Macroeconomic Advisers.
Lehman provides the starkest recent example of the difficulty of raising capital. In early April it was able
to raise $4 billion by issuing convertible preferred shares. Demand then was so strong that it increased the
number of shares it issued. Since then, however, its share price has sunk more than 90%. After talks fell
through for fresh capital from a Korean bank, Lehman announced plans to shed assets and slash its
dividend. Its share prices have continued to sink.
Confronting the Crisis
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U.S. officials are not powerless to confront the crisis. But they are far more constrained than they were a
year ago, after taking a series of steps to bolster financial markets, including slashing interest rates.
The Fed now has facilities in place to provide short-term funding to firms such as Lehman if it runs into a
liquidity crisis. As of Wednesday, no firms had used the Fed's lending facility for investment since late
July.
"A number of markets remain disrupted and illiquid," the Fed's Mr. Kohn said Thursday. "But I believe
that they would have been even more illiquid and the risk of disruption runs even greater without our
various facilities."
Doing more could lead to other problems. Fed officials are wary of pushing short-term interest rates
lower. At 2%, the federal-funds rate is 3.25 percentage points lower than it was a year ago, and looks
likely to stay on hold because the Fed worries that more rate cuts would worsen inflation. What's more,
other interest rates, such as mortgage rates, remain elevated as previous rate cuts have been counteracted
by the force of the credit crunch. It's not clear that further cuts would have much effect in bringing down
other rates.
Officials are also acutely aware of the problem of "moral hazard." Bailing out too many firms, the
reasoning goes, would encourage more risk taking in the future. That makes officials reluctant to be seen
as rescuing another institution. The Fed made a $29 billion loan to help J.P. Morgan take over Bear
Stearns. It's not clear that it would be willing to do that for another firm.
Treasury Secretary Henry Paulson has said that institutions must be allowed to fail and that markets can't
expect the government to lend money or support every time there's a crisis. "For market discipline to
constrain risk effectively, financial institutions must be allowed to fail," Mr. Paulson said in a speech in
July.
Bound Together
But the government is in somewhat of a bind, one that Mr. Paulson himself has noted. Financial markets
are now bound together by complex financial instruments like credit-default swaps and certain moneymarket instruments that firms and regulators have limited experience handling in a crisis. They worry that
problems could spread more widely through the system through the use of these instruments. Regulators
are working on addressing the clearing and settling of these instruments but aren't finished, and worry that
the failure of a firm could send ripple effects far and wide.
Moreover, Mr. Paulson, along with Federal Reserve Chairman Ben Bernanke, has called for a formal
procedure for facilitating a disposition of assets when an investment bank fails. But no such procedure yet
exists, complicating any decision by the government to let an institution fail. Efforts to modernize other
markets, like the market for credit-default swaps and repurchase agreements, are also incomplete.
"Today, our tools are limited," Mr. Paulson said in his July speech.
Policy makers could ultimately find themselves in a situation similar to one they faced a decade ago when
a global financial crisis was sweeping from country to country.
Starting in mid 1997, the International Monetary Fund, pushed by the U.S. Treasury, mounted
multibillion-dollar bailouts of Thailand, Indonesia and Korea. By August 1998, when Russia threatened to
default on its bonds, the Treasury and Federal Reserve decided to pull the plug. Another rescue would
have thrown good money after bad, they figured.
One of those opposing a prospective bailout was Timothy Geithner, then a senior Treasury official, now
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President of the Federal Reserve Bank of New York, which played a central role in the Bear Stearns
rescue. Mr. Geithner now has to help decide whether Lehman will become the Russia of this financial
crisis.
"Everyone thought Russia was too nuclear to fail," says Ted Truman, who was a senior Federal Reserve
official at the time and worked closely with the U.S. Treasury. "But we let it fail."
Markets, shocked by the U.S. inaction, were battered by Russia's default. A similar anxiety is weighing on
investors now.
"You could argue that you should let Lehman go. Everyone knows it's been on the ropes since May. It
wouldn't shock the market," says Mr. Truman. "But the reason to [rescue it] is not to create more chaos"
in the market, which could require yet more federal intervention later on.
--Carrick Mollenkamp, Peter Lattman, Tom Lauricella and Sudeep Reddy contributed to this article.
Write to Jon Hilsenrath at jon.hilsenrath@wsj.com2, David Enrich at david.enrich@wsj.com3 and
Deborah Solomon at deborah.solomon@wsj.com4
URL for this article:
http://online.wsj.com/article/SB122117886133526039.html
Hyperlinks in this Article:
(1) http://forums.wsj.com/viewtopic.php? t=3972
(2) mailto:jon.hilsenrath@wsj.com
(3) mailto:david.enrich@wsj.com
(4) mailto:deborah.solomon@wsj.com
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SEPTEMBER 17, 2008
Financial Turmoil Slams Global Markets
Central Banks Boost Capital as AIG Worry Jars Share Indexes
By L AURA SANT INI
HONG KONG -- Share prices in Asia and Europe swooned Tuesday and central banks
moved to add capital to markets as the fate of American Insurance Group Inc. intensified
investor worries that Wall Street's growing troubles would have global repercussions.
Markets in Shanghai, Hong Kong and Tokyo -- closed Monday because of holidays -registered big drops Tuesday as investors digested major blows to Wall Street's
confidence and Monday's 4.4% drop in the Dow Jones Industrial Average, its steepest
fall in more than six years.
Elsewhere, markets remained turbulent Tuesday, with U.S. markets volatile but near their
starting point ahead of an expected announcement by the Federal Reserve on interest
rates Tuesday. European markets were mostly down in intraday trading.
Blows to the financial sector in recent days included the bankruptcy filing Monday of
Lehman Brothers Holdings Inc. and the deal by Bank of America Corp. to purchase
Merrill Lynch & Co. Lehman's filing led regulators in South Korea to suspend the firm's
local businesses, while some Japanese banks detailed financial hits and the investment
bank suspended operations in Hong Kong. The filing also threw a stumbling block in front
of Citic Group's plan to buy shares of Citic International Financial Holdings Ltd., an
agreement on which Lehman advised.
But it was worry about New York-based AIG, which Tuesday morning in the U.S. was
pursuing ways to come up with billions in extra collateral and payments for certain
products following credit downgrades by Standard & Poor's and Moody's Investors
Service, that underscored most strongly the financial sector's sensitive state. The
insurance titan touches many parts of the financial world, insuring everything from big
corporate ventures to the executives who run them, plus other financial services and
interests in real estate and other businesses.
"The turmoil surrounding the financial sector looks like a complex web that will no doubt
flow through to many other layers of the global economy," said IG Markets sales trading
head Harley Salt. Added a broker in Melbourne, "The biggest fear is: who's next?"
AIG is an insurance giant across Asia, where its $14 billion of premiums last year were
double the total from its business in the U.S. A number of its Asian units said Tuesday
they are independent and have enough capital to meet all policy claims.
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On Tuesday, the European Central Bank pumped €70 billion ($100.2 billion) in one-day
funds into euro-zone money markets, more than double its Monday injection of €30
billion. The Bank of Japan injected 2.5 trillion yen ($23.84 billion) into Japanese money
markets in two separate transactions, pledging to ensure stability. In Taiwan, the central
bank trimmed capital-reserve ratios on deposits held by commercial banks, a move
which the central bank assured would pump about 200 billion Taiwanese dollars ($6.23
billion) into the banking system.
The Bank of England offered £20 billion ($36.05 billion) in extra two-day funds, atop
Monday's £5 billion in extra three-day funds. Central banks in Australia and India have
also taken steps to infuse fresh capital into their markets.
The moves followed other efforts to jump-start the world's economies, including China's
lowering of interest rates Monday for the first time in more than six years.
Still, investors fled equities. In Tokyo, the Nikkei 225 Stock Average fell 5%, while
indexes in South Korea and Hong Kong dropped 6.1% and 5.4%. Taiwan's index ended
the day down 4.9%. The Shanghai Composite, which tracks domestically listed Chinese
companies, sank 4.5%.
European markets weakened further during the day. London's FTSE 250 was down
3.4% intraday, while Paris was down 2% and Frankfurt 1.6%. In Russia, shares were
down 10% in afternoon trading. In the U.S., the Dow Jones Industrial Average was flat
ahead of a decision on interest rates by the Federal Reserve.
Investors fled to havens like bonds. Credit-default spreads widened to record levels, as
investors showed willingness to pay up for contracts that are essentially insurance
policies in case Asian corporations default on their debt.
Doffing of risk by investors also hurt some Asian currencies, which sagged as the U.S.
dollar attracted flight-to-safety flows. The South Korean currency, the won, hit a
four-year low against the U.S. dollar, dropping nearly 4.5% from Monday's close to
1,165.8 won per dollar. Year-to-date, the won has weakened 19.4% against the dollar.
The Indian rupee, which has lost about 15.5% against the dollar, dropped 1.4% on
Tuesday to 46.63 rupees per dollar. The Australian currency also came under pressure,
falling to $0.7881, its lowest level since August 2007.
The financial sector's woes complicate efforts by Asian policy makers to rein in inflation.
China's rate cut Monday signaled a shift by authorities from worrying about how to
contain inflation to supporting growth, some market watchers said. "China is not going to
stop here," said Irene Cheung, head of ABN Amro's local markets research group in
Singapore.
Ms. Cheung wondered, however, whether Asian central banks -- apart from China's -really have room to maneuver on interest-rate policies as they balance twin necessities
of fostering growth and containing inflation, which is reaching record levels in countries
such as Malaysia.
Analysts, portfolio managers and sell-side traders say that investors in Asia are waiting
to see how events unfold in the U.S., including a potential rate cut by the Federal
Reserve. Murkiness around how AIG intends to save itself also caused investors to flee.
"No one wants to put money to work until there's clarity about that," said one trader at a
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Western investment bank about AIG.
Some continue to see Asia as one-step removed from the financial storm. They point out
strong corporate balance sheets and fat coffers of central banks. They also noted that
some indexes and individual stocks closed above their lows Tuesday, an indication that
investors aren't in panic-mode regarding Asia's prospects within a weakening global
economy. Australia's S&P/ASX 200 benchmark, for instance, finished down 1.4%, after
losing 2.7% earlier in the trading day.
While retail investors are primarily pulling money out of stocks, some institutions say
they are "waiting on the sidelines" or even trying to pick up a few bargains. "We haven't
jumped in up to the eyeballs, but we have been buying steadily," says Hugh Young,
Singapore-based chief of Aberdeen Asset Management Asia. "What makes us really
comfortable is that balance sheets are strong," he said.
—Joellen Perry in Frankfurt and Rosalind Mathieson in Singapore contributed to this article.
Write to Laura Santini at laura.santini@wsj.com
Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved
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SEPTEMBER 16, 2008
U.S. Plans Rescue of AIG to Halt Crisis;
Central Banks Inject Cash as Credit Dries Up
$85 Billion Loan for Giant Insurer Aimed at Averting Collapse;
Historic Move Would Cap 10 Days That Reshaped U.S. Finance;
Fed Says AIG Will Sell Businesses in Orderly Manner
By MAT T HEW KARNIT SCHNIG , DEBO RAH SO L O MO N and L IAM PL EVEN
The U.S. government announced an emergency rescue of American International Group
Inc. -- one of the world's biggest insurers -- signaling the intensity of its concerns about
the danger a collapse could pose to the financial system.
It's a dramatic turnabout for the federal government, which has strongly resisted
overtures from AIG for an emergency loan or some intervention that would prevent the
insurer from falling into bankruptcy. Just last weekend, the government effectively pulled
the plug on Lehman Brothers Holdings Inc., allowing the big investment bank to fail
instead of giving it financial support.
The precise details of the government's plans were still being formulated late Tuesday.
The primary option being hammered out involved the Fed providing AIG with a short-term
"bridge" loan of $85 billion, according to people familiar with the situation. In exchange,
the government would receive warrants in AIG representing the right to buy its stock,
under certain conditions. That could put the government in a position to potentially
control a private insurer, a historic move, particularly considering that AIG isn't directly
regulated by the federal government.
The moves capped a day of high drama in Washington. Treasury Secretary Henry
Paulson and Federal Reserve Chairman Ben Bernanke convened in the early evening an
unexpected meeting of top congressional leaders, including Sen. Harry Reid of Nevada,
the majority leader, top members of the Senate Banking Committee and leaders, too,
from the House.
Sen. Richard Shelby of Alabama said he didn't receive a "satisfactory" answer from Mr.
Paulson in an early conversation about the ultimate scope of government intervention. "I
laid out -- where do you stop? Where do you draw the line?"
The Federal Reserve appeared to be motivated in part by worries that Wall Street's
financial crisis could begin to spill over into seemingly safe investments held by small
investors, such as money-market funds that invest in AIG debt.
Indeed, on Tuesday the $62 billion Primary Fund from the Reserve, a New York moneymarket firm, said it "broke the buck" -- that is, its net asset value fell below the
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$1-a-share level that funds like this must maintain. Breaking the buck is an extremely
rare occurrence. The fund was pinched by investments in bonds issued by now
collapsing Lehman Brothers.
Money-market funds are supposed to be among the safest investments available. No
fund in the $3.6 trillion money-market industry has lost money since 1994, when Orange
County, Calif., went bankrupt. A number of money-market funds own securities issued
by AIG. The firm is also a big insurer of some money-market instruments.
AIG's financial crisis intensified Monday night when its credit rating was downgraded,
forcing it to post $14.5 billion in collateral. The insurer has far more than that in assets
that it could sell, but it could not get the cash quickly enough to satisfy the collateral
demands. That explains the interest in obtaining a bridge loan to carry it through. AIG's
board approved the rescue Tuesday night.
The final decision to help AIG came Tuesday as the federal government concluded it
would be "catastrophic" to allow the insurer to fail, according to a person familiar with the
matter. Over the weekend, federal officials had tried to get the private sector to pony up
some funds. But when that effort failed, Fed Chairman Bernanke, New York Fed
President Timothy Geithner and Treasury Secretary Paulson concluded that federal
assistance was needed to avert an AIG bankruptcy, which they feared could have
disastrous repercussions.
Staff from the Federal Reserve and Treasury worked on the plan through Monday night.
President George W. Bush was briefed on the rescue Tuesday afternoon during a
meeting of the President's Working Group on Financial Markets.
That the government would prop up AIG financially offers a stark indication of the
breadth of the insurer's role in the global economy. If it were to have trouble meeting its
obligations, the potential domino effect could reach around the world.
For one thing, banks and mutual funds are major holders off AIG's debt and could take a
hit if the insurer were to default. In addition, AIG was a major seller of "credit-default
swaps," essentially, insurance against default on assets tied to corporate debt and
mortgage securities. Weakness at AIG could force financial institutions in the U.S.,
Europe and Asia that bought these swaps to take write-downs or losses.
AIG's millions of insurance policyholders appear to be considerably less at risk. That's
because of how the company is structured and regulated. Its insurance policies are
issued by separate subsidiaries of AIG, highly regulated units that have assets available
to pay claims. In the U.S., those assets can't be shifted out of the subsidiaries without
regulatory approval, and insurance is also regulated strictly abroad.
Tuesday afternoon, after the market closed, AIG put out a statement saying its basic
insurance and retirement services businesses are "fully capable of meeting their
obligations to policyholders." AIG said it was trying to "increase short-term liquidity in the
parent company," but said that didn't "include any effort to reduce the capital of any of
its subsidiaries or to tap into Asian operations for liquidity." Asia is one AIG's largest
markets.
Where the company is feeling financial pain is at the corporate level, even while its
insurance operations are healthy. If a bankruptcy filing did ensue, the insurance
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subsidiaries could continue to operate while in Chapter 11, or could also be sold.
Still, a collapse of the parent company would have huge ripple effects. The urgency of
federal aid came into stark relief Tuesday as other options fell off the table and
pressures continued to build. On Tuesday, AIG's attempt to raise as much as $75 billion
from private-sector banks failed. The banks advising the firm concluded it would be all
but impossible to organize a loan of that size, making the government AIG's chief hope.
The AIG bailout caps a tumultuous 10 days that have remade the American financial
system. In that time, the government has engineered rescues that insert it deep into the
housing and insurance industries, while Wall Street has watched two of its last four big
independent brokerage firms exit the scene.
The U.S. on Sept. 6 took over mortgage-lending giants Fannie Mae and Freddie Mac as
they teetered near collapse. This Sunday, the U.S. refused to bail out Wall Street pillar
Lehman Brothers, which filed for bankruptcy and is now being sold off in pieces. That
same day, another struggling Wall Street titan, Merrill Lynch & Co., sold itself to Bank of
America Corp..
As a result of AIG's credit downgrades, the insurer has to post $14.5 billion in collateral
to bolster its credit rating. In the debt markets, AIG also has to post additional collateral to
investment banks and others it trades with.
Adding to AIG's woes, investors continued to pummel the company's stock on Tuesday,
pushing the share price down another 21%, to $3.75. It was the third double-digit
percentage decline in the last three trading days.
Federal officials worked throughout the day to help the company forestall a possible
bankruptcy filing. Insurance regulators in New York, where AIG is based, are also
working on a plan to let AIG move some assets into and out of its subsidiaries in order to
be able to borrow up to $20 billion against some of them. But a spokesman says the
department is confident it is protecting policyholders.
"Our deal is contingent on a broader solution to AIG's problems," says the department
spokesman, David Neustadt.
AIG's cash squeeze is driven in large part by losses in a unit separate from its traditional
insurance businesses. That financial-products unit, which has been a part of AIG for
years, sold the credit-default swap contracts designed to protect investors against default
in an array of assets, including subprime mortgages.
But as the housing market has crumbled, the value of those contracts has dropped
sharply, driving $18 billion in losses over the past three quarters and forcing AIG to put
up billions of dollars in collateral. AIG raised $20 billion earlier this year. But the ongoing
demands are straining the holding company's resources.
That strain contributed to the ratings downgrades on Monday. Those downgrades, in
turn, ratcheted up the pressure on the company to come up with more cash, quickly.
Most insurance companies don't have financial-products units like these. But over nearly
four decades, former CEO, Maurice R. "Hank" Greenberg built AIG into a firm that
resembled no other. He transformed its insurance business, both by expanding abroad -notably in China, where AIG has its roots -- and by buying up other firms.
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Mr. Greenberg pushed into areas that have little to do with bread-and-butter businesses
like selling life insurance or protecting companies against property losses. In 1990, for
instance, he bought International Lease Finance Corp., which leases planes to airlines.
But in 2005, Mr. Greenberg stepped down amid an accounting scandal. But Mr.
Greenberg, who is fighting civil charges related to the scandal and has denied
wrongdoing, didn't fade from the scene. He still heads a firm that is AIG's largest
shareholder, and on Tuesday, he sent a letter to current CEO, Robert Willumstad, saying
he was "ready to offer any assistance that I can."
As confidence in AIG's fate has plummeted, the amount of money it feels compelled to
raise to calm its many constituents continues to rise. Though $40 billion was the figure
over the weekend, it climbed to 75 billion on Monday and, according to a person close to
the company, to $100 billion on Tuesday.
The rapid escalation in its potential needs has raised the spectre of bankruptcy. In
preparation for a possible bankruptcy filing, AIG has hired New York law firm Weil
Gotshal & Manges to advise it. Weil is also working for Lehman Brothers Holdings, which
filed for bankruptcy protection earlier this week.
The ratings downgrades also triggered a provision in some of AIG's large commercial
insurance policies that allow holders to cancel the policies and recoup some of the
premiums they paid, according a person familiar with the matter. It's not clear whether
policyholders are exercising that right.
But insurance brokers are contending with worried clients who have policies issued by
AIG. Daniel Glaser, the head of the brokerage unit at Marsh & McLennan Cos. (and a
former AIG executive) posted a letter to customers on the company's Web site saying
that AIG is "facing a liquidity crisis." Nonetheless, Mr. Glaser wrote that AIG meets the
broker's "financial guidelines," despite recent rating downgrades. "Therefore, we have no
restrictions on the use of AIG insurance company subsidiaries for client placements,"
Mr. Glaser wrote.
In Asia, where AIG operates a wide network of businesses, its affiliates sought to
reassure clients that they had sufficient capital to meet all policy claims. Regulators in
India, Hong Kong, Singapore and Thailand said local AIG units have enough capital to
cover their obligations. Regulators in China said they were monitoring the situation.
Customers outside the U.S. accounted for 79% of AIG's insurance premiums for life
insurance and retirement services last year. Japan and Taiwan are among AIG's largest
markets.
Despite reassurances from regulators that their policies were covered and warnings that
cancellations could lead to losses, dozens of people lined up outside AIG-affiliated
offices in Singapore. Some waited for three hours to be attended by staffers. Others
said that they wanted to make sure that their policies are safe, while others said they
would cancel their policies.
—Jon Hilsenrath, Diya Gullapalli, Serena Ng, Damian Paletta and Ashby Jones contributed to this article.
Write to Matthew Karnitschnig at matthew.karnitschnig@wsj.com, Deborah Solomon at
deborah.solomon@wsj.com and Liam Pleven at liam.pleven@wsj.com
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SEPTEMBER 18, 2008
Mounting Fears Shake World Markets
As Banking Giants Rush to Find Buyers
By T O M L AURICEL L A, L IZ RAPPAPO RT and ANNEL ENA L O BB
Fear coursed through the U.S. financial system on Wednesday, as hope for a resolution
to the year-old credit crisis faded.
Stocks tumbled, concern grew about which financial firm would fall next, and investors
rushed toward the safe haven of government bonds in the wake of the collapse of
Lehman Brothers Holdings Inc. and the crisis at insurer American International Group.
The market turmoil is doing more than inflicting losses on investors. Borrowing costs for
U.S. companies have skyrocketed, and the debt markets have become nearly
inaccessible to all but the most creditworthy borrowers.
The desperation was especially striking in the market for U.S. government debt, long
considered the safest of investments. At one point during the day, investors were willing
to pay more for one-month Treasurys than they could expect to get back when the bonds
matured. Some investors, in essence, had decided that a small but known loss was better
than the uncertainty connected to any other type of investment.
That's never happened before. In a special government auction on Wednesday, demand
ran so high that the Treasury Department sold $40 billion in bills, far beyond what it
needed to cover the government's obligations.
"We've seen crisis. We've seen recession. But we've not seen the core of the financial
system shaken like this," says Joseph Balestrino, a portfolio manager at Federated
Investors. "It's just crazy."
A 449-point selloff took the Dow Jones Industrial Average to its lowest level in almost
three years, leaving it 23% below where it stood a year ago. Volume on the New York
Stock Exchange was the second highest in history, falling just shy of the record set on
Tuesday. The VIX, a widely watched measure of market volatility that is often referred to
as the "fear index," shot up to its highest level since late 2002.
In Europe, stock markets lost roughly 2% of their value. In Russia, the scene of recent
massive declines, trading on the country's major exchanges was halted for the second
day in a row, this time only an hour and a half into the session. Gold prices rose 9% to
$846.60 an ounce amid the global turmoil.
"Forget about retail investors, all the pros are scared," says one broker. "People have no
idea where to put their money."
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For now, "if you have cash, you're going to put it in the short-term, most liquid stuff you
can," says Steve Van Order, fixed-income strategist for Calvert Asset Management.
Adding to the fear was a loss in a prominent money-market fund, the Reserve Primary
Fund, which held Lehman Brothers debt. It was the first time since 1994 that such a
fund, which is supposed to be as safe as a bank account, had lost money. The loss was
made worse by a run on the fund. Over two days, investors pulled more than half of their
assets from the fund, once valued at $64 billion.
"This is a panic situation" in the bond markets, says Charles Comiskey, head of U.S.
government-bond trading in New York at HSBC Securities USA Inc.
Riskier assets were sold off. Yields on bonds issued by financial companies hit a record
high of about six percentage points above U.S. Treasurys. In the market for creditdefault swaps -- essentially insurance against default on assets tied to corporate debt
and mortgage securities -- fears increased on Wednesday about whether counterparties
would be able to honor their agreements. Investors tried to reduce their exposures to two
more big players in the market, Goldman Sachs and Morgan Stanley. That sent the cost
of protection on both Wall Street firms soaring to new highs.
In the stock market, the pressure on financial firms continued, with Morgan Stanley stock
dropping 26% and Goldman Sachs shares losing 19%.
Investors say the government takeover of AIG and Lehman's bankruptcy are evidence
that the situation is grimmer than all but the most pessimistic had expected. Problems
have spread from complex debt markets tied directly to the housing market into plainvanilla corporate bonds.
"Another front is opening," says Ajay Rajadhyaksha, head of fixed-income research at
Barclays Capital.
Some fear that the dwindling ranks of investment banks, coming at a time when
commercial banks are pulling back on their own use of capital, will prolong the credit
crunch.
"It's unclear who is going to be a credit provider going forward, and if having fewer credit
providers means higher costs of borrowing going forward," says Basil Williams, chief
executive of hedge-fund managers Concordia Advisors.
Ordinarily, bondholders are better protected from losses than stock investors. But the
events of the past two weeks have shown that they are vulnerable, too. The Federal
Reserve's rescue of AIG doesn't protect the company's bondholders. That's because the
deal, which consists of a high-priced loan to the company from the government, requires
AIG to pay the Treasury before current bondholders. If AIG can't raise enough cash by
selling assets, bondholders won't be fully repaid.
As a result, despite the Fed lifeline, some AIG debt is changing hands at just 40 cents on
the dollar, less than half of the price one week ago. Now that Lehman has defaulted on
its debt, its senior bonds are worth as little as 17 cents on the dollar, traders say.
That's spilled over to other financial names seen as under stress. Bonds of Morgan
Stanley are trading at around 60 cents on the dollar. Goldman Sachs's bonds are trading
at prices in the range of 70 cents on the dollar.
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As the bond prices dropped, their yields rose. The spread between yields on corporate
bonds and safe U.S. Treasurys have blown out to the widest levels traders have seen in
years. On Wednesday, yields on investment-grade corporate bonds were more than four
percentage points higher than comparable Treasury bonds, according to Merrill Lynch.
Junk bonds ended the day more than nine percentage points over Treasurys,
approaching the 2002 high of 10.6 percentage points, according to Merrill.
Short-term debt markets, where companies borrow overnight or in periods up to one
year, have dried up. The money-market fund managers who normally buy such
short-term debt have suffered losses on their holdings of debt in Lehman Brothers and
other financial institutions.
If companies can't borrow in the short-term debt markets, they may be forced to draw
down on their revolving credit lines, yet another drain on banks' dwindling capital.
The Lehman bankruptcy also pressured the market for leveraged loans, which are used
by private-equity firms to finance buyouts. When the firm attempted to sell some of its
loan holdings earlier this week, prices dropped toward 85 cents on the dollar, according
to Standard & Poor's Leveraged Commentary & Data.
The damage has gone beyond banks and brokerages. Ford Motor Credit Co., the
finance arm of Ford Motor Co., paid 7.5% for overnight borrowings on Wednesday,
says one trader. Typically, the rate for such debt would be about one-quarter percentage
point over the federal-funds rate, which is currently 2%, he says. Even for companies
considered of the safest credit quality, the cost of overnight debt is soaring. General
Electric Co. was forced to pay 3.5% for overnight borrowing on Wednesday, the trader
says. In normal times, GE, which has the highest debt rating, would have to pay the
equivalent of the federal funds rate.
"There's no evident catalyst for ending the pain," says Guy Lebas, chief fixed-income
strategist at Janney Montgomery in Philadelphia.
—Emily Barrett and Min Zeng contributed to this article.
Write to Tom Lauricella at tom.lauricella@wsj.com, Liz Rappaport at
liz.rappaport@wsj.com and Annelena Lobb at annelena.lobb@wsj.com
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Short Squeeze: Fewer I-Banks, Fewer Places for Hedgies to Borrow Stock
Posted By Heidi N. Moore On September 18, 2008 @ 1:35 pm In Crisis on Wall Street, Hedge Funds, Investment Banks
| 27 Comments
“Capitalists,” declared Lenin, “will sell us the rope with which we will hang them.”
Lenin wasn’t a short-seller, but his words apply rather neatly as Morgan Stanley and Goldman Sachs Group watch
their stocks plummet another 30% today. Morgan Stanley CEO John Mack yesterday blamed short-sellers for the
sudden plunge in the stocks of his firm and Goldman Sachs. It was just the latest accusation that short-sellers have
targeted securities firms, and regulators including the U.K.’s Financial Services Authority and the SEC have plans to
rein in the practice. But perhaps investment bankers should look inward. After all, the investment banks are the
biggest lenders of stock to short-sellers.
Here is how it works: investment banks such as Morgan Stanley, Goldman, Lehman Brothers Holdings, Merrill Lynch
and Bear Stearns all nurtured a business called prime brokerage that was devoted solely to serving hedge funds.
There are many prime-brokerage services, but one of the biggest was lending stock so that hedge funds could
complete short-sales. In a short sale, a trader sells the borrowed stock, hoping it will fall in price and can be
repurchased later at a profit.
So why don’t investment banks just refuse to lend securities? They would lose revenue and their hedge-fund
customers–big drivers of business.
As of February, the top three prime brokers were Bear, Goldman and Morgan Stanley, with UBS increasing its
market share in Europe and Merrill Lynch and Bank of America building prime-brokerage operations to do battle
with the behemoths. Since then, of course, Bear has been absorbed into J.P. Morgan. And when Lehman announced
its earnings last week, it noted that customer balances at its prime-brokerage arm were down as hedge funds
spread the wealth among several firms. And while BofA gave up on the business and sold it to BNP Paribas, Merrill is
soon to be folded into BofA.
As investment banks go out of business or are sold, the number of prime brokers gets winnowed down. And many
of the ones that remain will be a small part of much larger firms where hedge fund profits won’t matter so much
that they can call the shots. Thus hedge funds may need to find new places from which to get their rope.
Article printed from Deal Journal - WSJ.com: http://blogs.wsj.com/deals
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SEPTEMBER 19, 2008, 12:41 P.M. ET
U.S. Drafts Sweeping Plan to Fight Crisis
Treasury Announces Plan
To Buy Troubled Mortgage Assets
By DEBO RAH SO L O MO N and DAMIAN PAL ET T A
WASHINGTON -- The federal government is working on a sweeping series of
programs that would represent perhaps the biggest intervention in financial
markets since the 1930s, embracing the need for a comprehensive approach to
the financial crisis after a series of ad hoc rescues.
Treasury Secretary Henry Paulson announced plans Friday to quickly set up a
"bold" government program to take over troubled mortgage assets from financial
institutions, along with other efforts to step up the purchase of mortgage-backed
securities. "The federal government must implement a program to remove these
illiquid assets that are weighing down our financial institutions and threatening
our economy," Mr. Paulson said in prepared remarks for a press conference.
(Read the full remarks)
President George W. Bush warned that a "significant" amount of taxpayer funds
will be put at risk with the government's plan to bolster shaky markets, but said
intervention is necessary to keep the financial system from grinding to a halt.
"This a pivotal moment for America's economy," Mr. Bush said Friday. "In our
nation's history, there have been moments that require us to come together
across party lines to address major challenges. This is such a moment."
Meanwhile, the Federal Reserve took another step deep into uncharted territory
Friday morning, effectively coming to the rescue of another struggling financial
sector -- this time the money market mutual fund industry. Separately, the
Securities and Exchange Commission proposed a temporary ban on short-selling
on 799 financial stocks. The ban, which is effective immediately, is set to last for
10 days, but could be extended for up to 30 days. (See related article.)
Mr. Paulson plans to work with Congress over the weekend to get legislation in
place next week, he said, calling for "prompt, bipartisan action." The program
must be big enough to have "maximum impact," while protecting taxpayers, said
Mr. Paulson.
Missouri Rep. Roy Blunt, the second-ranking House Republican, said lawmakers
"need to set politics aside" and cooperate on legislation aimed at shoring up the
nation's shaky financial system. Mr. Blunt said he expects Congress will act on
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the administration-backed plan soon. "This is going to happen in the five or six
days, one way or another," he said. Mr. Blunt added the plan is intended to
"establish a floor" under the market. But he said it is too early to know whether
the evolving legislation "is good enough to hit that target."
"The ultimate taxpayer protection will be the stability this troubled asset relief
program provides to our financial system, even as it will involve a significant
investment of taxpayer dollars," Mr. Paulson said.
More immediately, Fannie Mae and Freddie Mac -- which were taken over by the
government earlier this month -- will increase their purchases of mortgagebacked debt, he said. To facilitate that effort, Treasury will also expand the MBS
purchase program it announced earlier this month.
The details weren't released for a mechanism that would take bad assets off the
balance sheets of financial companies, a device that echoes similar moves taken
in past financial crises. The size of the entity could reach hundreds of billions of
dollars, Mr. Paulson said at a press conference.
Earlier, the Treasury announced a massive program Friday to shore up the
nation's money-market mutual-fund sector, responding to concerns that the
global financial crisis is starting to affect those historically safe assets. The move
is designed to stem an outflow of funds as consumers start to worry about even
the safest of investments, a sign of how the crisis is spreading to Main Street.
There is $3.4 trillion in money-market funds outstanding.
Under the Treasury's program, the government will insure the holdings of any
eligible publicly offered money-market fund. The funds must pay a fee to
participate in the program.
"The program provides support to investors in funds that participate in the
program and those funds will not 'break the buck,'" Treasury said in a statement,
referring to the concern that arises when the net asset value of money-market
funds falls below $1 per share.
The insurance program will be financed with up to $50 billion from the
Treasury's Exchange Stabilization Fund, which was created in 1934. President
Bush had to sign off on Treasury's use of the fund.
"Concerns about the net asset value of money-market funds falling below $1 have
exacerbated global financial market turmoil and caused severe liquidity strains
in world markets," Treasury said in a statement.
Fed Actions Carry Risks
Worried that money market mutual funds weren't liquid enough to handle a
building wave of redemptions from nervous investors, the Fed said it would use
its discount window to lend up to $230 billion to the industry -- via commercial
banks -- against illiquid asset backed commercial paper which is widely held by
money market funds.
The asset backed commercial paper market went through severe strain last year,
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because of holdings of highly troubled subprime mortgage debt instruments. But
Fed staff believe that isn't a problem for the industry now, and most of the assets
backing the instruments it will lend against are auto loans and credit card loans.
The paper the Fed is financing is high-rated and Fed staff don't see it as a moneylosing step.
The central bank is taking on a potentially big risk -- if these assets fall in value or
default, it is potentially on the hook, because the loans, to be made through its
discount window via banks, are non-recourse loans. But officials think the assets
are safe and healthy ones, and see the move as a temporary measure to provide
liquidity to the market. It took the step under a clause in the Federal Reserve act
that allows it to lend to any firm under "unusual and exigent" circumstances.
The Fed took a second step this morning, saying it would buy short-term debt
issued by Fannie Mae, Freddie Mac and Federal Home Loan Banks through
primary dealers. These instruments are called discount notes, and the Fed said it
would buy up to $69 billion worth of these securities to firm up this market.
According to Fed staff, agency discount notes amount to about 5% of the assets of
the money market mutual fund industry, so the step was another effort to provide
liquidity to the market.
The short-term agency debt market has also been under severe stress in the past
few days, with yields on agency discount notes soaring relative to U.S. Treasury
bills. This is unusual in any time, and especially unusual now, coming just a few
days after the government said it would rescue Fannie Mae and Freddie Mac.
The administration had been taking a patchwork approach to the financial crisis,
putting out fires as they ignited. The new moves represent an effort to take a
more systematic approach, after a spiral of bad debts, credit downgrades and
tumbling stocks brought down venerable names from investment bank Lehman
Brothers Holdings Inc. to insurance giant American International Group Inc.
Banks have grown unwilling to lend to one another, a sign of extreme stress,
because financial markets work only when institutions have faith in each other's
ability to meet their obligations.
Word of a coordinated government plan came first came Thursday, a day when
the Federal Reserve and other major central banks offered hundreds of billions
of dollars in loans to commercial banks to alleviate a deepening freeze in the
world's credit markets. That step appeared to have moderate impact on lending
among banks. Meanwhile, a wave of redemptions continued hitting moneymarket funds, causing a second large fund to shut to investors.
In Russia, officials suspended stock-market trading for the second-straight day
as the Russian government promised to inject $20 billion to halt a collapse in
share prices. In China, government officials directed purchases of bank shares
and encouraged companies to buy their own shares in efforts to prop up a falling
market.
Stocks Rallied Thursday, Early Friday
Still, word of a possible U.S. plan to address the crisis sent the stock market
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soaring on Thursday, in one of its sharpest reversals in recent memory. The Dow
Jones Industrial Average ended up 3.9%, the index's biggest percentage gain in
nearly six years, on record New York Stock Exchange volume. The blue-chip
index finished more than 560 points above its intraday low and reclaimed about
90% of its Wednesday losses. Nasdaq composite trading also saw trading volume
set a new single-day high at 3.89 billion shares. All 30 Dow component stocks
closed higher, but financial companies were the biggest winners, racking up
double-digit percentage gains after weeks of selling off.
Early Friday, the Dow Jones Industrial Average soared by 400 points at the start
of trading, as financial stocks surged.
The flurry of moves under discussion may bring the markets some breathing
room, but it isn't clear whether they will amount to a long-term solution to the
complex financial problems sweeping the market.
"The market wants to see a more systemic solution that doesn't leave us
wondering day after day about the next institution that's the weakest link in the
chain," said former Fed Board member Laurence Meyer, vice chairman of
Macroeconomic Advisers, an economic research firm.
Treasury Department officials have studied a structure to buy up distressed
assets for weeks, but have been reluctant to ask Congress for such authority
unless they were certain it could get approved. The intensified market turmoil
may have changed that political calculus, even with less than two months left
until the November elections.
A big question still to be answered is how the government will value the assets it
takes onto its books. One possible avenue could be some sort of auction facility,
so that the government would not have to be involved in negotiating asset values
with companies. Financial companies would likely take big losses.
President Bush met with Treasury Secretary Paulson, Securities and Exchange
Commission Chairman Christopher Cox and Federal Reserve Chairman Ben
Bernanke for 45 minutes Thursday to discuss "the serious conditions in our
financial markets," said White House spokesman Tony Fratto.
Messrs. Paulson, Cox and Bernanke later addressed congressional leaders
Thursday evening on their proposals. At the meeting, Mr. Bernanke began by
laying out the severity of the crisis. Mr. Paulson "made the sale," said a top
congressional aide.
House Financial Services Committee Chairman Barney Frank, the Massachusetts
Democrat, said his panel could hold a vote on the package as soon as Wednesday.
"They said they would like legislation to do it, and there was virtually unanimous
agreement that there would be legislation to do it," said Mr. Frank.
In a news conference after the meeting, Mr. Paulson described his effort as "an
approach to deal with the systemic risk and the stresses in our capital markets."
The "comprehensive" solution would deal with the souring real-estate and other
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illiquid assets at the heart of the financial crisis, he said.
Structure of New Program Unclear
Exactly how such an entity might be structured isn't yet clear. The possible plan
isn't expected to mirror the Resolution Trust Corp., which was used from 1989 to
1995 during the savings and loan crisis to hold and sell off the assets of failed
banks. Rather, a new entity might purchase assets at a steep discount from
solvent financial institutions and eventually sell them back into the market.
The program may look more like the Reconstruction Finance Corporation, a
Depression-era relief program formed in 1932 by President Hoover that tried to
inject liquidity into the market by giving loans to banks and other businesses.
According to a top congressional aide, the Treasury department wants authority
to either control the program or have it be a separate division of the government.
A series of veteran policy makers, including former Treasury Secretary Lawrence
Summers and former Fed Chief Paul Volcker, has pushed in recent weeks for
such a government agency that would attempt a comprehensive solution to the
markets crisis.
The idea would be to steady the market so that investors regain confidence in
financial institutions and resume conducting business normally with them.
"By stepping in here and getting the markets to function again, the government
could deliver the Sunday punch to this financial turmoil," said former
Comptroller of the Currency Eugene Ludwig, who is now chief executive of
Promontory Financial Group, and a big proponent for the idea. "By taking the
first step and making a market the new government entity could take fear out of
marketplace," he added.
Thursday, Republican nominee Sen. John McCain sought a broad expansion of
government regulation over financial institutions, including the formation of a
body to both assume distressed mortgages and help failing investment banks.
Saying the government cannot "wait until the system fails," Sen. McCain called
for the creation of an entity that would essentially help companies sell off bad
loans and other impaired assets. It is unclear how the body, dubbed the Mortgage
and Financial Institutions trust, would operate, including whether or not
institutions would seek help or whether the government would intervene on its
own behalf.
His rival, Democratic Sen. Barack Obama of Illinois was less specific about what
steps he would take, offering broader outlines of policy proposals that included a
"Homeowner and Financial Support Act." The measure, which would inject
capital and liquidity in the financial system, is designed to provide a more
coordinated response than "the daily improvisations that have characterized
policy-making over the last year."
—Jon Hilsenrath, Greg Hitt, Tom Barkley, Brian Blackstone, Maya Jackson Randall, Henry J. Pulizzi, Joellen Perry, Laura Meckler,
Nick Timiraos, Elizabeth Holmes, Michael M. Phillips and Craig Karmin contributed to this article.
Write to Deborah Solomon at deborah.solomon@wsj.com and Damian Paletta
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at damian.paletta@wsj.com
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SEPTEMBER 19, 2008
Street Scenes: The Players
Remaking Financial World
By SUSANNE CRAIG , CARRICK MO L L ENKAMP, DEBO RAH SO L O MO N and DAN F IT ZPAT RICK
History has thrown a handful of men together this week with a task that they
themselves might have brushed off as unthinkable just days ago: Give the U.S.
financial system its biggest makeover since the 1930s. And do it quickly.
They hail from all parts of the financial world, a banker from North Carolina, a
London financial executive, the U.S. Treasury chieftain who himself once ruled a
Wall Street powerhouse. Along with small cadre of other men, they are struggling
to shore up the foundations of Wall Street, on the fly.
It's too early to know whether the choices they've made -- rapid-fire acquisitions
of Wall Street icons Merrill Lynch & Co. and Lehman Brothers Holdings Inc.,
government seizure of one of the world's biggest insurers, American
International Group Inc. -- were the right ones. Rarely are decisions on the
trillion-dollar scale made so hastily and with so little vetting.
Now, the government appears ready to embark on yet another attempt to stem
the financial carnage. The Treasury Department and the Federal Reserve are
considering ways to take bad assets off the balance sheets of financial
institutions, according to a person familiar with the matter.
Here is a look at how this group was thrown together and the influences that have
shaped their decisions to date. The account is based on interviews with numerous
primary players, as well as individuals who witnessed the action.
HENRY PAULSON
Too Big to Fail
Since Alexander Hamilton first held the job 219 years ago, the position of
Treasury secretary largely centered on advising the administration on economic
and fiscal policy.
In a few short months, Henry Paulson has rewritten that job description.
Today he finds himself in a position of power unmatched by his predecessors. He
decides whether Wall Street firms live or die, picking winners and losers with the
power of the federal purse. It's a particularly unusual role, given the Bush
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administration's laissez-faire approach to markets.
Mr. Paulson, 62 years old, has used this expanded power to set a precedent that's
now coming back to haunt him. In recent days he helped orchestrate government
takeovers of insurer AIG and mortgage giants Fannie Mae and Freddie Mac.
Prior to that, in March, he helped structure a rescue of Bear Stearns Cos., which
included an agreement that the Federal Reserve would take on $30 billion in
Bear Stearns's assets if J.P. Morgan Chase & Co. would buy the struggling
investment bank.
In all of these cases, shareholders suffered huge losses. Still, these decisions
raised the difficult issue of "moral hazard" -- the idea that government bailouts
encourage more risk-taking, since financial firms assume they'll be thrown a
lifeline if they get into trouble.
But are some companies simply too big to be allowed to fail? There's no way to be
certain, without letting them fail. And that has risks of its own.
In recent days, the AIG matter presented precisely this conundrum. The
immense company had more than $1 trillion in assets at the end of the second
quarter, and insured everything from lives in India to cars in the U.S. to airplanes
and oil rigs, operating in 130 countries.
The bailout question puts Mr. Paulson in an uncomfortable position. A
Republican who came to Washington only in 2006, he once headed investment
bank Goldman Sachs, a veritable icon of the free market.
As the financial crisis has deepened, Mr. Paulson's views on bailouts have
evolved. A look at his actions in the past week illustrate this difficult balancing
act.
With Lehman's shares plunging early last week, Mr. Paulson fielded phone calls
from Wall Street executives. The message: They would consider buying the firm
and saving it from possible collapse -- but only if they, too, got the benefits of the
Bear deal.
Huddled with advisers in his office overlooking the White House, Mr. Paulson
decided he had had enough. The government must stand pat: No bailout for
Lehman.
He decamped to New York City, and on Friday evening, in a high-ceilinged
conference room at the massive stone-and-iron New York Fed building in lower
Manhattan, he tried to persuade Wall Street executives that it was their job, not
the government's, to fix the unfolding mess at Lehman.
"You have a responsibility to the marketplace," he told them, according to a
person who was there.
Saturday morning, in the same room, Mr. Paulson and Timothy Geithner,
president of the New York Fed, ordered the assembled Wall Street titans to break
into three groups and start cooking up some solutions.
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One group included top brass from Morgan Stanley, Merrill and Citigroup Inc. It
was dubbed the "LTCM Group," and its task would be to propose something
modeled on the 1998 bailout of Long Term Capital Management, a huge hedge
fund that collapsed and was bailed out when Wall Street firms contributed some
$3.63 billion.
The second group, including executives from Goldman and Credit Suisse Group,
began poring over Lehman's commercial real-estate business, which has caused
huge losses. Their job: Figure out the assets' actual value.
The third group, dubbed "Lights Out," was charged with studying the fallout of a
Lehman failure.
By midday Saturday, however, Mr. Paulson started thinking more closely about
AIG. He started talking to executives at Goldman and J.P. Morgan Chase to see if
they could help AIG, perhaps by pulling together private loans.
Earlier on Saturday -- with Lehman executives also in the building seeking a
bailout -- Mr. Paulson was disinclined to give AIG financial support until he knew
more about the scope of the insurer's problems.
AIG's chief, Robert Willumstad, persisted. "I'm proposing a transaction, not a
bailout," he told Messrs. Paulson and Geithner, according to a person familiar
with the exchange.
By Sunday, however, with the potential for a private-sector solution collapsing,
Mr. Paulson began realizing that government money would have to be involved.
He believed an AIG collapse could be disastrous to the global economy because
AIG's financial tentacles extended so deeply into world financial markets.
Officials were particularly concerned that AIG's troubles would spill over into the
money-market mutual funds held by millions of Americans, given its role in
insuring some of the investments popular among funds like these.
By Monday, things were moving too quickly: In the wake of a ratings downgrade
of AIG, it now would take an $85 billion loan to avert possible collapse. Goldman
and J.P. Morgan couldn't raise the money fast enough.
So on Tuesday, Mr. Paulson decided to support a government loan. "A disorderly
failure of AIG," the Fed said, "could add to already significant levels of financial
market fragility," boost borrowing costs and cut into household wealth while
triggering "materially weaker economic performance."
JOHN THAIN
Get Ahead of the Tsunami
On Saturday, John Thain, Merrill's chief executive, was busy at the New York Fed
working on Lehman's problems when a sudden realization hit him: If he didn't
act fast, his own brokerage firm, Merrill, might not survive this crisis.
It occurred while listening to Lehman's president, Herbert H. "Bart" McDade III,
give a sobering summary of Lehman's assets and liabilities. "This could be me by
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Friday," Mr. Thain thought, according to people who have spoken to him.
The stakes were high for Mr. Thain, a Goldman alum and former head of the
New York Stock Exchange who had been Merrill's CEO only since December.
Over the past year, Merrill has written down more than $46 billion due to bad
bets on real estate and other mortgage-related investments. Mr. Thain was
brought in to clean up the mess. Still, Merrill's stock was getting hammered. It
had fallen more than 12% on Friday alone.
The 53-year-old Mr. Thain ducked out of his meeting, called Kenneth D. Lewis,
the CEO of Bank of America Corp., and asked him if he'd be interested in buying
Merrill.
By 2:30 that afternoon, the two men were face to face in New York. The meeting
set in motion a 36-hour marathon negotiating session.
Mr. Thain dispatched Merrill's president, Gregory Fleming, to meet with Bank of
America's team so they could start combing through Merrill's books.
Saturday afternoon, another twist came: Two top Goldman executives were
expressing interest in buying at 9.9% stake in Merrill.
Merrill Lynch, the biggest brokerage in the U.S., was officially in play.
By midafternoon Sunday -- only 24 hours after the first approach -- Merrill and
Bank of America deal makers had agreed on a price: $29 a share. Merrill's top
managers and directors hastily gathered for a special board meeting to approve
the sale.
"When I took this job, this was not the outcome I intended," Mr. Thain said,
according to people who were there. "But it is what is best for shareholders."
KENNETH D. LEWIS
Emerging on Top
The boldest gamble of Mr. Lewis's career started with the Saturday morning
phone call from Mr. Thain.
Mr. Lewis didn't hesitate. Here was a chance for the Mississippi-born son of a
soldier and night-shift nurse -- a man known among bankers for craving the
respect of the Wall Street establishment -- to elevate Bank of America as rivals
crumbled around him.
Bank of America is the only employer Mr. Lewis ever had. He started in 1969 as a
credit analyst when the bank was called North Carolina National Bank.
He took over as CEO in 2001 and since then has engineered more than $162
billion in acquisitions. Bank of America now ranks as the biggest retail bank in
the U.S.
Earlier this year, its purchase of Countrywide Financial Corp., the foundering
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mortgage giant, was thought to be Mr. Lewis's crowning moment. Buying
Merrill, with its slogan of "bringing Wall Street to Main Street," would be far
more significant.
Only days earlier, Mr. Lewis had considered buying Lehman. By Friday, he
decided he couldn't do a deal without government financial support, something
Mr. Paulson, the Treasury chief, was unwilling to offer.
So Saturday morning, Mr. Lewis had told his exhausted deal team to return to
Charlotte. Then came Mr. Thain's call.
Mr. Lewis ordered his team straight back to New York. The prospective deal
already had a code name: "Project Alpha."
Mr. Lewis himself rushed to the Big Apple that afternoon. He met with Mr. Thain
for an hour inside Bank of America's corporate apartment, overlooking Central
Park.
When Mr. Lewis returned home Monday, a voicemail awaited him. It was from
his mentor, Hugh McColl, a buccaneering figure who had kicked off Bank of
America's expansion efforts in the 1980s. Mr. McColl offered his congratulations.
ROBERT E. DIAMOND JR.
A Second Chance
Robert E. Diamond Jr., on a plane to New York from London last Thursday,
napped for four hours. He knew he'd get little sleep the next few days.
The 57-year-old president of Barclays PLC, the U.K.'s third-largest bank by
market value, was thinking of buying Lehman. It represented a golden
opportunity to set up a big shop on Wall Street. For the past dozen years, he had
helped expanded Barclays from a middling London bank into a broad-based
European investment house.
But he felt a deal would be unlikely without some support from the U.S.
government or from other big Wall Street firms.
On Friday Mr. Diamond -- using a freight elevator to avoid the media at
Lehman's office -- met with Lehman's chief, Richard Fuld. But the structure of
the deal he proposed would require funding help from other Wall Street firms, as
well as an assist from the U.S. government to cover the value of Lehman's assets.
By late Sunday morning, Mr. Diamond was told his idea was a no-go. Barclay's
withdrew. It appeared Lehman would file for bankruptcy.
Then, on Sunday evening, it suddenly looked like Mr. Diamond might get a
second chance. As he walked to Smith & Wollensky steakhouse in midtown
Manhattan, Mr. Diamond's thoughts had turned to a cool beer, when his
cellphone rang. It was Mr. McDade, Lehman's president, raising the possibility
that a bankruptcy filing might actually open another path to a deal.
"Is there any chance that if this goes into receivership, we can try and do
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something?" Mr. McDade asked, according to a person familiar with the call.
Within hours, Lehman had filed for bankruptcy protection. Mr. Diamond then
plowed headlong into bankruptcy law to see if he could quickly swoop in and cut
a deal. He knew he would have to move quickly before Lehman started losing its
employees, one of the firm's key assets.
On Tuesday, Barclays agreed to buy the bulk of Lehman's North American
business, which won't include the firm's risky holdings and liabilities, for $1.75
billion.
RICHARD FULD JR.
Down and Out
Lehman colleagues long marveled at Mr. Fuld's knack for winning, at bond
trading and on Wall Street. One Lehman partner once told an associate: "If Dick
Fuld were in front of you on line to buy a lottery ticket, hand him your $2 because
that bastard is going to win."
That luck ran out Sunday. After repeatedly insisting that he would never sell
158-year-old Lehman -- a firm he worked at for 41 years -- Mr. Fuld was forced
to try to do just that.
Mr. Fuld, 62, spent much of the weekend holed up in his 31st-floor executive
suite overlooking midtown Manhattan. With Lehman employees angry at the
firm's precarious condition, Mr. Fuld was given extra security detail.
As he and other Lehman executives scrambled to find a deal, Mr. Fuld told a top
adviser: "I just want my people to survive."
A lot was riding on this for Mr. Fuld, who was credited with almost
singlehandedly rebuilding Lehman in the mid-1990s after it was spun off from
American Express. But in the past two fiscal quarters the firm has rung up losses
of $6.7 billion on bad real-estate bets.
He arrived at work at 7 a.m. on Saturday, wearing a blue suit and tie. Exhausted
from the week's events, he tried to take a quick nap around 10 a.m., but it was a
short one., Almost immediately, Mr. Paulson, the Treasury secretary, called to
get a status report, according to a person familiar with the matter.
When Bank of America withdrew from takeover talks with Lehman Saturday
afternoon, Mr. Fuld phoned Mr. Lewis several times to make another appeal,
according to a person familiar with the matter. Mr. Lewis didn't return the calls.
What Mr. Fuld didn't know was that, by then, Bank of America was already deep
in talks to buy rival Merrill.
Sunday, in a last-ditch effort to find a buyer, Mr. Fuld called John Mack, Morgan
Stanley's chief, and asked him if a deal was possible.
The answer was no.
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With that, Lehman's fate was effectively sealed, and it filed for bankruptcy early
Monday.
It was a remarkable fall for an executive who relished control. Under Mr. Fuld,
there never were casual Fridays. His signature look included crisp, white,
hand-tailored shirts. Employees routinely referred to him as "The Chairman."
Outside Lehman headquarters on Monday, a painter offered angry employees an
outlet. He exhibited a large portrait of Mr. Fuld and asked people to sign it. One
employee scrawled: "Nice trade, Dick!"
Also on Monday, according to regulatory filings, Mr. Fuld sold more than two
million Lehman shares at about 20 cents a share. The sale netted him almost
$525,000, filings show.
Those same shares were valued at more than $145 million at the beginning of
2008.
Then, on Tuesday, a quick turnabout: Barclays agreed to buy Lehman's U.S.
brokerage unit. That move salvaged, at least for now, part of the once-proud
securities firm.
In a letter to employees announcing that deal, Mr. Fuld wrote: "I know that this
has been very painful on all of you, both personally and financially. For this, I feel
horrible."
—Jon E. Hilsenrath contributed to this article.
Write to Susanne Craig at susanne.craig@wsj.com, Carrick Mollenkamp at
carrick.mollenkamp@wsj.com, Deborah Solomon at deborah.solomon@wsj.com
and Dan Fitzpatrick at dan.fitzpatrick@wsj.com
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SEPTEMBER 20, 2008
Bailout of Money Funds Seems to Stanch Outflow
Fear That Had Gripped $3.4 Trillion Market Abates,
Ending the Reluctance of Funds to Buy Vital Commercial Paper
By DIYA G UL L APAL L I and SHEF AL I ANAND
The federal bailout of money-market funds seems to have stanched the outflow of
investments that bedeviled the industry this past week -- and ended the economythreatening reluctance of the funds to buy vital commercial paper.
As news broke that the government will insure fund assets and the Federal
Reserve will lend to funds, the fear that had gripped the $3.4 trillion money-fund
realm abated. Larry Fink, chief executive of asset manager BlackRock Inc.,
which sponsors nine money funds, said the situation "is stabilizing." The investor
rush out of money funds appeared to end, and the commercial-paper market
came back to life.
The news came too late for the embattled Reserve Primary Fund, which had
helped touch off the crisis. Almost all the fund's investors have requested
withdrawals. On Friday, the fund, run by Reserve Management Co., announced it
is suspending redemptions and delaying payment for longer than its previously
disclosed seven-day hiatus.
On Friday, the U.S. Treasury said it was establishing a temporary guaranty
program for the money-fund industry. For the next year, it is insuring retail and
institutional funds, though not those investing exclusively in municipal and
government debt. Funds must pay a fee to participate in the program.
The insurance program will be financed with as much as $50 billion from the
Treasury's Exchange Stabilization Fund, which was created in 1934. President
George W. Bush had to sign off on Treasury's use of the fund. Also, the Federal
Reserve said it will essentially lend as much as $230 billion to the industry, via
banks, to be used against their illiquid asset-backed holdings.
The withdrawals from money funds were stunning. They generated by far the
highest redemptions on record, losing $144.5 billion through earlier this past
week, according to AMG Data Services. The industry had only $7.1 billion in
redemptions the week before.
The redemptions subsequently created huge problems for the $1.7 trillion
commercial-paper market. Money funds weren't buying the paper anymore and
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were dumping it to cash out fleeing investors. This threatened to tip the economy
into recession by cutting off a vital funding source for U.S. business.
The funds' push into Treasurys helped pull their short-term yields down to zero,
which backfired on the money funds. On Friday, fund tracker Lipper said that
more than 40% of the 1,263 U.S. taxable money-market mutual funds it tracks
posted zero returns amid their negligible returns from their concentration in
government paper.
As a result of money funds' buyers strike, commercial paper became increasingly
expensive, soaring to 8% yields from a little more than 2% the week before as
investors demanded to get paid more for taking on increasing risk. Companies
like International Business Machines Corp. had to pay as much as 6% for such
borrowing this week.
The possibility of businesses shutting down for want of funding, said Paul Schott
Stevens, the Investment Company Institute president, was bracing for the
government. He told Washington officials of the worry conveyed by his talks with
executives this past week at dozens of fund firms.
Although system-wide statistics for money funds weren't immediately available
Friday, anecdotal evidence suggests that the investor exodus was receding,
barring some new eruption.
Some money-fund customers canceled plans to redeem their investments in
cash, according to Legg Mason, which manages $187 billion in money funds.
Meanwhile, funds across the industry that had charged into the relative safety of
Treasurys reversed course.
At Federated Investors Inc., which manages more than $240 billion in money
funds, fund manager Deborah Cunningham noticed a swift decline in calls from
worried clients on Friday. The tone of money-fund investors who did call, she
said, "is a thousand times lighter." Instead of asking about the funds' exposure to
troubled names like Lehman Brothers Holdings Inc. and American International
Group Inc., "today's question is: are you going to participate in the insurance,"
she says. Federated money funds don't own Lehman or AIG paper.
Investors' historic run on money funds began after one of the largest, Reserve
Primary Fund, on Tuesday "broke the buck," or went under the sacrosanct
$1-a-share net asset value. The cause was its debt holdings in Lehman, which
went to zero when the firm filed for bankruptcy. The fund's dip under $1 NAV
eroded investors' confidence, causing them to pull out in droves across money
funds on Wednesday and Thursday. That stampede out the door caused another
prominent fund, the $12.3 billion Putnam Prime Money Fund (Institutional) to
shut down on Thursday.
While the stock market cheered the federal rescue plan, small bankers decried
the Federal Deposit Insurance Corp.-like protection extended to money funds.
Camden R. Fine, head of the Independent Community Bankers of America,
cautioned that the federal plan risked draining funding from small banks.
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Fallout from the Reserve fund debacle continued. Ameriprise Financial
announced on Friday that it has filed a suit in U.S. District Court in Minnesota
against the fund's parent, Reserve Management. Ameriprise and a subsidiary
hold more than 300,000 retail-client accounts in the fund. Third Avenue
Institutional International Value Fund also filed a suit on Friday in U.S. District
Court in the Southern District of New York alleging, among other things, that
Reserve misled investors earlier in the week about its ability to preserve $1 net
asset value. Reserve declined requests for comment.
—Anusha Shrivastava contributed to this article.
Write to Diya Gullapalli at diya.gullapalli@wsj.com and Shefali Anand at
shefali.anand@wsj.com
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BUSINESS
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SEPTEMBER 24, 2008
Libor's Accuracy Becomes Issue Again
Questions on Reliability of Interest Rate
Rise Amid Central Banks' Liquidity Push
By CARRICK MO L L ENKAMP
The accuracy of a widely used interest rate, seen as critical to judging the health
of the financial markets at a precarious time, is coming under question for the
second time this year.
Doubts about the London interbank offered rate, or Libor, center on whether
banks are understating what it costs them to borrow dollars in stressed financial
markets. Libor's reliability became an issue again this week when banks paid
higher interest rates to borrow using collateral than they did for unsecured loans.
Those questions come as central banks inject liquidity into the market to restore
the confidence of banks that have been reluctant to lend to one another. Other
lending markets, including commercial paper, which are short-term IOUs issued
by companies, have also struggled, potentially causing a credit crunch to spread
throughout the economy.
Libor is supposed to reflect average bank-borrowing costs. Overseen by the
British Bankers' Association in London, the rate serves as a benchmark for the
borrowing costs of homeowners and companies. During the credit crisis, it has
provided a gauge for whether banks trust one another enough to lend money.
Last week, Libor rates surged in a sign that banks were having trouble borrowing
money amid the problems at American International Group Inc. and Lehman
Brothers Holdings Inc.
Concerns about Libor's accuracy emerged out of the rates being paid in another
market used by banks to get cash. The Federal Reserve's term auction facility,
one of numerous efforts the Fed has been using to fight the credit crunch, allows
banks to borrow, but they must put up collateral.
Because of that, banks should be able to pay a lower interest rate than they do
when they borrow from each other because those loans are unsecured. It is the
same reason why rates for a mortgage, which is secured by a house, are lower
than those for credit cards, where the borrower doesn't put up any collateral. In
other words, the rate for the Fed auction should be lower than Libor.
But on Monday, the rate for the 28-day Fed facility was 3.75%, which was much
higher than Libor. On Monday, the one-month dollar Libor rate was 3.19% while
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Tuesday's rate was 3.21%.
The Fed facility should be lower, said Scott Peng, a Citigroup Inc. U.S. rate
strategist. The "market needs some accurate transaction-based measure of
interbank lending."
Earlier this year, Libor appeared to be sending false signals. Banks complained
to the BBA that rival banks might not be reporting their true borrowing costs
because they didn't want to admit that others were treating them as if they had
troubles. That led to a BBA review and the pledge that the rates banks contribute
would be better policed. Every morning, 16 banks submit borrowing rates in a
process that produces Libor rates at lunchtime in London.
Lesley McLeod, a BBA spokeswoman, said the BBA stands by the Libor. "Libor is
accurate," she said. "It is constantly monitored and currently reflects the extreme
market volatility present in these unprecedented circumstances."
Write to Carrick Mollenkamp at carrick.mollenkamp@wsj.com
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SEPTEMBER 29, 2008
Lehman's Demise Triggered
Cash Crunch Around Globe
Decision to Let Firm Fail Marked a Turning Point in Crisis
By CARRICK MO L L ENKAMP and MARK WHIT EHO USE in London, JO N HIL SENRAT H in Washington and IANT HE JEANNE DUG AN in New
York
Two weeks ago, Wall Street titans and the government's most powerful economic
stewards made a fateful choice: Rather than propping up another failing
financial institution, they let 158-year-old Lehman Brothers Holdings Inc.
collapse.
Now, the consequences of that decision look more dire than almost anyone
imagined.
Lehman's bankruptcy filing in the early hours of Monday, Sept. 15, sparked a
chain reaction that sent credit markets into disarray. It accelerated the
downward spiral of giant U.S. insurer American International Group Inc. and
precipitated losses for everyone from Norwegian pensioners to investors in the
Reserve Primary Fund, a U.S. money-market mutual fund that was supposed to
be as safe as cash. Within days, the chaos enveloped even Wall Street pillars
Goldman Sachs Group Inc. and Morgan Stanley. Alarmed U.S. officials rushed to
unveil a more systemic solution to the crisis, leading to Sunday's agreement with
congressional leaders on a $700 billion financial-markets bailout plan.
The genesis and aftermath of Lehman's downfall illustrate the difficult position
policy makers are in as they grapple with a deepening financial crisis. They don't
want to be seen as too willing to step in and save financial institutions that got
into trouble by taking big risks. But in an age where markets, banks and investors
are linked through a web of complex and opaque financial relationships, the pain
of letting a large institution go has proved almost overwhelming.
In hindsight, some critics say the systemic crisis that has emerged since the
Lehman collapse could have been avoided if the government had stepped in.
Before Lehman, federal officials had dealt with a series of financial brushfires in
a way designed to keep troubled institutions such as Fannie Mae, Freddie Mac
and Bear Stearns Cos. in business. Judging them as too big to fail, officials
committed billions of taxpayer dollars to prop them up. Not so Lehman.
"I don't understand why they didn't understand that the markets would be
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completely spooked by this failure," says Richard Portes, professor of economics
at London Business School and president of the Centre for Economic Policy
Research. Rather than showing the government's resolve, he says, letting
Lehman fail only exacerbated the central problem that has afflicted markets
since the financial crisis began more than a year ago: Nobody knows which
financial firms will be able to make good on their debts.
To be sure, Lehman's downfall was largely of its own making. The firm bet
heavily on investments in overheated real-estate markets, used large amounts of
borrowed money to supercharge its returns, then was slower than others to
recognize its losses and raise capital when its bets went wrong. The depth of the
firm's woes made finding a willing buyer a difficult task, leaving officials with few
viable options.
Given the limited time and information available, many experts believe
government officials made the best choices possible.
Struggle for Capital
As they watched Lehman struggle to raise capital, policy makers -- including
Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke
and New York Fed President Timothy Geithner -- mulled the question of whether
they could let Lehman fail. On the one hand, they didn't want to come to the
rescue because they were concerned about moral hazard, the idea that bailouts
encourage irresponsible risk-taking, according to people familiar with the
planning. They doubted Lehman had viable buyers and they thought the market
and the Fed had had time to prepare to handle the fallout if a big institution
collapsed. Still, some Fed officials were leery of sending signals that the Fed was
done working with Wall Street to stop the spreading crisis. Mr. Geithner, for one,
had been telling others that the markets were still in for serious trouble.
"If you don't do something, the outcome is going to be bad," Mr. Geithner told
executives as they gathered to bargain over Lehman's fate at the New York Fed's
downtown headquarters on Friday night, Sept. 12, according to a person in the
meeting.
At one point, officials raised with Wall Street bankers the possibility of a privatesector rescue fund, but the bankers either balked at the idea of bailing out a
competitor or didn't have the extra funds needed, people familiar with the
situation said.
Prepare the Markets
Over the weekend, as possible buyouts by Bank of America Corp. and U.K. bank
Barclays PLC fell through, Fed officials focused on what needed to be done to
prepare markets for what would be the largest bankruptcy in U.S. history.
Lehman's total assets of more than $630 billion dwarf WorldCom's assets when
the telecom company filed for bankruptcy in 2002 with assets of $104 billion.
Officials were particularly concerned with two areas: the credit-default-swap
market, where players buy and sell insurance against defaults on corporate and
other bonds; and the so-called repo market, where Wall Street banks fund their
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investments by putting up securities as collateral for short-term loans.
The Fed had been pushing Wall Street firms for months to set up a new
clearinghouse for credit-default swaps. The idea was to provide a more orderly
settlement of trades in this opaque, diffuse market with a staggering $55 trillion
in notional value, and, among other things, make the market less vulnerable if a
major dealer failed. But that hadn't gotten off the ground. As a result, nobody
knew exactly which firms had made trades with Lehman and for what amounts.
On Monday, those trades would be stuck in limbo. In a last-ditch effort to ease
the problem, New York Fed staff worked with Lehman officials and the firm's
major trading partners to figure out which firms were on opposite sides of trades
with Lehman and cancel them out. If, for example, two of Lehman's trading
partners had made opposite bets on the debt of General Motors Corp., they could
cancel their trades with Lehman and face each other directly instead.
The Fed had also seen with the collapse of Bear Stearns how the repo market was
prone to severe disruptions when lenders got skittish, a problem that threatened
to cut off crucial funding to Wall Street banks. Because repo loans are made for
periods of as little as a day, the funding can disappear suddenly -- one reason the
Fed set up an emergency facility to lend to securities firms in the wake of Bear
Stearns's collapse. Fed officials worked furiously through Sunday to expand that
facility, allowing banks to put up as collateral for loans a wider range of
securities, including stocks.
On Sunday, after the Barclays deal fell through, the group began to "spray foam
on the runway" -- the term Mr. Geithner used to describe measures to cushion
the blow. By that night, Fed officials recognized that their preparations might not
cover all contingencies. Still, they expected the turbulence to settle down after a
time, with the help of the expanded lending facilities they hurried Sunday to put
in place. They also felt that financial institutions and markets had been given
enough time to prepare for the shock of a large failure since the crisis consumed
Bear Stearns in March.
But Lehman's bankruptcy, filed early Monday morning in federal bankruptcy
court -- case No. 08-13555 -- proved far more destabilizing, and spread much
further, than many had expected. The bankruptcy immediately wiped out huge
investments for Lehman shareholders and bondholders. Among the biggest was
Norway's government pension fund, which invests the country's surplus oil
revenue. As of the end of 2007, the most recent data available, the fund owned
more than $800 million worth of Lehman bonds and stock. Lehman's demise
has become a lightning rod for critics who have long questioned the way the
government was investing the oil resources. A spokesman said the fund's
management is "very concerned and monitoring the situation closely."
The government's decision to let Lehman go marked a turning point in the way
investors assess risk. When the Fed stepped in to engineer the takeover of Bear
Stearns by J.P. Morgan Chase & Co. in March, Bear's shareholders lost most of
their investments, but bondholders came out well. In the financial hierarchy of
risk, this wasn't surprising, since bondholders have more contractual rights to
get their money back than equity holders. But it created a false impression
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among investors that the government would step in to rescue bondholders when
the next bank ran into trouble. By letting Lehman fail, the government had
suddenly disabused the market of that notion.
The reaction was most evident in the massive credit-default-swap market, where
the cost of insurance against bond defaults shot up Monday in its largest one-day
rise ever. In the U.S., the average cost of five-year insurance on $10 million in
debt rose to $194,000 from $152,000 Friday, according to the Markit CDX
index.
When the cost of default insurance rises, that generates losses for sellers of
insurance, such as banks, hedge funds and insurance companies. At the same
time, those sellers must put up extra cash as collateral to guarantee they will be
able to make good on their obligations. On Monday alone, sellers of insurance
had to find some $140 billion to make such margin calls, estimates assetmanagement firm Bridgewater Associates. As investors scrambled to get the
cash, they were forced to sell whatever they could -- a liquidation that hit
financial markets around the world.
Cash Calls
The cash calls added to the problems of AIG, which was already teetering toward
collapse as it sought to meet more than $14 billion in added collateral payments
triggered by a downgrade in its credit rating. AIG was one of the biggest sellers in
the default insurance market, with contracts outstanding on more than $400
billion in bonds.
To make matters worse, actual trading in the CDS market declined to a trickle as
players tried to assess how much of their money was tied up in Lehman. The
bankruptcy meant that many hedge funds and banks that were on the profitable
side of a trade with Lehman were now out of luck because they couldn't collect
their money. Also, clients of Lehman's prime brokerage, which provides lending
and trading services to hedge funds, would have to try to retrieve their money or
their securities through the courts.
Autonomy Capital Research, a London-based hedge fund that was started in
2003 by former Lehman trader Robert Charles Gibbins, was among the Lehman
clients who got caught. When Lehman filed for bankruptcy protection, it froze
about $60 million of Autonomy's funds, according to a person close to the
situation. That is about 2% of the $2.5 billion Autonomy manages. An official at
Autonomy declined to comment.
Spooked that other securities firms could fail, hedge funds rushed to buy default
insurance on the firms with which they did business. But sellers were hesitant,
prompting something akin to what happens if every homeowner in a
neighborhood tries to buy homeowners insurance at exactly the same time. The
moves dramatically drove up the cost of insurance on Morgan Stanley and
Goldman Sachs debt in what became a dangerous spiral of fear about those
firms.
At the same time, hedge funds began pulling their money out of the two firms.
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Over the next few days, for example, Morgan Stanley would lose about 10% of the
assets in its prime-brokerage business.
"It was just mayhem," says Thomas Priore, the CEO of New York-based hedge
fund Institutional Credit Partners LLC. "People were paralyzed by fear of what
could erupt."
Amid the uncertainty about how Lehman's bankruptcy would affect other
financial institutions, rumors and confusion sparked wild swings in stock prices.
On Tuesday, for example, a London-based analyst issued a report saying that
Swiss banking giant UBS AG, already hurt by tens of billions of dollars in writedowns, might lose another $4 billion because of its exposure to Lehman. Shares
in UBS fell 17% on the day. UBS subsequently said its exposure was no more than
$300 million.
Rising concerns about the health of financial institutions quickly spread to the
markets on which banks depend to borrow money. At around 7 a.m. Tuesday in
New York, the market got its first jolt of how bad the day was going to be: In
London, the British Bankers' Association reported a huge rise in the London
interbank offered rate, a benchmark that is supposed to reflect banks' borrowing
costs. In its sharpest spike ever, overnight dollar Libor had risen to 6.44% from
3.11%. But even at those rates, banks were balking at lending to one another.
Within a few hours, the markets had shifted their focus to the fate of Goldman
Sachs and Morgan Stanley, which found themselves fighting to restore investors'
flagging confidence. During an earnings presentation in which he answered one
after another question about the firm's ability to borrow money, Goldman chief
financial officer David Viniar made an admission: "We certainly did not
anticipate exactly what happened to Lehman," he said.
Morgan Stanley's stock, meanwhile, plunged 28% in early trading as investors
bet that it would be the next after Lehman to fall. At around 4 p.m., the firm
decided to report its third-quarter earnings a day early, in the hope that the
decent results would halt the stock decline.
"I care that it could be contagion," Morgan Stanley chief financial officer Colm
Kelleher said in a conference call with analysts. "You've got fear in the market."
Even as Morgan Stanley's call was taking place, the Lehman fallout cropped up
in a different corner of finance: so-called money-market funds, widely seen as a
safe alternative to bank deposits. Many of the funds had bought IOUs, known as
commercial paper, which Lehman issued to borrow money for short periods.
Now, though, the paper was worth only 20 cents on the dollar.
At around 5 p.m. New York time, a well-known money-market fund manager
called The Reserve said that its main fund, the Reserve Primary Fund, owned
Lehman debt with a face value of $785 million. The result, said The Reserve,
which had criticized its rivals for taking on too much risk in the
commercial-paper market, was that its net asset value had fallen below $1 a
share -- the first time a money-market fund had "broken the buck" in 14 years.
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The trouble in the commercial-paper market presented a particularly serious
threat to the broader economy. Companies all over the world depend on
commercial paper for short-term borrowings, which they use for everything from
paying salaries to buying raw materials. But as jittery money-market funds
pulled out, the market all but froze.
On Wednesday, the freeze in lending markets triggered a dramatic turn of events
in the U.K. Amid growing concerns about its heavy dependence on markets to
fund its business, HBOS PLC, the UK's biggest mortgage lender, saw it share
price plummet by 19%. The situation was a red flag for government officials, who
suffered embarrassment earlier this year when they were forced to nationalize
troubled mortgage lender Northern Rock PLC, which had become the target of
the country's first bank run in more than a century.
Moving quickly, the government brokered an emergency sale of HBOS to U.K.
bank Lloyds TSB Group PLC. In a sign of their desperation to make the deal
happen, officials went so far as to amend the U.K.'s antitrust rules, which could
have prevented the merger. Together, HBOS and Lloyds control nearly a third of
the U.K. mortgage market.
Back in New York, the situation at Morgan Stanley and Goldman Sachs was
worsening rapidly. In the middle of the trading day, at about 2 p.m., Morgan
Stanley CEO John Mack dispatched an email to employees: "What's happening
out here? It's very clear to me -- we're in the midst of a market controlled by fear
and rumors." By the end of Wednesday, employees at Morgan Stanley and
Goldman were shell-shocked. Morgan Stanley's shares had fallen 24% to $21.75
while Goldman, the largest investment bank by market value, fell 14% to $114.50.
By Thursday, Messrs. Paulson and Bernanke decided that the fallout presented
too great a threat to the financial system and the economy. In the biggest
government intervention in financial markets since the 1930s, they extended
federal insurance to some $3.4 trillion in money-market funds and proposed a
$700 billion plan to take bad assets off the balance sheets of banks.
Three days later, Goldman Sachs and Morgan Stanley applied to the Fed to
become commercial banks -- a historic move that ended the tradition of lightly
regulated Wall Street securities firms that take big risks in the pursuit of equally
big returns.
To some, the government's decision to resort to a bailout represents a tacit
admission: For all officials' desire to allow markets to punish the risk-taking that
engendered the crisis, banks have the upper hand. "Lehman demonstrated that
it's much harder than we thought to deal effectively with banks' misbehavior,"
says Charles Wyplosz, an economics professor at the Graduate Institute in
Geneva. "You have to look the devil in the eyes and the eyes are pretty
frightening."
—Sue Craig in New York, Michael M. Phillips in Washington and Neil Shah in London contributed to this article.
Write to Carrick Mollenkamp at carrick.mollenkamp@wsj.com, Mark
Whitehouse at mark.whitehouse@wsj.com, Jon Hilsenrath at
jon.hilsenrath@wsj.com and Ianthe Jeanne Dugan at ianthe.dugan@wsj.com
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Fed Statement on Plan to Buy Commercial Paper
Posted By topeditor On October 7, 2008 @ 9:00 am In Credit Crisis, Fed | 3 Comments
The Fed released the following statement on a plan backed by the Treasury to buy commercial paper directly from
issuers.
The Federal Reserve Board on Tuesday announced the creation of the Commercial Paper Funding Facility (CPFF), a
facility that will complement the Federal Reserve’s existing credit facilities to help provide liquidity to term funding
markets. The CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose
vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible
issuers. The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the
assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention
of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation
with market participants. The Treasury believes this facility is necessary to prevent substantial disruptions to the
financial markets and the economy and will make a special deposit at the Federal Reserve Bank of New York in
support of this facility.
The commercial paper market has been under considerable strain in recent weeks as money market mutual funds
and other investors, themselves often facing liquidity pressures, have become increasingly reluctant to purchase
commercial paper, especially at longer-dated maturities. As a result, the volume of outstanding commercial paper
has shrunk, interest rates on longer-term commercial paper have increased significantly, and an increasingly high
percentage of outstanding paper must now be refinanced each day. A large share of outstanding commercial paper
is issued or sponsored by financial intermediaries, and their difficulties placing commercial paper have made it more
difficult for those intermediaries to play their vital role in meeting the credit needs of businesses and households.
By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing
commercial paper obligations, this facility should encourage investors to once again engage in term lending in the
commercial paper market. Added investor demand should lower commercial paper rates from their current
elevated levels and foster issuance of longer-term commercial paper. An improved commercial paper market will
enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households.
Article printed from Real Time Economics: http://blogs.wsj.com/economics
URL to article: http://blogs.wsj.com/economics/2008/10/07/fed-statement-on-plan-to-buy-commercialpaper/
10/7/2008 9:18 AM
Markets Fall on Doubts Rescues Will Succeed - WSJ.com
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OCTOBER 7, 2008
Markets Fall on Doubts Rescues Will Succeed
Fed, U.K. Weigh More Action as Initial Salvos Fail to Rally Confidence; Dow Closes Below 10000 in Wild Day for World
Exchanges
By JO N HIL SENRAT H and CARRICK MO L L ENKAMP
The global financial crisis has taken a perilous turn: As government efforts to
tame it grow more aggressive, markets are becoming less confident those efforts
will succeed.
On Monday, the Federal Reserve and European governments stepped up relief
efforts, above and beyond the $700 billion rescue package approved by the
Congress last week. But markets around the world responded with a massive vote
of no confidence. European stocks saw their biggest drop in at least 20 years, and
the Dow Jones Industrial Average dropped below the 10000 mark, a stark sign
that the crisis may be outpacing policy makers' ability to contain it.
The deepening malaise illustrates how the financial crisis has moved far beyond
U.S. subprime-mortgage troubles to a much more fundamental breakdown of
trust. The best efforts of U.S. and European officials haven't solved the central
problem: Nobody knows which firms will go under, making almost everybody
afraid to lend.
The problem has become so severe that it's affecting not only banks, but regular
companies, which are finding it more difficult to borrow money for everyday
activities such as paying workers and buying supplies. If sustained, the freeze in
short-term-lending markets will weigh heavily on the weakening global economy.
Investors are now coming to recognize this harsh reality.
"In order to shore up confidence in the system -- and by the system, I mean the
money markets -- you need something bigger, and you need something that is
pretty consistent across countries," says Hans Lorenzen, credit strategist in
London for Citigroup Inc. "And you need it pretty quickly."
The Fed, 12 months into a sometimes makeshift campaign that is rewriting
textbooks on central banking, unveiled more measures Monday to unblock the
stoppage that has plagued short-term-lending markets for the past few weeks. It
said it will begin paying interest on the reserves that banks leave on deposit with
the central bank, a key addition to its playbook. The move will make it easier for
the Fed to manage interest rates while it floods a damaged financial system with
loans that nobody in the private sector will make.
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U.S. officials are also examining ways to ease deepening strains in the
commercial-paper market, a crucial source of short-term loans for banks and
other companies in the U.S. and Europe. Interest-rate cuts by the Fed look
increasingly likely to follow.
On Monday evening, U.K. officials were in talks with bank executives about
possible emergency injections of capital from the government, a person familiar
with the matter said. U.K. Treasury chief Alistair Darling didn't offer a specific
plan.
As the credit crisis becomes more of a global problem, coordinated action on
interest rates could become more appealing to policy makers. Such moves could
be on the agenda when global financial officials gather this weekend in
Washington as part of annual meetings of the International Monetary Fund and
World Bank.
"Coordination is of the essence," said Olivier Blanchard, chief economist of the
IMF, in an interview ahead of the meetings.
European Union countries made a renewed effort Monday to coordinate their
response to the crisis, after a series of unilateral moves by European nations
failed to have the desired effect. French President Nicolas Sarkozy, whose
country currently holds the EU's rotating presidency, read out on television a
common statement by the 27 EU nations that each "will adopt all the necessary
measures to protect the stability of the financial system."
The declarations followed the surprise move on Sunday by Chancellor Angela
Merkel of Germany, Europe's biggest economy, to guarantee all residents' bank
accounts, only a day after she had criticized a similar move by Ireland. On
Monday, Austria, Sweden and Denmark joined the growing list of countries that
have improved their deposit-guarantee programs.
All the activity has done little to ease strains in lending markets, which have
deteriorated rapidly since last month's collapse of U.S. securities firm Lehman
Brothers Holdings Inc. Lehman's bankruptcy filing sent shock waves throughout
global markets, precipitating losses even for U.S. money-market investment
funds, which were supposed to be as safe as cash.
Shrinking Market
In one worrying sign, the U.S. commercial-paper market shrank by a record
$94.9 billion during the week ended Oct. 1, to $1.61 trillion in debt outstanding,
according to the Fed. That followed a $61 billion decline the week before. Most of
the recent contractions were in commercial paper tied to financial companies in
the U.S. and overseas.
On Monday, the Fed took steps to try to get the money flowing again. In addition
to paying interest on bank reserves, the Fed said it would aggressively expand its
lending to needy banks through a special auction program, with plans to make
$900 billion in cash available by year end, compared with the $150 billion
planned just two weeks ago.
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The Fed's latest moves add to a litany of aggressive actions U.S. policy makers
have taken in the past year to address the spiraling crisis, including the recent
$700 billion rescue package. Since last September, the Fed has pulled
aggressively on its traditional lever, interest rates, reducing the short-term
federal-funds rate to 2% from 5.25% over just a few months.
It has also undertaken a steady stream of unorthodox measures: backstopping
money-market mutual funds, creating new borrowing facilities for investment
banks, taking on troubled assets from Bear Stearns Cos. and American
International Group Inc., to name a few. In the process, its own balance sheet has
been radically transformed. Once a bland storehouse for Treasury securities, the
Fed's coffers are now filled with loans to a wobbly financial system, often backed
by collateral few other financial institutions want to hold.
Three factors, however, have made it difficult to accomplish the mission of
keeping credit flowing. First, banks and investors are pushing to pare back their
debt, a process known as deleveraging. The Fed can slow that process, but it can't
stop it.
Second, the financial innovations of recent years -- once thought to be a good
thing, because they spread risk -- have become a curse. That's because they
obscure where risk is held, exacerbating uncertainty over which financial
institutions will survive.
Third, the failure of Lehman and other financial institutions has so damaged
confidence that even grand rescue plans are proving unable to restore it.
Fed officials show no signs of stopping their aggressive efforts to fight the crisis.
In Europe, some governments have gone much further than the U.S. in trying to
alleviate the pain. Ireland, for example, has issued a blanket guarantee covering
virtually all the debts of its six largest banks.
But coming up with a pan-European plan is proving difficult, in large part
because any large-scale bailout would require the approval of many countries.
While the European Central Bank oversees monetary policy for the 15 countries
that share the euro currency, it cannot step in to provide a lifeline to individual
banks. Within the euro zone, such emergency assistance is the province of
national central banks, typically working together with governments.
An effort at common action on Saturday, before the latest round of shocks,
largely failed. Germany and the U.K. rejected Mr. Sarkozy's suggestion of a
common bailout fund for European banks akin to the U.S.'s $700 billion rescue
plan, unhappy at the idea of sinking taxpayer money into a fund they can't
control.
"Europe's economic integration is rather deep, and the inter-bank market is an
integrated Europe market," says Daniel Gros, director of the Center for European
Policy Studies, a Brussels think tank. "But national politicians haven't understood
that yet, and they're acting as if banks still had a nationality, so that some banks
are their children and others are not."
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Alessandro Profumo, chief executive of Italian bank UniCredit, says he hopes for
a "European solution." He contends that "the country-by-country solution doesn't
work at all because now the financial system is really a system which is
completely interconnected."
On Sunday, UniCredit, Italy's second-biggest bank in terms of market value,
announced plans to raise €6.6 billion to shore up its finances. In an interview,
Mr. Profumo conceded that his bank had misjudged the scope of the credit crisis.
Problems may be particularly acute in Europe because banks there are more
dependent on the short-term-lending markets than are banks in the U.S. and
Asia. They've shown a particular hunger for dollar loans, which they used to
finance dollar-denominated investments, such as U.S. mortgage securities.
European banks steadily increased their dollar borrowings, reaching a total of
about $800 billion at the end of last year, compared with $500 billion in 2005,
according to the Bank for International Settlements.
Simon Adamson, an analyst at debt-research firm CreditSights, notes that a
heavy reliance on short-term-lending markets, rather than regular customer
deposits, is common among the European banks that have run into trouble in
recent weeks. "It is mainly when this feature is found in combination with other
perceived weaknesses that confidence evaporates," he says.
Amplified Problems
The difficulties encountered by Germany's Hypo Real Estate Holding AG, one of
the region's biggest lenders, underscore how fast things can unravel -- and how
the world's interconnected financial markets are amplifying the problems. Over
the weekend, the German government and financial firms agreed to a €15 billion
bailout package on top of a previously arranged €30 billion rescue plan.
Hypo's troubles started last month, when Lehman's bankruptcy filing caused
short-term lending markets to freeze. Within a day, a benchmark bank
borrowing rate known as the London interbank offered rate, or Libor, saw its
sharpest increase on record.
Caught up in the lending freeze was Depfa Bank PLC, a little-known Dublin
banking unit of Hypo. Until this month, Depfa had been highly dependent on
loans from other banks. When the market for such lending froze up, Depfa's
access to funding came to a halt. "That market has dried out," Hypo spokesman
Hans Obermeier said.
—Marcus Walker, David Gauthier-Villars, Joellen Perry and Serena Ng contributed to this article.
Write to Jon Hilsenrath at jon.hilsenrath@wsj.com and Carrick Mollenkamp at
carrick.mollenkamp@wsj.com
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OCTOBER 8, 2008
Fed Will Lend Directly to Corporations
Fed to Lend Directly to Companies for First Time Since Great Depression, Hints at a Rate Cut; Stocks Fall as Dow Hits 5-Year
Low
By JO N HIL SENRAT H, DIYA G UL L APAL L I and RANDAL L SMIT H
The Federal Reserve said it will bypass ailing banks and lend directly to
American corporations for the first time since the Great Depression, and it hinted
strongly at further interest-r