Banks Fear a Deepening of Turmoil
By CARRICK MOLLENKAMP and MARK WHITEHOUSE
March 17, 2008; Page A1
Many bankers are steeling themselves for the global financial crisis to both last
longer and grow deeper, a shift in mood that could magnify the potential for
upheaval in markets and economies world-wide.
Just a month ago, financiers in the U.S. and Europe held out hope that the turmoil
might end this year. Now, a new view is emerging: As the malaise spreads beyond
risky mortgage securities and into the high-octane world of derivative investments,
the pain is likely to extend well into 2009.
Yesterday's rapid sale of Bear Stearns & Co. to J.P. Morgan Chase & Co. -- along
with the Federal Reserve's surprise Sunday-evening cut in its emergency lending
rate -- signals that regulators and the banking industry alike are prepared to take
unusual steps to reassure financial markets. The Fed also made the rare move of
saying it will lend directly to securities dealers, the first time it has done so since
the 1930s.
However, the fact that yesterday's Bear Stearns deal puts a paltry $2-a-share
value on the storied investment bank, which as recently as a week ago was trading around $70, is unlikely to
assuage fears that the worst is in the past.
The next four weeks will be critical in determining whether or not bankers' gloomy mood is justified. Tomorrow,
the worlds' biggest banks and brokers will start reporting precisely how much money they lost in the first
quarter on bad investments, on top of previous losses. These reports will also hold vital clues to what they feel
the future holds.
As last week's meltdown at Bear Stearns shows, bankers' mood swings can sometimes bring about the very
scenarios they fear. The 85-year-old firm suffered a de facto run on the bank when nervous lenders and clients
stopped doing business with it, sparking others to follow suit.
The global economy relies heavily on banks' willingness to lend money not only to companies and individuals,
but also to one another -- providing "liquidity," or an ample flow of cash coursing through the world's
economies. The current period of turmoil has its roots in a stark disappearance of this liquidity. Lending that
would otherwise fund everything from basic corporate operations, to sophisticated investment strategies used
by hedge funds, has dried up.
The darkening outlook among bankers can help to explain why previous efforts by the Fed and other central
banks haven't yet had the desired effect of reviving the flow of money.
"Why do I have to provide liquidity to one of my competitors, when I don't know if the liquidity in the market will
continue to be there or not?" asks Alessandro Profumo, the chief executive of one of Europe's largest banks,
UniCredit Group. "I have to take care of my company."
Signs of Malaise
Signs of malaise are abundant. Last week, banks' own cost of borrowing reached their highest level in two
months. Meantime, the highly specialized markets that let banks securitize, or package and sell loans, remain
all but frozen.
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A week ago broker-dealer Lehman Brothers Holdings Inc. announced a fresh round of layoffs totaling 5% of its
work force. That followed reductions by Bear Stearns, Morgan Stanley and Merrill Lynch & Co. At Société
Générale in London, traders who sell bank debt have given up on finding customers some days. "The market
is not open every day," says Demetrio Salorio, deputy head of debt capital markets for Société Générale there.
As banks try to reduce their own holdings of unwanted investments, their selling further pushes down values.
Swiss banking giant UBS AG, among the hardest hit by the financial crisis, is reducing its balance sheet -- the
amount of loans, securities and other assets it holds -- by some 520 billion Swiss francs (about $520 billion)
from its level at the end of last year. That amounts to a 20% reduction.
People familiar with the situation say UBS has weighed moves such as selling billions of dollars in mortgage
securities and a U.S. brokerage unit.
A UBS spokesman declined to comment on the mortgage securities, and said the brokerage unit isn't currently
for sale.
So far, banks and insurers have written down more than $150 billion in securities tied to subprime-mortgage
loans. Those markdowns include both residential mortgage securities and debt pools known as collateralized
debt obligations that are underpinned by mortgage securities. Losses like these could total some $285 billion,
Standard & Poor's estimated Thursday.
As problems extend beyond mortgage securities, though, some economists forecast that total losses to the
financial sector could exceed $1 trillion, or about 7% of U.S. annual economic output. That would be more than
double the level of losses suffered by savings-and-loan associations and commercial banks between 1986 and
1995, and about equivalent to the scale of Japanese-bank losses in the wake of the bursting of that country's
stock and real-estate bubbles roughly two decades ago.
Several times over the past year, investors' hopes for light at the end of the tunnel have proved premature. In
June, the credit crisis began unfolding as two Bear Stearns hedge funds imploded. Bankers believed the
markets would stabilize by the fall. Earlier this year, banks' fourth-quarter reports were seen as a next line in
the sand, as auditors forced them to come clean on their exposures to subprime-mortgage securities. Both
times, however, trouble reared its head again.
First Glimpse
Now, as banks and brokers report their first-quarter results in coming weeks, the question will be how far their
problems have extended beyond subprime. The first glimpse will come tomorrow, when Lehman and Goldman
Sachs Group Inc. are expected to report write-downs on everything from loans used for corporate acquisitions,
to securities backed by so-called "Alt-A" mortgage loans, which are considered to be of higher quality than the
riskiest "subprime" category of mortgages.
Then in April, big consumer lenders such as J.P. Morgan Chase & Co., Bank of America Corp., and Wachovia
Corp. will provide their outlook on the health of the U.S. economy.
In April and May, European banks such as UBS will report their own results. Analysts expect UBS, which
already has reported $18 billion in write-downs, to report as much as $15 billion in new losses, including $7.9
billion in markdowns tied to Alt-A securities.
"The first quarter is looking bad," said Scott Bugie, a managing director at Standard & Poor's in Paris. "Losses
are increasing in the Alt-A's. They are increasing in the home-equity lines....It's just all performing poorly."
Analysts estimate losses on corporate-buyout loans alone could be as much as $15 billion in the first quarter.
Banks and investors also face a significant unknown: What will happen to trillions of dollars in complex
securities tied to the cost of insurance against corporate debt defaults. These arcane securities -- known by
terms such as "synthetic collateralized debt obligations," or CDOs, and "constant-proportion debt obligations,"
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or CPDOs -- provide income to investors by selling insurance against a default to other buyers. However,
because of the way these contracts are structured, they can suffer losses when insurance costs rise.
Right now, that's what is happening. Last week, jittery investors pushed up the prices of insurance contracts,
known as credit-default swaps, to record levels amid concerns that Bear Stearns's problems could spread to
other financial institutions. As of Friday, the average annual cost of $10 million of five-year insurance on 125
U.S. and Canadian high-quality companies was $191,000, up from $80,969 at the beginning of the year,
according to the Markit CDX index.
Getting out of a credit-default swap contract isn't like selling a stock. If a bank or other investor sells such
insurance, the way it typically gets out of the deal is by going out and buying the same amount of insurance for
itself. But if the price of that insurance has risen in the meantime, the bank has to pay more than what it is
receiving under the terms of the older contract. That leads to losses.
If there is a rush to buy additional insurance, that can push prices higher, exacerbating the problem. Another
concern is that the sellers of these insurance contracts might not pay up if companies do, in fact, default on
their debt payments.
This market is immense. In all, such contracts have been written on the equivalent of some $43 trillion in
various kinds of bonds, according to the Bank for International Settlements.
Among the most vulnerable are the CPDOs, which have sold insurance on the equivalent of some $30 billion in
bonds. They contain triggers that force their holders to call off their bets if losses reach a certain level, a
feature that could force them to rush into the market to buy insurance. Analysts estimate those triggers will
start to go off when the average cost of default insurance in the U.S. and Europe reaches about $180,000 or
$190,000 per $10 million in debt, a level it approached last week.
Rippling Out
That could cause further repercussions in the larger market for synthetic CDOs, and for banks, which have
been big players in the market. "The question is, how far does this ripple out," says Scott MacDonald, who
directs research at Aladdin Capital Management LLC.
As in previous crises, the turmoil won't end until bargain-hunting investors decide that the time is ripe to start
buying -- putting a floor under falling prices. So far, though, these kinds of investors, typically banks and hedge
funds, have suffered as prices even for top-rated securities keep falling. In London, hedge fund Peloton
Partners LLP loaded up on triple-A-rated securities tied to mortgages, only to find itself forced to shut down last
month as the price of those securities plummeted.
Thus many potential buyers are sitting on the sidelines. "We don't need to swing at every pitch, because I think
we're going to see some fat pitches over the next couple of months," says Max Bublitz, chief strategist at SCM
Advisors LLC, a San Francisco money manager with $9.8 billion in fixed-income assets under management.
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