Financial markets ride out a turbulent week

September 24, 2008
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Last week was a rollercoaster ride for investors and a period of nervous uncertainty for just about everyone. The Dow Jones industrial average plummeted more than 500 points Monday on the news that investment bank Lehman Brothers had filed for bankruptcy. 

Originally, neither the government nor private investors stepped in to help Lehman Brothers, and to some that was a signal that the Fed had drawn a line in the sand to let players in the financial market know the government wasn’t going to bail out everybody that got into trouble. But on Wednesday, British bank Barclays announced it would buy Lehman Brothers’ North American investment banking and capital markets operations. Too, the American International Group, the world’s largest insurer, began badgering the Federal Reserve on Monday for help in the form of a bridge loan because it was on the precipice of failure due to the collapse of the subprime mortgage market.

The following day, the Fed agreed to give AIG a two-year, $85 billion emergency loan. Tom Sarb, a partner with Miller Johnson and a member of it’s Bankruptcy-Credit/Debtors Rights Group, said he wasn’t necessarily surprised to hear Wednesday that the Fed came to the rescue of AIG but not Lehman Brothers. From what Sarb understands, AIG was more a question of liquidity than solvency: There appears to be confidence that ultimately AIG has the assets to support its debt, whereas Lehman had taken on a lot of risk over the years and hadn’t borrowed the money to take on the risk. Sarb said he thinks the Federal Reserve feared that AIG was so intertwined in the financial markets in terms of securing so many others’ debt securities that the Fed decided it just couldn’t afford to let that entity fail. Perhaps for Lehman Brothers, there were less broad implications in its failure, Sarb explained.

Kerby Wallick, a senior investment manager with Legacy Trust, said he wasn’t really surprised that the Fed threw AIG a lifeline. While there are very few firms left that fit the description “too big to fail,” he said, AIG is one of them.

“More accurately, AIG was too wide to fail,” Wallick said. “As Ben Bernanke spelled out in an emergency meeting with those trying to put the deal together, AIG’s failure would be ‘felt across America and around the world.’”

Essentially, Wallick explained, AIG was on the hook for hundreds of billions of dollars of loans it had insured for other financial institutions and if it had failed, those insured loans would have been forced back onto the books of the institutions that owned them. That would have triggered additional multi-billion waves of write downs and additional liquidity crises, he said.

The Fed’s rescue of AEG marked its second bail out in just one month and the third this year. Earlier this year the brokerage firm of Bear Stearns, one of the largest investment banks and securities companies in the world, fell victim to rising mortgage defaults and steeply declining U.S. home values and the Federal Reserve rescued it by extending JP Morgan Chase a $30 billion credit line to buy Bear Stearns at a rock bottom price.

Wallick said one thing that was uncertain at the time the Fed bailed out Bear Stearns was how the whole system of financial institutions and counter-party dealings was intertwined and interrelated. If the Fed had let Bear Stearns go, would it have dragged down Lehman Brothers the next day and Merrill Lynch the day after that?

“We may not have a full understanding of exactly what collateral damage they were seeing: It may have been too great for them to ignore,” Wallick said. “At that point the financial institutions were tethered together to a large degree. Since then they’ve had the time now to unwind some of those tethers, so that you can have a situation like today where a Lehman can go under without immediately dragging everybody else with them.”

“I think it’s essential today for the government to kind of re-clarify or redefine its role and make it clear that it has limited resources and is not able to be the safety net for everybody,” Wallick remarked. “It has to look at each situation and figure out if an institution is allowed to fail, what ramifications does it have for American consumers?”

The Treasury Department’s Sept. 7 bail out of Fannie Mae and Freddie Mac made more sense because it directly affected consumers and the hobbled housing market. The government couldn’t have allowed them to fail because together, Fannie and Freddie either owned or guaranteed nearly half the U.S. mortgage market, Wallick pointed out.

“Fannie and Freddie always had that implied relationship with the federal government. It was kind of like their rich uncle who everybody assumed would step in and save them if they had to,” Wallick said. “At the same time, the message is clear today that not everybody gets to tap into that rich uncle.”

The problem is, whenever the government bails a firm out, it’s at the taxpayer’s expense. Sarb doesn’t see how the Federal Reserve, with its limited resources, can continue the bail-outs.

“At some point, it is going to put pressure on taxpayers, whether in terms of the need to increase taxes or simply that it makes the bonds issued by the U.S. government more expensive, because taxpayers have issued more and have to pay off more in the long run,” Sarb observed.

Financial institutions have been battered in recent months by rising mortgage defaults and declining home values. However, Bank of America bought Countrywide, then LaSalle Bank, and is now proposing to buy Merrill Lynch. Does Bank of America have the strength and financial wherewithal to take on all of that? Wallick said Bank of America does have the girth to do it: The $150 billion market cap institution has plenty of room in its footprint to add some retail brokerage and some investment banking, but he also thinks there’s some risk the company may have bitten off more than it can chew. 

The credit system is in an extremely fragile state right now, and it stands to reason the credit environment will get even tighter, Wallick said. It will also make an economic recovery much more drawn out, and it wouldn’t be surprising if the Federal Reserve responds by lowering the federal fund rate. That wouldn’t hurt, said Grand Valley State University associate professor Daniel Giedeman, Ph.D.

“At least it would send another signal that the Fed is willing to provide liquidity,” Giedeman said. “Would the actual lowering of the rate have a huge impact? I don’t know, but just the sense that the Fed is there and is cognizant of what’s going on might not be a bad thing. On the other hand, what is that going to do potentially for inflation later on? But sometimes you have to weigh the short term benefits with the long-term costs.”

According to Wallick, the financial industry and the American consumer in general have a fairly long and sometimes painful process ahead of them in de-leveraging and shoring up their balance sheet because there is too much debt out there. 

“In our minds, the good news is that the process is at least starting,” he added. “It’s critical to moving down the road to recovery to just let the weaker players take their consequences.”

Wallick doesn’t think more government regulation on banks is the answer because they’re already highly regulated. Rather, he believes the answer is more accountability in the secondary mortgage market.

Sarb said financial instruments have become so sophisticated that very few people understand them — including the people who were buying and selling them — so he expects to see more regulation in the area of derivatives.

Giedeman said he’s concerned about what’s happening but he’s not in a panic about it: He hasn’t rearranged his portfolio just yet. He does think there will be something of a cascading effect on other financial institutions, but not a full-out domino effect.

Are Michigan businesses and investors affected any more adversely than in other states by these recent developments? Wallick, Giedeman and Sarb don’t think so.

“It’s a rough patch, for sure, but you’re already seeing with Bank of America pursuing Merrill Lynch that there are firms out there looking for opportunities and bargains in the market,” Giedeman said. “I’m not as pessimistic as some others are: I don’t compare this to the Great Depression.”

Neither Wallick nor Sarb compare it to the Great Depression either.

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