The Fallout and the Bailout.

corporate bond marketI feel like I keep repeating myself, the crisis is related to property and leverage. Unlike the tech bubble the issues caused by property and leverage affect the financial systems much more than technology did. The degree of leverage in the system is astounding, much of the whole wealth of the world is currently ‘borrowed’ and that’s a very scary thing, at least for me when I dwell on it.

Some institutions are leveraged differently than others but in general commercial banks are leveraged at 10 to 1 so for every dollar they actually own they owe 10. Savings institutions are about 8.4 to 1 and credit unions are the same. Brokerage firms and hedge-funds are at 32 to 1. Be afraid, that means for every Euro or Dollar they have they owe thirty two! Is there any lender out there that would give you thirty two times earnings? If you average out all institutions you come out with an over all leverage of about 12 to 1.

But stop right there… this doesn’t include derivatives! and they are not necessarily based on much of anything! If you look at a bank like Citibank they have (on their balance sheet) leverage of about 8.4 to 1. that seems fairly timid, but if you take out all of the intangibles like goodwill -which is there due to acquisitions etc – it’s more like 40 to 1! The losses they made in relation to their balance sheet were huge, when they wrote off 18 billion – which is equal to the entire value of all of AIB to put it in perspective-

With Banks normally there are for instance leverage is generally about 10 to 1, so if a bank has $100 in assets they have $90 in debt and about $10 in assets. If their asset base increases by one dollar – bringing their actual equity to $11 they can then increase debt by another $9 to maintain that leveraged ratio. So if the amount of assets you own go up in value then your equity increases and with banks they were leveraging all the way as property prices rose. However, the Achilles heel is that when things go bust the loss on the way down is equally destructive on the way down.

Banks balance sheets were looking incredibly strong on the way up however when the prices fell the balance sheets retracted very rapidly, as a firm deleverages in order to keep that 10 to 1 ratio we talked about earlier you have to shed the debt and equity very rapidly and in big tranches in order to maintain your leverage ration and solvency. So this whole crisis is to a degree partly a case of deleverage as much as it is about leverage.

Due to the remit of many banks they are being forced to sell assets whether there are ready buyers or not in order to maintain their regulatory limits on leverage, if there are no ready buyers then one answer is to drop prices, that means that perfectly good portfolios of good mortgages or bonds have to be liquidated in order to bring down the asset to leverage ratio. The banks then call on the hedge-funds whom they lent to and say they want their money back, the hedge-funds have to sell and that forced sale affects other markets, you can see this in the debt markets in corporate bonds and municipal bond markets and even high quality premium mortgages are falling in values. A point to note is that the quality of the loans is not always bad, the liquidity crisis can then turn into a solvency crisis.

credit crisis and distressed debtSo why don’t the banks just not sell the assets and get rid of the debt? Well, they are not independent of each-other, because the debt usually linked directly to the asset and therefore the over all value. An example is best served here: imagine a bank lends out money to Joe Soap, and the Joe Soap’s of the world are buying houses at 90% loan to value so they buy a 100k house putting in 10k of their own and borrowing 90k. Right, the bank has the first lien on that property or first ‘ownership’ so that goes on their balance sheet as an asset, and the overall value or market cap is 100k the bank is now leveraged at 9 to 1 (90k of theirs and 10k of yours). you’re house goes up in value to 150k, so now they have the ability to lend out more money because their first lien is implied away, basically because the house is worth much more their 90k loan is more secure being only 60% so they can take on more loans etc.

But when this reverses and prices fall, if they were at their 9 or 10 to 1 limit then they have to flog the debt with the equity as one is attached to the other so that they maintain their regulatory leverage limitations, so if they went ahead and had eventually lent out 135k based on your 150k value (135 being 90% of 150) they have to offload that debt fast, but if there is not a buyer then that debt, which may be perfectly good is worth less, I am almost tempted to write worth-less as just ‘worthless’.

It was solvency rather than liquidity that killed Bear Stearns, liquidity is the ability to turn wealth or assets into money, think of it as a ‘cashflow’ or think about it as having things that you can turn into cash-flow (ie: assets), Solvency on the other had is the ability of a firm to pay off the bills due. In a solvency crisis creditors and investors will lose out – basically the company folds and their loss is in part passed on to the creditors. So when you are heavily leveraged as Bear Stearns was liquidity becomes a problem, as the prices of their assets are falling it makes it hard to sell them (because the market for buying them is also in crisis) thus their cash-flow is getting hurt on the way down but eventually it hits their actual solvency or their ability to dissolve any outstanding debts. The tax paying public bears some of the brunt as well. Why? Because the government are bailing them out, and when the government spends they recoup by leveraging taxes. So any bailouts of any shape will be paid for by Joe Public.

market in distressed debtThere is going to be massive money made in distressed debt now because buyers are thin on the ground for debt that has to be sold one way or the other so the cash rich can take advantage of this. The Carlyle group for instance fell in part because of the market fear, the prices collapsed due to market panic whether it was justified or not. The price of debt is now well below face value. The Carlyle Group was highly leveraged but it was on a high quality loan book, however when they couldn’t obtain the short term money they needed to keep those loans live they had to sell in huge quantities into that un-receptive market, selling totally outweighs buying at the moment and hence the bond prices are in the doldrums but that doesn’t necessarily mean the bonds themselves are all bad loans.

A good way to picture it is that there is a cinema full of people and suddenly a fair city re-run comes on, everybody dashes for the door at once and there is a crush, that compression of everybody selling at once means that the prices for those bonds goes right down the tubes.

As asset values fell the underlying equity was dissolved, there has been a lot of fire sales, this market panic meant that many lenders were afraid to lend to other banks, and we saw the LIBOR and EURIBOR rates peak at almost 1% above the base rate. This crisis was meant to be over and done with in a few months, instead its a full blown recession. Confidence went out the window even further when the rating agencies were found to be pricing junk bonds as good quality bonds, this adds to the ‘credibility crisis’ I have spoken about on many occasions.

Mono-line insurers were tagged onto the back of the loan bond markets and as liquidity dried up the non-liquid nature of the property bonds (because they could not be turned into cash fast) meant that what should have been a cash flow problem turned into crisis, investors who couldn’t trust ratings would not bid on securitized bonds, and that had nothing to do with the credit quality it had everything to do with market sentiment. The Fed in the USA is now swapping non-liquid assets and holding them and giving back cash in return so that the need to push bonds through a non-buying market which just keeps causing more bad sentiment and problems. There is likely going to be a rally in the future, and when it comes it will come fast, the first 10% in a rally is normally gained faster than most people can get into the market.

The time to buy? I don’t know for sure but I am and have been starting to buy bank stocks of the quality firms who I believe will outlast this current crisis. I hope I’m not making a mistake!

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