black monday – current financial crisisfaculty.salisbury.edu/~lxarvi/data/black_monday... · •...

Black Monday

Exploring Current Financial Crisis

Bellevance Honors Program

Mind Sharpnel & Cookies Lecture Series

Salisbury University

Tuesday, September 23, 2008

by

Arvi Arunachalam

(c) Arvi Arunachalam

Warning Signs

• Ann Lee, 2006, " Wall St House of Cards"– "It warned of the danger to the nation from the sale of trillions of dollars

of complex financial products called "structured credit derivatives.“

• 2006 value of derivatives, $ 26 Trillion, twice US GDP

• Regulatory black hole, complexity beyond regulation

• CFTC has no control, regulates only commodities

• Today, nominal value of derivatives $ 100 Trillion, twice

global GDP

• Risk bearer is unknown due to complexity

• Warren Buffett, “Financial weapons of mass destruction”

• Credit Rating Agencies – indiscriminate ratings of risky

CDOs (mortgage backed securities,..) as low risk


Indicators

• Began 13 months ago

• Collapse of two Bear Stearns hedge funds

• Credit Default Swaps – premiums increase

• Credit Rating Agencies – earlier errors, agency

problems, lack of oversight on ratings, sudden

downgrades

• Financial Institutions – write down of bad assets, need

huge capital infusion

• Capital flight – from stocks to commodities to Treasuries,

Gold

• Countrywide, largest mortgage lender fails 2007

• Mortgage insurers, MBIA, Ambac,.. near death


Time Line of Crisis

• Sunday, Sept 7:

– US govt takes over Fannie Mae, Freddie Mac $5.5 T in MBS

• Monday, Sept 15:

– Lehman Bros files for bankruptcy, refused bailout

– market plummets, 6th largest one day drop in history

– Merrill Lynch bought by Bank of America

• Tuesday, Sept 16:

– Govt gives AIG short term bridge loan of $85 B to orderly unwind

assets (sell) (Fed Govt owns 80% of AIG)

– Reports of banks' interest in WaMu (has $200 B in FDIC insured

deposits from investors)


Time Line of Crisis• Wed, Sept 17

– $121 B was borrowed from Fed by financial institutions (short

term lending facility)

– Treasury sells $ 40 B of 35 day T-bills, DJ falls 4.1%, MS 24 %

– Housing new starts falls 6.2%, lowest in 17 years

• Thur, Sept 18

– Virtual run on money market funds - $180 B withdrawal by

institutions, unprecedented in history since Depression (usually

long term investors) MM funds worth $ 4 T market.– Resolution Trust Corp - to orderly unwind mortgages worth $ 5 T

• Fri, Sept 20

– Fed government guaranty for $4 T

• Sat, Sept 21

– Congress legislate $700 B to buy bad debt - largest since Great

Depression (proposal 3 pages long), increases

DIA – ETF movement Sept 10 – 23, 2008

Short Positions on Financial Firms


Key PlayersVictors Vanquished

Ken Lewis – Bank of America

John Thain – Merrill Lynch

Robert Willumstad – AIG

Richard Fuld – Lehman Brothers

Benjamin Bernanke – Fed

Reserve Chairman

Henry Paulson – Treasury

Secretary


Firms & Numbers• AIG

– Biggest issuer of CDS, $ 240 B exposure, default on $ 24 B

• ML

– Wrote down $ 41.4 B is assets, raised $ 21 B in equity

• Total write downs by financial firms

– $ 408 B in 2007 of distressed assets (Jon Haskins, Economist Goldman Sachs)

– Raised $ 367 B in new capital

• Value of sub-prime loans issued in the last 5 years

– $ 2.1T – this is an estimate

• Value of Freddie, Fannie Mac exposure

– $ 5.5 T of US mortgages

• 2008 1Q commercial borrowing

– Down to 5.1% half from 2002

• Value of CDS - $ 62 Trillion from $ 144 Billion in 10 yrs


Global Contagion

• UK government steps in to rescue Northern

Rock

– run on the bank, 1st in 150 yrs, cost $100 B

• HBOS loses 30% value in 2 days

– UK's largest mortgage lender, acquired by Lloyds for

12.5 B pounds

• Markets in Asia, Australia, Europe drop

dramatically


Lack of Confidence

• Soverign Wealth Funds

– invested $ 43 B to Citi, ML, MS from Kuwait, UAE,

China, Singapore

• China Investment Corporation

– lost more than 75% of investment in Blackrock ($ 8B)

& Morgan Stanley

• Singapore Government Investment Corp

– invested $4.4 B in ML, lost a big chunk - reluctant to

recapitalize US assets again

• Waiting to stabilize, positive impact of AIG

bailout (AIG $1T balance sheet, $110 B

revenues, 110K employees 130 countries)


Why is this crisis severe?

• Slowing economy

– Recession: from fast growing to inflation filled slowing

down

• Deleveraging economy

– highly leveraged to less leverage, lack of credit, more

collateral, 02-06 household debt 11%

• Shrinking economy

– US economy after WW II from 50% of global GDP to

current 25 %( Source: David Rubenstein, Chairman Carlyle Group)

• Economy slowdown Financial Markets

previous

crisis

current

crisis


Credit Default Swaps

• Bets on whether a borrower will default

bonds rated

lower

bonds price

declines

stock price

falls

need to

raise capital

Financial accelerator – Ben Bernanke

write down

distressed

assets

borrow money

to pay off debt


U.S. Govt Bailouts

Source: Reuters / Christian Science Monitor


Crisis ComparisonS & L crisis (1989-92)

• $100 B losses (Market value of

insolvent banks)

• 21% prime rate

• High inflation

• 3,000 banks, thrifts failed, merged

• Economy, agricultural sector deep in

recession

• Initial bailout request $ 25 B

• Final cost of bailout to taxpayers

$150 B

Current financial crisis (2007- ??)

• $1,200 B of sub-prime mortgage

securities ($200-300 B held by US banks)

• 5.25 2 % prime rate (Sep 07 – Apr 08)

• Low inflation

• 3 of 5 top investment banks failed, no

independent investment banks remain

• Economy in recession, not severe yet

• Initial bailout request $700 B – might

reach $ 1 T (guess by Trea Sec)

• Final cost ??????


Reasons – Regulatory Complacency

• Fair Value Accounting (SEC, FASB)

– Mark to market: assign market value to assets

– illiquidity, opacity, what value to assign?

• Short selling

– Naked short selling: shorting stock without owning

• irrationally forced asset price decrease

– Removal of uptick rule:

• traders could short a stock only after it had moved up

– Hedge funds short positions on Credit Default Swaps

• Hedge funds

– No reporting requirements nor oversight


Effect of Crisis

• Availability of credit :

– student loans, credit card rates, mortgages, auto loans becomes

expensive

• Lending to institutions

– restricts credit to local business - car dealers, construction etc

• AIG break up

– ILFC largest aircraft leasing firm, sell off foreign insurance

businesses

• 70% of all spending in US by consumers

– cut back on spending, more recession, later recovery - little

savings and are deep in debt through credit cards, car loans,

home-equity loans

• Increasing unemployment


Fed Government Deficit

• Pre-crisis national debt $ 10.3 Trillion

• Bailout amounts

– Freddie, Fannie $ 100.0 Billion

– Bear Stearns $ 29.0 Billion

– AIG $ 85.0 Billion

– Paulson’s plan $ 700.0 Billion

• Post-crisis national debt $ 11.6 Trillion +

• Trade deficit $ 9.0 Trillion

• Unfunded obligations (SS,..) $ 54.0 Trillion


What can be done ?

• Unified regulator, FINRA

• Tougher oversight, ensure compliance

• Reinstate uptick rule for short sellers

• Hedge funds

– make it more transparent

• Independent agency to dispose bad debt

– Ensure transparency, no party affiliation, smooth

transition

• Taxpayer stake in firms rescued

– No free lunch for Wall St firms


Source: NBC Nightly news, Sept 22, 2008

http://www.msnbc.msn.com/id/3032619/


Updates

• Sept 24:– NY Insurance Regulator to regulate $ 12 T out of $ 62 T CDS

market

– Berkshire invests $ 5 B in Goldman Sachs

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