Wednesday, 17 September 2008

The fall of Lehman Brothers

Yes, never before has a financial storm hit the "proud" investment banks so badly. When LTCM - Long Term Capital Management - a large hedge fund collapsed in 1998 - the figures were USD 4 billion. Now the figures are much bigger.Let us look at the genesis of this crisis and try figuring it out in a simple manner.

  1. Mortgages were sold to American residents (the great American dream - every American owns a house) by "Originators" (the largest of them was Countrywide Finance in the US). Look at the Home Ownerships rates in Slide 1. In year 2005, it was almost 70%, the highest in history (I don't have data for 2006 or 2007).
  2. The Originator collects their Origination Fee (say 2 or 3% of the mortgage) and then sells the Mortgage to a wholesale investor in the form of Mortgage Backed Security (MBS). These wholesale investors could be commercial banks (like Bank of America) or asset managers (like Vanguard, PIMCO, Fidelity, etc) or hedge funds. Typically it is investment banks like Lehman Brothers, Goldman, etc that were doing the structuring of the MBS and helping in selling it to investors. The investment banks collected their feesof 2 to 4% on the structuring. Why does the Originator offload the mortgages from their books? This is to free up capital and to originate more mortgages so that they can get their 2 or 3% fee.
  3. Of course, Originators have to keep finding newer clients to sell more mortgages and that is where they started selling Sub-prime mortgages. This meant that they were giving mortgages to people who may not have the financial capacity to service the mortgages. There were bad practices like:* Teaser rate mortgages - that is mortgages given at an artificial low rate of 2% for the first few years (obviously, there is no free lunch........the interest rate in later years would be much higher!).* In a low-interest rate scenario, most of them sold ARMs (adjustable rate mortgages) - floating rate mortgages. When interest rates zoomed, many people couldn't afford to pay the higher mortgage payments.* Encouraging people to buy a second or third property based on the home-equity of the first property (the practice of home equity doesn't exist in India).
  4. The going was good as long as Property Prices were going up. Everyone was feeling rich. The homeowners were happy to take more and more mortgages as property prices were shooting up and they would feel left out. The originators got their 2% fee. The investment banks got their 2% fee. The investors were sitting on MBS that seemed well into the money. In fact, the going was so good that many investment banks started making Principal Investments in MBS, rather than selling it out to investors. (Investment banks make Principal Investments when they buy shares or bonds for their own books. They also operate pure Agency business - brokerage - when they buy shares or bonds for their clients). These MBS were sold to investors worldwide - Australia, Hong Kong (when I was in HK in 2007, UBS was selling US-based MBS to HK high network investors!), India (ICICI had some exposure), etc.
  5. The music in the musical chairs stopped when interest rates shot up and property prices tanked and many of the homeowners - subprime and others - started defaulting on payments. And, this started in year 2007.
  6. So, the investors who had invested in the MBS found that they had bought it at higher prices and the value of the MBS had come down dramatically. In some cases, the MBS structures were very complex that people were not able to determine their current values. (Remember, unlike shares that are traded on stock exchanges and valuation is readily available, MBS are private investments with no observable quotations and no ready market).In August 2007, Bear Stearns shut 2 hedge funds that invested in MBS. This was the first sign of trouble!
  7. Then investors started writing down their investments - UBS wrote off $10 billion in Dec 2007 and got more equity funding from GIC of Singapore of $9.7 billion to shore up its capital. Subsequently it has written down over $37 billion and has raised capital through rights issue. UBS changed its CEO and many top managers.
  8. Even Merrill Lynch did similar things in 2007 and got a new CEO. The new CEO of Merrill Lynch sold off some of these assets about $ 30 billion of them at a value of 22 cents to a dollar.
  9. Other banks also wrote off their investments to varying degrees. In all, till date an estimated $510 billion has been written off. Isn't this huge?Look at Slide 2. The outstanding Mortgage related bond market debt as of end 2006 is $ 6,492 billion! Assuming an US population of 350 million, this translates to per capita mortgage debt of $18,500. So, only 7.8% (=510/6492) has been written off when property prices have contracted by over 30 to 50%! Some estimates put the total writedowns to $1.6 trillion (that is 1,600 billion).
  10. Even if the banks wanted to sell off these assets at a loss, it wasn't possible as the market for these instruments also disappeared and no one would touch these "toxic assets".
  11. The question is: If all investors in MBS were hurt, why is it that only Bear Stearns and Lehman Brothers and Merrill Lynch or smaller hedge funds have shut shop? Why hasn'tBank of America shut shop or a UBS shut shop? Why hasn't Goldman Sachs shut shop?This is where one needs to see the characteristic of the investor.* A Bank of America is a commercial bank that has tighter regulations. It has a diverse business and it has stable funds (largely deposits). Given its stable investors, BofA can hope to hang onto its assets. So, BofA can writes off $30 billion and still withstand the writeoff.
  14. UBS - has had huge writeoffs. UBS is largely a wealth management firm (managing wealth of others) and hence has a stable business. It has had to sell off some assets and raise more capital from its existing as well as new shareholders. Till date it seems to have weathered the storm.See enclosed the detailed report of UBS prepared for Swiss authorities and investors.* Smaller hedge funds - would have shut shop. These don't get reportedly as widely!
  15. Bear Stearns and Merrill LynchHere is a detailed story of Bear Stearns.
  16. If you read the article in detail, you will figure out that there was a crisis of confidence. Investment banks are heavily leveraged, that is, their main source of funds is debt taken from investors on a short-term basis. These investors could be other banks or pension funds or asset management firms. Unlike commercial banks whose source of funds is a relatively stable deposit base, investment banks' source of funds depends on the confidence of those who have given it the funds. Should the confidence disappear, the investors will pull back their money. Other banks will not choose to deal with Bear Stearns or Merrill Lynch. So, Bear Stearns and Merrill Lynch got bought out by JP Morgan and BofA respectively. In the case of Bear Stearns, the Fed chose to guarantee any potential loses of the assets taken over by JPM from Bear Stearns.Merrill choose to get sold to BofA before it was too late! Only the executives in Merrill know the value of the "toxic assets"* Lehman BrothersLB is the oldest investment bank......started 158 years ago! The CEO of LB erred in not raising capital quickly enough or selling its assets. As its losses mounted and it had to writedown more, the confidence in the marketplace kept dipping. Last week, the talks with Korea Development Bank didn't frutify. Talks with Barclays also collapsed. Investors were getting jittery and other banks would have stopped trading with Lehman. So, LB chose to file for Chapter 11 bankruptcy. Chapter 11 bankruptcy prevents lenders to LB from pulling out the funds. This gives LB some time to slowly dismantle its business.
  17. Goldman Sachs: GS had to writedown a little. Goldman Sachs has been able to weather the storm. Apparently, some smart traders within Goldman recognised in early 2007 that the mortgage industry would see trouble and then they offloaded all their positions.
  18. Freddie Mac and Fannie MaeThese companies (they once used to be govt owned institutions, later they were made private companies) were the largest issuers of MBS and were sitting on huge pools of subprime mortgages. They also played a huge negative role in encouraging the practices of the mortgage markets. Finally the US govt had to takeover these companies.
  19. What does this all mean to the future of global financial markets? * Cash is king.• Business is all about prudence. Warren Buffett always advocates a simple business. He says "All boats ride when the tide is in. You should be a boat that rides even when the tide is out".• Question all assumptions! Like Nasim Taleb's "The Black Swan", the fact that you are only seeing white swans doesn't mean there is no black swan. In this instance, the assumption was that property prices would come down..........and they wouldn't come down so dramatically. In the year 2006 itself, the Spanish property prices had crashed by over 30%. This should have been the Black Swan!• Risk management practices need to be stronger. Many banks didn't adopt the principle of "Don't put all eggs in one basket". Even if you didn't put all eggs in one basket, monitor them closely to see whether they became rotten.• The era of independent investment banks may be over. Commercial banks will rule the markets. GS and Morgan Stanley are the only global independent investment banks!
  20. The futureSure enough, things will be stable in the next few months.Sure enough, there will be other innovations in the next few years when markets will do well.Sure enough, there will be more malpractices and imprudent business practices that will bring big business to dust.This last year it was the turn of the "proud" investment banks to bite the dust. Hopefully, after the dust settles, the remaining banks will learn to be humble.