There's A Hole In My Bucket

Dear Liza, dear Liza, there's a hole in my bucket, dear Liza, a hole. The bucket is the U.S. financial system, soon to be the U.S. economy. Let's face it. This is the worst financial crisis since the Great Depression. It has the potential to get much, much worse. Something needs to be done in order to at least stop the bleeding. Hank Paulson and Co. can't wave a magic wand and fix everything by buying up $700 billion in toxic debt. They can however, start Fixing A Hole (The Beatles - Sgt. Pepper's). The plan will help. There is no doubt about that. There is also no doubt about the fact that nobody wanted it to come to this. The government should always remain as far out of the markets as possible. Yes, there is a role for government in basic regulation, but excessive intervention serves to privatize rewards and socialize losses.

Now you might say, well, "hey, wasn't it a lack of regulation that got us into this in the first place?" Yes, it partially was. It was also partially the fault of the government who enacted legislation in the 1970s, and again in the 1990s that encouraged lenders to give out mortgages and loans to people who couldn't necessarily afford to pay them back. This legislation really took effect as soon as interest rates plummeted in the early 2000s.

Have you ever seen the commercials that say "BAD CREDIT, LOW CREDIT... NO MONEY DOWN!!" or "NO CREDIT, NO MONEY,NO PROBLEM"? Yeah, you saw them. You don't see them much anymore. Basically, credit was extended to people who could not afford to keep up with the payments in the long-run. Sure they could pay for it when the overnight rate was 1%, and money was basically free, but rates went up 17 times to 5.25% for overnight borrowing. That feeds through to the rates on mortgages in a big way. Most of these mortgages were ARMs. They reset to the higher rate after a few years. So all of a sudden, instead of paying say $10 in interest, you're paying $30. If you're income is $60, that's a big problem. Now, it was made a lot better by the fact that home prices were rising. So, you at least had some more equity in your house. Then the value of homes started dropping. The bubble burst. So now what do you do? Well, in some cases, the value of the mortgage was worth more than the home - negative equity. So what do you do? You default. You don't pay.

That feeds through. The lender that gave you the $200,000 mortgage can maybe now expect to recover $100,000. In some areas where home prices have fallen by as much as 30%, maybe you expect to receive less. So, why isn't this a localized problem? Why isn't it just the lenders in California, and Florida (or wherever) that are feeling the pain? Well. This is where we can put some blame on the banks, the financial engineers. There are these things called structured products. They take many forms. Some are Collateralized Debt Obligations (CDO), some are Collateralized Loan Obligations (CLO), some are Mortgage-Backed Securities (MBS). In their most basic form, they take a payment from here, a payment from there, throw it in a nice blender, and you have a new security to sell around the world.

The ratings agencies didn't really know how to deal with this. Some of these products had pretty reliable characteristics (AAA). But some of the other tranches (think, different "levels" of the debt) were super risky. Sometimes a lot of the product was made up of super risky cashflows. They added the juiced up yield that investors were starved for.

So what happened? Well, these loans started to go sour. People started missing payments. People started defaulting. The cash flows that were expected to occur now won't occur. The major banks invested in these assets. Over the past year, they have had to continually write the value of these assets down. They banks have to mark them to market. As noted in an earlier post, Merrill recently wrote down the value of some of its holdings to 22 cents on the dollar. Many other banks have followed suit, although potentially not quite as drastically. So these writedowns have resulted in big-time losses.

The big-time losses are bad, but it's made worse when many of the financial institutions were levered at 30 to 1. That means for every dollar of equity, there was 30 dollars of debt on the balance sheet. It's all fine and good to juice up returns through leverage (debt costs less than equity), but when the losses start piling up, the equity cushion disappears quickly. So the banks have had to raise collectively hundreds of billions of capital to cushion the losses.

But what happens when everyone is holding these assets, but no one really knows what the other guy is holding. All the banks trade with each other, and they are all exposed to counterparty risk - the risk that the guy you trade with or lend to today won't be around tomorrow. Traditionally, the risk was fairly low between the big-name institutions. Lehman would have no problems trading, lending, or borrowing with Bear. Things changed. Borrowing between banks became risky. The London Interbank Offered Rate (LIBOR) hit its all time high on Tuesday at 6.88%. What's worse, thousands of companies have their cost of borrowing directly tied to LIBOR. BANG! The cost of funding business just skyrocketed. Not good at all.

After the nationalization of Fannie and Freddie, the outright collapse at Lehman, the near-collapse at Merrill (thank-you B of A), and the rescue of AIG, there was a general panic in the markets. It was more a crisis of confidence than anything else. Institutions that had largely avoided the heart of the disaster (Morgan Stanley and Goldman Sachs), were now the target of the short-sellers. People had zero confidence in the companies, and zero confidence in the business model. If you didn't have a large base of deposits to draw upon, you were dead meat. So down went Lehman and Merrill, and with them, the business model of the pure investment bank. Morgan and Goldman two Monday's ago applied to be bank holding companies. The end of an era.

Where do we stand now? Well, this crisis will reach mainstreet. The American public might change it's tune about not bailing out the "fat cats" once they realize that they can't get their student loan, a mortgage, or a new line of credit. If a few more institutions the size of WaMu fail, then the FDIC probably will run out of money to cover the losses. Then it will hit mainstreet. Hopefully the bailout is passed. Personally, I'm a big-free market guy. I dislike the government greatly. However, if ever there were a time for the government to step in and try to stop the bleeding, it is right now. There is no liquidity out there. Look at what happened with Xstrata and Lomnin today. No financing for the deal, the deal falls through - lots of value erased. This will continue to happen if liquidity doesn't return. It will get worse if we have to keep on going institution by institution, trying to determine which ones we can save, which ones can be acquired, and which ones will fail.

The bailout bill needs to pass. The Democrats and the Republicans need to come together and get it done. Nancy Pelosi needs NOT to make a highly partisan speech moments before voting. Hopefully, in due course, if the deal goes through, the asset values will rise again, and the government make end up making money. The government needs to step in and fix the hole in the bucket. Until the leaking stops, the financial institutions won't be able to deliver the water (loans) to the public. We need to stop the bucket from completely bursting. It will be disaster for Wall Street, and yes, Main Street will feel it in a big, big way.