Issue 43 - April 09, 2008

Q1 2008

The first quarter of 2008 was a watershed period for financial markets. The series of credit related problems which began last summer culminated in the failure of Bear Stearns, the fifth largest US investment bank; a firm which had been profitable for its previous 85 years. While the initial strains were limited to the sub-prime segment of the mortgage market, illiquidity and excessive leverage conspired to create an avalanche of issues across the credit spectrum.

The seeds of these problems were sown over a number of years and as such it will certainly take more than one quarter to restore equilibrium, but the process is well underway. The Federal Reserve has continued to fight the problem on a number of fronts. They have lowered the benchmark rate from 5.25% to 2.25% and have substantially relaxed standard collateral requirements. In addition, they have sponsored a variety of creative funding programs in an effort to provide sufficient liquidity to the banking system.

The Call

On Thursday, March 13th Bear Stearns informed the Treasury, the SEC, and the Federal Reserve that they were on the brink of filing bankruptcy …

Banks and broker dealers are chartered to be vastly different animals. They have different regulatory requirements and oversight and in theory, different businesses. These distinctions were put in place in 1933 through an act of Congress known as “The Glass Steagall Act”. This act was on the books until 1999 when it was repealed in an effort to increase efficiencies and competition among modern day financial institutions. While the Graham-Leach-Bliley act officially repealed the 1930s legislation, many meaningful distinctions remained.

Banks lend money and their deposits are guaranteed by the Federal Deposit Insurance Corporation, better known as the FDIC. They are supervised by the Federal Reserve and the Office of the Controller of the Currency and they have strict regulatory capital requirements.

Broker dealers are not banks. They are in the business of underwriting stocks and bonds and are responsible for the secondary trading of those instruments. Client funds held at broker dealers are not guaranteed by the FDIC; however they are insured by the Securities Investor Protection Corporation, or SIPC. Broker dealers report to the Securities and Exchange Commission and Financial Industry Regulatory Authority (FINRA), and they enjoy much more relaxed capital requirements.

Deposits make up the majority of the funding for a typical bank while broker dealers are reliant on the open market on a daily basis to fund their positions either on a secured or unsecured basis. Because of the nature of their business and the strict regulatory and capital environment under which they operate, banks have a decided advantage when it comes to illiquid markets. They have access to the Federal Reserve’s balance sheet through what is known as the “Discount Window”. This funding source is the ultimate “Get out of Jail Free” card for illiquid markets. A bank may go to the window and post securities at the benchmark rate in exchange for cash in order to help them through any difficult period. Historically, broker dealers had no such access. If the open market no longer wishes to finance their positions on any basis – that institution has no further option than to seek the protection of the bankruptcy court. Liquidity is definitely not courageous. Once there was a suggestion that Bear Stearns, a broker dealer, was in trouble, no one was willing to gamble with their own funds and the run was on.

The Response

By Friday morning, the news was out. A potential failure would have far reaching and unprecedented implications involving thousand of positions and contracts and hundreds of counterparties. The Federal Reserve, in coordination with the Treasury, worked over the weekend to arrange for a buyer of Bear Stearns. There was only one bidder, JP Morgan, and it was clear that there needed to be a deal by the time markets began to trade on Monday, March 17th in Tokyo. Terms were released on Sunday evening. In addition to the purchase news of Bear Stearns, the Federal Reserve announced that for the first time since the 1930s, those broker dealers who were also primary dealers of government bonds would also have the ability to borrow directly from the Federal Reserve window for the next six months. The primary purpose of such a facility was to ensure that the dealer community would be able to finance themselves and withstand the anticipated liquidity drains first thing on Monday. But it also had the self-serving benefit of ensuring that there was someone left to assist the Treasury in their own issuing mechanics (of U.S. Treasury securities).

Despite the announcements, many broker dealers saw their stock values decline precipitously as markets participants sold first and asked questions later; Lehman Brothers was at the epicenter of this turmoil. Markets ultimately calmed and Lehman has subsequently been able to raise substantial capital. Markets have continued to stabilize as it appears that after nine months of rolling disclosures, the scope of the problem is understood, or nearly understood, and the tools are in place to help facilitate further unwinding.

The coming months will likely feature additional credit write-downs and painful losses as assets transfer to buyers with stronger balance sheets. However, as banks get back to business they will be presented with extraordinary earnings opportunities. Credit spreads are wide by modern standards and many of the unregulated lenders that banks competed against are no longer standing.

Housing overall will continue to be a challenge and those local markets which have already suffered the largest declines will likely have the longest period of recovery. There are a number of plans on the table to provide relief at both the homeowner and the lending institution levels. But even a plan that might be announced today will have practicalities which will need to be addressed. This will take time and the recovery will be uneven.

Investing Opportunities

Long-term investors have been treated poorly through this process. Valuations have been largely ignored and quality stocks and bonds have been in many cases simply a source of cash to meet margin calls and redemptions. Indiscriminate selling however has led to meaningful dislocations particularly in the highest quality sectors of the market. Municipal Bonds for example remain at absolute levels well in excess of US Treasuries – unprecedented territory and opportunity.

The economic news is not likely to improve in the short-term, but it is important to consider that markets anticipate (not always correctly) and that the current levels of valuation reflect extreme pessimism. Further de-leveraging will not necessarily preclude forward progress on returns, although it is fair to say that it will be a drag. On the positive side, what good news we do receive will go a long way in this environment.

• Q1 2008
• The Call
• The Response
• Investing Opportunities