Comment 59: An anatomy of the meltdown of Wall Street and beyond. Tracing the liquidity squeeze (9) (Sept. 25, 2008)

We always say that the ongoing liquidity squeeze is like a major hurricane that spurs many violent financial tornadoes, and causes wave after wave of panics in the financial market. The recent fall of Lehman Brothers, the sale of Merrill Lynch and the defacto nationalization of the insurance giant AIG has even touched off the run on 3 trillion dollar mutual money market funds due to some funds holding papers of Lehman Brothers sustained substantial losses. We will not argue here whether US Treasury should have bailed out Lehman Brothers just like Bear Stearns to minimize the impact of this firestorm, but will only point out that apparently this firestorm caught US Treasury by surprise and sent it into panic to the degree to propose the hastily assembled 700 billion dollar Wall Street bailout plan. Since the name of this plan is still not well settled yet, we tentatively call this plan R.T.C.II, where R.T.C. stands for “Resolution Trust Corp.” that was the old entity of Reagan-Senior Bush era to hold the soured assets of failed savings and loans of late 1980's. What this huge government spending will do to the financial market, where the money will come from and what impact this plan will have on the overall economy need to be evaluated carefully. This comment is dedicated to this purpose.

To understand the full scope and the impact of this R.T.C.II on the financial market, we need to examine the process of the meltdown of Wall Street and extract common characters of failures. Many aspects of this task have already been discussed extensively in the comments in this series, titled “Tracing the liquidity squeeze”, and in article 10, so those aspects will be only summarized here. To begin with we post our favorite updated graph to show the onset of financial panics at the right. Due to the width of the daily graph, we cannot show the whole graph, but have only extracted the portions of the graph that are relevant to this discussion. The heights of the red and the green curves measure the level of panic of the financial market; the definitions of those curves are given in the graph so will not be repeated here. Section (1) of the graph covers the period of the first firestorm that shut down the market of commercial papers backed by ill fated mortgages and the implosion of SIV (see Comments 46, 48, 49, 50, and 51 about that opening salvo of the era of financial firestorms). Section (2) of the graph covers the 2007 year-end panic that has forced The Federal Reserve Board to lower the target rate of federal funds by an unprecedented amount in a very short period. Section (3) covers the period of the fall of Bear Stearns, and Section (4) deals with the current panic of our concern. The period of the fall of Fannie Mae and Freddie Mac is not included since everyone knows that US Government will not walk away from debt obligations and mortgage backed securities guaranteed by those two mortgage giants, and so the financial market did not panic very much. We can see that in the ongoing panic the heights of the red and the green curves far exceed the previous peaks in Sections (1) to (3). This helps us to understand why US Treasury is panicked into proposing the 700 billion dollar bailout plan.

We estimate that there are 3 trillion dollar toxic debts in face value. When various entities purchased those toxic debts, most of them have used short-term borrowings to finance the purchases. The reason of this financial scheme is as follows: The entities that bought the toxic debts profits from the difference between the interests received from the toxic debts and the interests paid out to borrow the money to finance the purchases. The lowest cost borrowing is the short-term borrowing. Since the efficiency of profit in this model is rather poor due to the small difference between two kinds of interest rates, the participating entities need to borrow huge amount of money to purchase large amount of toxic debts in order to have enough profits that makes the effort worthwhile. The ratio of borrowed amount to the capital of an entity is called the “leverage” ratio. Those entities loaded up with large amount of toxic debts usually have a very high leverage ratio, often as high as more than 30 times. At the bubbling times those entities had no trouble to roll over their short-term borrowings and enjoyed enormous amount of easy profit. However, when the bubble bursts and the liquidity squeeze sets in, those highly leveraged entities encounter increasingly the difficulty of rolling over their short-term debts and start to fall apart, naturally from financially weak ones first.

Let us consider an example to illustrate how the leverage backfires. Suppose an investment bank with 30 billion dollars of capital decides to use 3 billion dollars of its capital to engage in the game of toxic debts. It borrows 30 times of the 3 billion dollars, that is 90 billion dollars in short-term to purchase 90 billion dollars of toxic debts. Such purchases naturally boost the price of toxic debts. During the bubbling years the rollover of 90 billion dollars of short-term borrowings is not a problem and the game brings in handsome profits quarter after quarter. However, when the bubble bursts and the liquidity squeeze sets in, the purchasers of the toxic debts dry up and the price of those toxic debts naturally fall. Suppose the price of toxic debts falls by one-third so the market value of 90 billion dollar toxic debts held by the investment bank now only worth 60 billion dollars. This loss of 30 billion dollars wipes out all the capitals of the firm so that it is insolvent by definition. When the market notices the trouble of the firm, lenders refuse to rollover the 90 billion dollar short-term borrowings, and the clients of the firm will withdraw money from their accounts managed by the firm. Thus the investment bank collapse literally within a very short time. That was what happened to Bear Stearns and Lehman Brothers. That is also why Merrill Lynch is merged with Bank of America so its short-term borrowings can be supported by Bank of America's huge deposit base.

The demise of the insurance giant AIG takes somewhat different path. In Comment 54 we have estimated the exposure to toxic debts for various industries by examining the pattern of sale of corporate bonds in the last half of 2007, using data from the z1-report of The Federal Reserve Board. In that comment we found no evidence that insurance companies were exposed significantly to toxic debts directly. However, we warned that it does not mean insurance companies are free from indirect exposure to toxic debts through financial derivatives. Considering large amount of financial derivatives to insure the default on those toxic debts outstanding, insurance industry is one of the natural suspects that has provided such insurances. Unfortunately that suspect has become the reality with AIG. AIG has sold more than 100 billion dollar worth of such insurances. As the price of toxic debts fell, AIG sustained increased call of collateral to cover its losses in those insurances, and thus was driven to the brink of bankruptcy. Those financial derivatives, called Credit Default Swap or CDS, are unregulated private contracts between two parties. The default of AIG will nullify the protection bestowed on the holders of actual toxic debts through the insurance so many of them will be pulled into destruction, too. It is estimated that there are over 60 trillion dollar worth of CDS outstanding. Considering that there are only less than 10 trillion dollars of US corporate bonds in total, the players in the game of CDS are multiple players. This means that many players pulled into destruction by the default of AIG must have sold some form of CDS to others so the buyers of their CDS will also fail, and so on. This kind of domino effect will bring down the whole house cards of CDS of 60 plus trillion dollars. The collapse of the house of CDS will certainly bring down the whole global financial system and will usher in a global depression. That is the reason why US Government has no choice but to infuse 85 billion dollars into AIG to prevent its outright default.

The bane of heavy leverage is not only limited to the entities that lose big in toxic debts. Even the firms showing reasonable earnings cannot escape the fate of demise as it becomes increasingly difficult to roll over their short-term borrowings, even though those borrowings are not related to losing positions, at the time of steadily advancing liquidity squeeze. That is why the remaining two prominent investment bankers, Morgan Stanley and Goldman Sachs have abruptly transformed themselves into commercial bank holding companies. Investment bankers are loosely regulated by SEC but commercial bank holding companies are regulated tightly by The Federal Reserve Board. Readers interested in the detailed implications of the transition are referred to an excellent article by John Hilsenrath, Damian Paletta and Aaron Lucchetti on the website of The Wall Street Journal. In essence, commercial banks are not allowed to have high leverages as investment banks, and are forbidden to conduct risky dealings, but are allowed to take deposits from depositors to secure a more stable funding. The transition is tantamount to the announcement that the leverage will be reduced and the firms will be managed much more conservatively from now on. This transition has allowed those two firms to attract urgently needed capital infusion to reduce their leverage. After the announcement Morgan Stanley has already received capital infusion from a giant Japanese bank, and Goldman Sachs has received capital infusion from Warren Buffett's Berkshire Hathaway.

The rapid-fire disappearance of five major investment banks and the demise of AIG can be properly described as the meltdown of Wall Street. Some claim that after the meltdown, Wall Street will be dominated by hedge funds and private equity firms, playing the role of the five disappeared investment bankers. No matter who play the dominant roles on Wall Street from now on, the days of high leverages are over. Swash-buckling wheeler dealers will be replaced by stogy commercial bankers with regulators looking over their shoulders every step on the way. Total size of deals on Wall Street will be much smaller since high leverage ratios are not allowed. Overall profits from the deals will be reduced substantially as the result. Far fewer people will be working for Wall Street, too. Though this meltdown will not send Wall Street into oblivion yet as depicted in the sarcastic drama of article 7 on this website, its former glory days have definitely gone with the wind.

The common undertone in our discussion of the meltdown of Wall Street is the ongoing liquidity squeeze. Readers not familiar with previous writings in this series titled “Tracing the liquidity squeeze” may wonder where this liquidity squeeze come from. Let us summarize our finding here quickly. Since articles 1, 2, and 2A, we have found that the US economic cycle is synchronized with the flows and ebbs of trade deficits and the trade deficit is in turn pushed around by the exchange rate of US Dollar with the currencies of its trade partners. In Comment 46, the starting comment of this series, we have pointed out that the formation of the current debt bubble and its burst are due to the third phase of the runaway trade deficit and the wane of that trade deficit since 2006. In article 10 a more thorough study of the relation between bubbles and trade deficits is presented. The reason that the flows and ebbs of trade deficit will cause the formation of bubble and its burst can be summarized quickly as follows: A modern financial system requires seed money to operate. In the era before globalization the seed money must come from personal savings. In the globalization era, the runaway trade deficit can replace personal savings to serve as the seed money to the financial system. As US runs trade deficit, dollars are handed over to foreign manufacturers and those dollars eventually flow into the hands of foreign governments through the process of currency market intervention to keep their currency suppressed and their exports humming. Foreign governments have no choice but to bring large blocks of those dollars back to the US financial market to generate some returns. Those returned dollars flow through the hands of Wall Street and become the seed money to the US financial market to be lent out repeatedly. By this way Wall Street can brew bubbles by repeatedly lending out this huge sum of flowing back dollars without the constraints imposed by The Federal Reserve Board. At the present stage US personal savings have dwindled to near zero and almost all the seed money comes from the runaway trade deficit. However, the runaway trade deficit causes US Dollar to depreciate in spite of tremendous efforts of foreign governments to prevent its fall. As Dollar falls, US trade deficit wanes. US trade deficit has peaked in early 2006 at 6% of GDP, but dwindled to 5% of GDP by early 2008. This means less seed money for the financial market and an ongoing liquidity squeeze. There is no prospect that US Dollar will strengthen in near future to the degree that US trade deficit will expand anew, and there is also no prospect that US personal savings can grow rapidly in foreseeable future. Thus we should expect the liquidity squeezed to continue for quite a while.

As Wall Street melts away under its own weight, the burden to carry toxic debts shifts mainly to the shoulder of commercial banks, posing serious danger for the whole financial system. US Treasury's proposed 700 billion dollar bailout plan is designed to prevent the collapse of the financial system. The plan is to buy toxic debts held by various financial entities. The first question is at what price to buy those toxic debts. The current ongoing market price is like 50% to 60% discount for those toxic debts from their face value. Some financial entities have written down toxic debts to certain degree, some already to the level of the market price and some are not. There are also substantial number of holders of toxic debts that have not written down their holdings. The buying of the toxic debts will be performed through reverse auctions that works as follows: US Government will announce a reverse auction, say of buying 50 billion dollars of toxic debts. The entities that want to participate will submit a price for their toxic debts. US Government buys those debts from the lowest priced ones first until it fills all 50 billion dollars. How about to view the auction from the holders of the toxic debts? If a holder sells his toxic debt below the price that has been written down, he will receive a financial hit. Therefore, the holders will be reluctant to sell their holdings below the already written down prices. For example, if a holder has already written down his holdings by 30%, he will not sell the holdings to US Government beyond this 30% discount, otherwise he will receive a financial hit. We can expect that the most written down toxic debts will be sold first. As the reverse auctions are repeated, the prices that US Government pays will steadily rise. As a whole the prices sold to US Government will be substantially higher than the ongoing market price. In order to deflect the unavoidable criticism that US taxpayers are ripped off by paying such high prices, an idea of “maturity price” is floated. The maturity price is the money that can be recovered if the toxic debts backed by subprime mortgages are allowed to be kept to maturity. Let us estimate what this maturity price is. It is said that totally 5 million mortgages will be foreclosed in the aftermath of the burst of the mortgage bubble. Let us assume that only 3.5 million foreclosures are due to subprime mortgages. There are 1 trillion dollar worth of subprime mortgages. With average housing price about $200,000, there are totally 5 million subprime mortgages outstanding. The 3.5 million foreclosures mean an eventual 70% foreclosure rate. Suppose 60% of the amount of the mortgage can be recovered at the time of foreclosure. That means at the end 1 trillion dollar worth of subprime mortgages will become 580 billion dollars, that is the discount by 48%. If this whole process takes 10 years to complete and annual inflation rate will be 3%, after adjusted for this inflation, the current value of maturity price of this 1 trillion dollar subprime mortgages becomes about 400 billion dollars, or 60% discount. This number is not so different from the current market price for such toxic debts. The expected substantially higher buying price of those debts under the plan, thus, cannot be the maturity price. It is an arbitrary higher price necessary to save the troubled financial system. If we concentrate only on this plan, US taxpayers is almost certain to lose a substantial sum when the dust finally settles. However, what amount US taxpayers will lose should not be the concern here. The question is if the whole financial system collapses and the real economy is pulled into a deep recession, what will be the cost. Therefore, our concern is on the consequence of this plan, not its superficial costs to taxpayers.

Even with this 700 billion dollar rescue plan, there is still a serious uncertainty hanging on the head of the whole financial system. We estimate that there are about 3 trillion dollars of toxic debts outstanding. With a market price of 50% discount the loss is something like 1.5 trillion dollars. So far various financial entities have written down about 500 billion dollars. Counting the 85 billion dollar infusion by US Government to AIG and the likely under write-down by those financial entities, there are still about 800 billion dollars of loss not accounted for. Some of those hidden toxic debts are probably held by deep pocket investors who purchased those toxic debts from their own capital so do not need to roll over short-term borrowings, and are willing to hold them to maturity. We do not need to worry about those lucky (may be unlucky) investors. However, we suspect there are a few hundred billion dollars of loss, or about 600 billion dollars of toxic debts not accounted for. Most likely the holders of those toxic debts are protected by derivatives like CDS so that those holders do not consider that they have lost any money and thus no need to report their holdings. As explained in the discussion about the demise of AIG those private unregulated derivatives are zero sum games. If someones are protected by the insurances, someone must have sold those insurances and now carrying enormous potential losses. We do not know who those insurance sellers are, but the market participants speculate that they may be large multinational banks. The sales of those insurances are not tangible securities and certainly are not covered by the rescue plan. What if the mystery holders of those toxic debts decide to tender their securities to US Government through the reverse auctions and then request insurance sellers to make good of the difference between the price they bought those securities and the price that US Government buys those toxic debts. At that time another firestorm is certain to erupt.

The amount of liquidity, or some call it credits, is determined not totally by the amount of the seed money for the financial market, but also influenced by the speed of turning over the seed money. In a simplistic way we may consider as follows: Suppose there are 600 billion dollars of trade deficit to serve as the seed money for the financial market. If it is turned over 5 times a year, 3 trillion dollars of liquidity or credit are created. If it turns over 10 times a year, 6 trillion dollars of liquidity or credit are created, and so on. At the height of the bubble, both the seed money from the trade deficit and the turn over speed reached the maximum and thus allowed the entities leveraged to the maximum. When the trade deficit wanes, the seed money starts to shrink, buyers of the already highly inflated debt instruments dwindle, the prices of those toxic debts start to fall, and the turnover speed also slumps. The resulting squeeze on liquidity is thus much worse than the rate of the shrinkage of the seed money. The 700 billion dollar rescue plan replaces some toxic debts with cash for the financial system. The financing of this rescue plan is to get the money by selling Treasuries into the open market. This means that the source of the financing of this rescue plan also come from the seed money provided by the trade deficit, so the plan will not increase the total amount of seed money. What this rescue plan will do is to push up the turnover rate of the seed money somewhat by unclogging the artery of the financial system that are clogged by toxic debts, and thus helps to ease the liquidity squeeze to certain degree. However, if the trade deficit continues to wane as we expect, the dwindling seed money will eventually overwhelm the stimulus on the turnover rate provided by the plan, and the condition of the liquidity squeeze will return to the level before the rescue plan, probably within 6 months. We regard this rescue plan as a temporary relief, but not as the panacea. What will US Government do if our projection becomes the reality and the grand liquidity squeeze returns? The last resort of US Government is for The Federal Reserve Board to print money in large scale to replenish the dwindling seed money for the financial market. Such large scale monetization,of course, is highly inflationary. Any time when economy rises its head, inflation is going to zoom up. If The Federal Reserve Board acts prudently by raising interest rate at that time, then another economic slow down will set in, creating a prolonged stop-and-go scenario with the economy standing still when averaged out. If The Federal Reserve Board lags behind the inflation surge, then high inflation will turn into hyper inflation and the scene of 1970's will be repeated.