Black Sunday?

Well,

It has been entirely too long since my last post! :-)

Family-wise, we are all very busy. This summer was rather on the boring side for the Baldwin family what with still supporting two mortgages in this down housing market. Times are tight especially given the significant increases in food and energy prices of late. Still, we are managing to keep our collective heads above water financially, at least for the time being. I am mega-busy on the job as we are now knee-deep in our Lotus Notes to Microsoft Exchange email migration, which I am entirely responsible for. This project will hopefully be complete before the Thanksgiving holiday, at which point we'll be able to dial it down a notch or two and breath a little bit. Until then, I will have no life.

Finances, you know I love to talk about finance and economics.

Yesterday, Lehman Brothers, the 150 year old brokerage house, announced chapter 11 bankruptcy filing after several failed attempts to either obtain funding or find someone to buy them last week. The market responded by dropping 4.5% or over 500 points in a single day. Not good. Remember Black Monday from way back in 1987? Today may indeed end up being called Black Sunday in the history books folks. AIG, one of the largest insurers in the world, is quite likely next on the Wall Street chopping block, with likely followers such as WAMU (Washington Mutual) - the largest S&L in the United States mind you, along with several other large regional and national banks with significant risk exposure to derivative investments gone bad - such as CDO's, CLO's, RBMS's, CMBS's, and various other acronyms that most folks don't have much familiarity with (which is probably part of the problem in all honesty - too much unregulated complexity). For those who don't really understand what is going on here, all you have to understand is that we are beginning the process of enduring what will become the largest unraveling of the financial system since the Great Depression itself. The risks at this point, while sounding somewhat alarmist, are systemic in nature, meaning the entire system is at risk, because everything has become so intimately and complexly intertwined that the biggest problem is that we won't really know just how systemic the effects will be until it's too late.

What is behind all of this? Why all of the doom and gloom on my part? Well, perhaps I'll spend a few minutes and attempt to describe in relative lamen's terms what's happening here. While this all, on the surface, may seem to be related to the subprime mortgage debacle, that whole problem was more symptomatic than anything else. The underlying problem is that we've forgotten the basic fundamentals of finance. Proper capitalization is key. What caused the Great Depression back in the 1930's? A massive credit contraction due to irresponsible lending, too much leverage, and greed. The credit contraction brought about asset price deflation, meaning declines in asset prices, including real estate, and of course, the legendary stock market crash. What is causing today's financial meltdown? A credit contraction due to irresponsible lending, too much leverage, and greed. The credit contraction, which initially reared it's ugly head with the subprime mortgages, is continuing to rear it's ever larger head, with Alt-A mortgages being the next major "problem" we've yet to really see. Look for more bad news in the coming months given 16% of all Alt-A mortgages are currently beyond 60 days late at this point in time, and getting worse by the month, and most of these Alt-A mortgages haven't reset to prevailing rates yet! So, the credit contraction will continue, in fact in many ways it is just getting started. In short, it is going to get worse before it gets better. We are already seeing asset deflation in home prices and commercial real estate prices. The de-leveraging process is now under way. We've written down roughly 520 billion dollars so far, with estimates ranging from 1-2 trillion before we're out the woods. So, at best, we're half way through the asset price deflations from a securities perspective, at worse, we're only 25% of the way down this road less travelled.

Banks take your deposit monies and then leverage those monies, making loans against assets such as cars, houses, commercial real estate properties, and banks also invest your monies in other investments which earn a higher rate of return than they pay you. SEC regulations require banks to retain a 10:1 capital reserve ratio. Put another way, for every $10.00 that a bank has leveraged, it must have $1.00 in capital reserves. Capital reserves are extremely important to the solvency of any financial institution. What we're really seeing right now as part of this whole financial meltdown, is that most of the banks and brokerage houses aren't properly capitalized. Lehman Brothers leverage ratio was 32:1 today, the day it claimed bankruptcy. Too much leverage works well, as long as asset prices rise, but the second asset prices start declining, it is all but guaranteed that capital reserves won't be sufficient to cover the margin calls that assuredly will come a knockin, and sure enough, as the de-leveraging process moves forward, Lehman Brothers, just like Bear Stearns, will not be the last major financial company to fail. These failures will have global implications. Japanese banks held a great deal of Lehman Brothers debt for instance, and now those same Japanese banks, who were already in bad shape, have nothing to show for their Lehman Brothers investments. Not good.

For certain, no one really knows just exactly what's going to happen tomorrow, next week, next month or next year. From my cheap seats though, things look worse than they ever have, much worse than the last time I took the time to post anything to my blog. When you see names such as AIG, Citicorp, WAMU, GM/GMAC, Ford, and Wachovia all with similar financial balance sheet problems, all of which are potentially on the perverbial chopping block, it doesn't bode well for the U.S. economic situation. Of one thing I am certain, we will get through this, somehow or another, we'll all get through what appears to be an increasingly dismal financial meltdown.

I won't even start to discuss the Fannie/Freddie situation, I could write paragraphs on how the government bailout is in fact a sign of just how dire things really are, and how things will get worse as a result of said bailout. All I'll say is that anyone who thinks that Fannie and Freddie would ever do anything BUT fail, need only to look at the capitalization ratio of these two firms, who hold a paltry 160 billion in assets to cover some 5.4 trillion dollars in mortgages. Last I checked, a 10:1 capital reserves ratio would mean these two agencies should have held some 540 billion in reserves. 160 doesn't even come close, so you end up with the same problem described above. When asset prices deflate, in this case the American dream, our homes, neither Fannie nor Freddie held the required capital reserves to cover the losses. Once again, we've strayed away from solid fundamentals, and we're going to pay the piper sooner or later.

There's an old adage that time heals all wounds. The Fannie/Freddie bailout will make the S&L crisis look like child's play in comparison. What we really need is time. Same as with the S&L crisis, we need a way to allow our major financial institutions to remain solvent, even though many of them are technically insolvent right now, until such time as they can de-leverage, re-capitalize, and perform the required write-downs over a period of many years. That's exactly what we did when South America defaulted on all of it's debt back in the 1980's at which point just about every U.S. financial institution became insolvent overnight. Rather than let a systemic problem produce massive bank failures, we changed the regs and allowed banks to gradually absorb massive write-downs of the South American debt defaults over many years. This is basically the same thing we need this time around. Opponents will argue moral hazard. We'll have some of that too, as today's demonstration of allowing Lehman Brothers to fail clearly demonstrated.

There are many more complexities that we could talk about, the most important of which is probably the effects on the CDS markets. Credit Default Swaps. Look them up on Wikipedia when you find a few spare moments. You will be hearing more about the CDS market, which is valued literally in the ten's of trillions of dollars. Not bad considering CDS's didn't even exist until the mid 1990's! The CDS market allows companies to build a contract to cover risk assessments against all sorts of securities. It's all very complex. Think of it this way. Let's say you were to consider buying ten million of CDO contracts, but you were worried about the risk. You could go to the CDS markets and essentially buy insurance for your 10 million dollars of CDO contracts, for say, a hundred grand. For that hundred grand, someone (the buyer of the CDS itself) will guarantee that you will continue to get paid if the CDO contracts default for any reason. It's a fancy way of allowing investors to essentially buy insurance policies on the underlying investments, which allows them to mitigate the risk inherent in the contract, or specifically the potential for the investment to default. Put another way, it allows the investor to swap the risk in return for making insurance payments on the contract, hence the words credit default swap.

The failure of Lehman Brothers will result in quite a large number of defaults on some 620 billion in outstanding debts. Think about what that will mean for the CDS market that I just wrote about above. Most of those bad debts are secured with CDS contracts. Trillions of dollars of nominal CDS contract values are at stake, and the process of unravelling the complexities of who all holds the 620 billion in derivatives that just went worthless due to the Lehman Brothers bankruptcy filing is just getting under way as a result. Those who hold the hundreds of billions of dollars will want those who promised to keep making the payments to, well, keep making the payments. The trouble is, it's a big ponzi scheme, as the sellers and buyers of the CDS contracts are the very same players, meaning the banks and brokerage houses (a guy at JP Morgan was the creator of CDS's back in 1995 if memory serves) that are already enduring huge write-downs and insolvency issues. Does anyone really think that any of these banks, brokerage houses, or insurance companies are in a currently in a well capitalized position to honor the payments on trillions of dollars of nominal contract values? Yeah, I didn't think so either.

Hang on to your collective hats folks, we are living in VERY interesting times!