Nearly a year ago I wrote "Five Lessons from the Mortgage Meltdown." Now, the markets have fallen dramatically and the entire financial system is in a state of emergency.
( MER) have been acquired by
Bank of America
. Bear Stearns was saved by a
-engineered buyout by
JP Morgan Chase
( FNM) and
( FNM) were finally absorbed by the Federal Government.
( LEH) was forced into filing for bankruptcy.
American International Group
was also saved by the government and
is teetering on collapse.
So have we learned anything from the breakdown of our financial companies? I certainly hope so. Here are five things to understand.
1. The Elimination of Glass-Steagell Makes Sense, But...
As I explain in "
," not all financial institutions are the same. One important distinction is between commercial banks or savings and loans (together, I'll refer to them in this article as banks) and broker-dealers.
Banks have a natural deposit base. Their customers will place cash in checking accounts or time deposits, such as savings accounts and certificate of deposits (CDs). The banks in turn use those funds to lend out to customers who want to buy homes, buy cars, build factories, start businesses, etc. Broker-dealers for the most part do not have bank deposits from which they can create natural liquidity (of course there are exceptions such as Merrill Lynch, which had built a bank with tens of billion of dollars in a separately held bank).
Under the Glass-Steagall Act of 1933, banking and brokerage functions were segregated. Thus, in more "normal" times a bank would lend money from their deposit base and a broker would buy and sell securities for their own account support by their shareholder's equity. The Glass-Steagall Act was repealed by the Gramm-Leach-Bliley Act in 1999, so banks could get in to the brokerage and investment banking business, while broker-dealers tried to become lending institutions.
The elimination of Glass-Steagall made sense. Most of the major European banks have never operated under such a prohibition. However, those that survived always had deposit bases. Where Gramm-Leach- Bliley stopped short was not requiring lending activities to be limited to depository institutions. If that was a provision in the legislation, then the American institutions would be like their European peers. But it was not, so we were set up for lesson number two.
2. Liquidty Matters
If you cannot source your funding needs from deposits, then you have to go to the credit markets. As the insatiable appetite for housing was being fed, more and more mortgages were being issued, and
forms of credit expanded as well.
Brokers who did not have natural deposits and banks that got involved in the lending business -- above their deposit bases -- had to borrow vast sums of money.
First, they tried to do this in the unsecured credit markets through the issuance of "commercial paper." The problem with the commercial paper markets is that it is short term in nature and as such, does not provide long term funding against the long term lending that was taking place. Furthermore, there is a practical limit as to how much commercial paper can be issued.
So the next step was to begin to securitize the loans in the forms of asset-backed securities (ABS) such as MBS (mortgage-backed securities), CDO (collateralized debt obligations) and CLO (collateralized loan obligations). Some of these asset-backed securities were sold to investors who
used leverage to fund these purchases. However, some of these securities could not be sold and thus the banks and brokers maintained a proprietary inventory of them.
At some point these companies stretched their
too far. They could no longer borrow to support their ABS holdings. Also, the housing market began to slow down. The mortgages supporting the lowest graded asset-backed securities -- labeled "subprime" -- began to default at much higher rates than originally expected. The values of these securities began to decline. However, that wasn't a problem. The balance sheets of the financial companies could support some minor adjustment to ABS valuation. The one big new problem to deal with was that the definition of valuation changed.
3. FASB 157 -- Fair Value Accounting Didn't Work As Planned
The complexity of ABS was such that the pricing of these securities were driven by computerized models that were developed by mathematicians employed by the banks and brokers. To fully appreciate the complexity of such pricing, you have to understand or at the very least, accept the fact that no two ABS were alike. Common characteristics in the ABS world are virtually non-existent. So, when any economic changes or variable assumptions were changed for an ABS (or a sub-component referred to as a "tranche") the mathematicians would re-price the ABS based on their models.
Along comes the Financial Accounting Standards Board (FASB). The FASB is an independent group of accounts which oversee accounting rules in the United States, thus formulating the basis for
. The FASB released
- Fair Value Measurements.
Under fair value accounting, a market-based measurement of price had to be adopted by the brokers and banks. This market price was referred to as an exchange price, which was defined as "the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability."
With 157, the FASB was trying to prevent a reoccurrence of what happened with
. Enron was an energy company that "cooked up" the assets on its balance sheet in order to hide losses and bolster its stock price. The FASB intentions were honorable. Unfortunately, the FASB did not understand the securities markets.
Using a market or exchange price makes total sense when you have a public market or exchange from which the prices can be ascertained. The process of obtaining a market price is called price discovery. In the stock market, price discovery is an easy task. One can go to an exchange, use a live market price feed or access data sources, such as the Internet or print publications. The dissemination of stock price information is extensive and reliable. The same cannot be said in the fixed-income markets, with the exception of government securities, which are similar to stocks in terms of price discovery and dissemination.
Whether it is corporate bonds, municipal bonds or asset-backed securities, there is no central market by which prices can be determined. Markets are made by dealers and quite often, sellers are at the mercy of those dealers (who can be few in number). Thus, not only were market prices for ABS less reliable than that of model-based pricing, but the act of finding a market actually could and in many instances, created a lower priced bid because of the scarcity of dealers and the illiquid nature of the securities.
The requirement to "mark to market" set in motion a viscous negative spiral in the pricing of asset-backed securities. This resulted in huge
by the banks and brokers that held those securities. Rather than prevent another Enron, the FASB may have created a whole industry of Enrons. However, another viscous negative spiral would soon kick in beyond the impact of market to market rules.
4. Credit Default Swaps Can Run Wild
Credit default swaps (CDS) are derivative contracts that protect bond holders or creditors against potential default by creditors. Typically, the buyer of the contract makes periodic payments to the seller of the swap. In the event of a default the seller will be obligated to purchase the defaulted securities at an agreed upon price, usually the par value of the debt instrument. In essence, credit default swaps are insurance contracts.
This can be an effective hedging tool for the holder of debt. The cost of buying a CDS can be quite minimal when a company still maintains a good credit rating. The costs will go up once a company's credit rating begins to deteriorate. However, the CDS the story does not end there.
Speculators began to enter the CDS market. They bought these swaps without even owning any debt of the company which was linked to the CDS. The "notional" value (contract value) of credit default swaps began to surpass the amount of debt for many companies. Unlike the securities market, there is no zero sum game when a credit default swaps can be created out of thin air to satisfy the demand from buyers. As the CDS world is not regulated, the proliferation of these contracts grew.
As ABS values began to be marked ever lower the valuation or "spread" on CDS began to rise. This caused an even greater rush to buy more CDS and a concurrent selling of the debt of those companies. However, in order to make these swaps pay off, the buyers needed to create a default. Since they did not own the debt and the debt markets were illiquid they needed to take the strategy to the next level.
5. Without the 'Up-Tick Rule,' Stocks Can Be Driven Down -- Fast
After the 1929 stock market crash a new trading rule was placed into effect called the up-tick rule. The rule was intended to protect shareholders against "bear raids" on stocks. Bear raids are when
gang up on a stock to drive the price down. The up-tick rule required that short-sellers sell stock on an up-tick. An up-tick is a price which is higher than the last transacted price.
In theory, this insures that short-sellers are selling stock to buyers without driving the price down. Furthermore, SEC Regulation "SHO" requires that short-sellers locate stock to borrow for delivery and prohibits
In 2007, the Securities and Exchange Commission eliminated the up-tick rule. Thus, short sellers could sell stock without limitation so long as they could borrow the stock. However, the short sellers also disregarded Regulation SHO. The result was the ability to sell stocks with reckless abandon. Many of these stocks had large amounts of open CDS contracts. Sometimes, scurrilous rumors were used in conjunction with CDS and short sales to create bear raids in a stock and drive stock prices so low that the companies' existence were put into jeopardy. (Update: "
To summarize, remember these points:
Mortgages and other forms of lending must take place within an institution that has a natural deposit base.
Long term assets, such as an asset-backed securities, require long term funding.
FASB 157, while well intentioned, has created mark to market rules that have created more problems and complexity for the financial services sector.
Credit default swaps grew to a speculative frenzy that resulted in further credit deterioration.
The elimination of the up-tick rule created a market environment that gave an unfair advantage to short-sellers and harmed shareholders.
At the time of publication, Rothbort had no positions in the stocks mentioned, although positions can change at any time.
Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele.
Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.
Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.
For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at
. Scott appreciates your feedback;
to send him an email.