What is happening on the financial markets?
The problem is a lack of liquidity.
Last week, a banker friend told me a story about an investor who tried to sell $10M worth of treasury equivalent bonds and he got NO bids. Investors were simply not willing to give up their cash because they were concerned about their own liquidity.
As a further example, last Wednesday the 3-month T-bill rate dropped virtually to 0%. Think about that. People were willing to buy that safe asset, with no rate of return, just because it was better than any of the alternatives.
So last Wednesday, you had this freeze in trading on the stock market. Liquidity dried up.
Stock prices, particularly of financial institutions, dropped fairly precipitously on Wednesday and Thursday and that is when you saw the federal government deciding to step in with new policies.
How does a huge brokerage firm Lehman Brothers fail?
Leverage generally is Total Assets/ Total Equity. A typical bank will have 10 cents of equity and 90 cents of debt financing for every dollar of asset. That creates an asset to equity ratio of 10. ($1/$0.10)
For Lehman, their leverage ratios were much higher – in the range of 25- 40. They were very highly leveraged and thus much higher risk.
Compounding the problem, their debt or liabilities were not deposits like at a bank, but rather bonds, short-term commercial paper and notes. Bank deposits are guaranteed (FDIC insured) up to $100,000, so generally people don’t rush in and pull those deposits even when a bank has problems. Lehman Brothers did not have the luxury of that core deposit funding base. As their debt increased, people who loaned Lehman money become increasingly sensitive to any negative information that Lehman might reveal.
Imagine for the sake of argument that ALL of Lehman Brother’s asset are in loans or securities. They finance those assets through owner’s equity and debt. But what happens when, as many of these large financial institutions did, an increasing percentage of the assets on the balance sheet are troubled. What happens when the accounting world forces you value these assets at the market price? If nobody wants to own them, they become very difficult to price and the firm must mark-them-to-market at lower values thereby creating losses. When the market thinks that a company is going to have to take big losses on its assets, liquidity dries up quickly.
Merrill Lynch recently sold $30B worth of collateralized debt obligations (CDO’s) for 22 cents on the dollar and thus took a substantial loss. For Lehman, the failing event was that investors who owned Lehman’s debt or were counterparties on Lehman’s derivatives contracts, would not reinvest or renew the contracts. The only way to repay the debt is to sell assets. But what happens when people aren’t willing to buy what you own?
When your assets are worth less than the value of your debt, you are technically insolvent. Borrowers run for the exits and you don’t have access to cash to pay your obligations. That’s what brought Lehman Brothers down.
What do you make of the Federal government’s $700 Billion bailout?
What the Federal treasury is proposing is to be a buyer of these devalued assets.
Why should taxpayers bailout those who are to blame? Why $700B? Which firm’s assets are you going to buy? Who is going to do the buying? What price are you going to pay? These are all valid questions.
Henry Paulson, the US Treasury Secretary, is saying, Trust us, we are going to do what is right for the tax payer. Congress is saying, Give us some guarantees!
Why not let them fail?
Federal Reserve Chairman, Ben Bernanke, said yesterday that the economy will go into a recession sooner rather than later and that it will be more severe if they don’t act now.
What is your opinion?
I think he’s right. If you are a bank and you have these troubled assets on the books, one way to get your capital ratio back in line is by shrinking your asset base – by not making loans. You don’t make loans because every time you make another $1 loan, you need 10 more cents in capital and you don’t have enough capital right now. Large financial institutions are simply not loaning money and that means that prospective borrowers are competing for a much smaller pool of available funds.
The lack of liquidity will slow the economy down.
How will it affect Columbia SC?
First, many of the smaller financial institutions never got mixed up in holding these troubled mortgage assets on their balance sheet.
If the Treasury issues all of these new bonds to finance this bailout, the risk is that taxes will have to go up. That will certainly affect us all and worsen the economic downturn.
Underpinning all of this is falling mortgage values which is to a large degree due to falling home prices. In some parts of the U.S., housing prices are off 30 – 40% from their peak. People are finding themselves in the same boat as Lehman Brothers. The value of their home is less than what they owe on the home. What do you do then? You may choose to simply walk away. Does it affect your house price if the two houses next door are not selling?
We have to get to the root cause of falling home prices or the cycle will simply repeat itself. We need to pursue policies that will directly stabilize home prices.
Timothy W. Koch (Ph.D. Purdue University, 1976) is Professor of Banking and Finance and chair of the Finance Department at the University of South Carolina. He is the author of a textbook, Bank Management, published by Thomson South-Western, and a book, General Banking, used in state banking schools. His current research interests include the pricing of fixed income securities and derivatives, bank management, and banking structure. He has served as a consultant to financial institutions and is the President of the Graduate School of Banking at Colorado.