Credit Crisis Enters Final Stage, as US Government Steps in

• ...Credit crisis reaches climax, as Lehman fails, AIG is bailed out and Merrill/HBOS are taken over....
• ...Central Banks try to prevent financial market meltdown by unprecedented liquidity infusions ...
• ...but only a US government plan to buy the illiquid toxic Mortgage-related assets brings calm
• ...as it might signal that the long phase of healing has started....
• ...Contour of the new financial architecture becomes clearer: Chapter Investment Banks closed ...

Markets came to a near standstill...

It has been a remarkable week in financial markets, as Lehman Brothers filed for chapter 11 bankruptcy and Merrill Lynch sold itself in less than 24 hours to BoA, as it feared a similar fate like Lehman if it had to confront the markets on Monday morning. The AIG bail-out on Tuesday night, the flight out of money market funds after one fund broke the buck, the massive, unprecedented liquidity provision from Central Bankers, the run on the Investment Banks and the catharsis announcement on Thursday night of a US plan to address the root problem of the credit crisis, notably the illiquid toxic mortgagerelated assets on the banks balance sheets complete the picture of a hectic week on the financial markets.

In this note, we put things in their context and draw some preliminary conclusions. Most attention goes to the US government plan that may be the start of a solution for the credit crisis that holds the market and the economy hostage.

Bear Stearns & GSE's were the prelude

The "bail out" of Bear Stearns via a takeover by JPM and supported by a 29 billion $ loan of the Fed in mid-March cannot be left out of the story. It was an amazing event, as the Fed expanded its "too big/too interconnected to fail" theory to primary dealers, that were in the aftermath of the event allowed to tap the discount window (for liquidity). Markets, at that time, considered that other Investment Banks had come under the umbrella of the Fed, as the Fed indeed acquired some oversight on these institutions for the first time. It was also considered as a potential turning point in the crisis, something that proved to be completely wrong.

On Sunday September 7, the Treasury decided to take Freddie Mac & Fannie Mae, the mortgage behemoths, into conservatorship, which should be considered as quasi-nationalization. The Treasury guaranteed their solvency for an amount of up to 100 billion $ per institution, in exchange for preferred stocks that will de facto wipe out existing common and preferred shareholders. The institution got access to a special liquidity credit window. Both institutions were also authorized to increase their outstanding mortgage exposure (to keep the mortgage market open) and the Treasury promised to buy new GSE MBS. Interestingly, while the shareholders were wiped out, bond holders saw their assets gain value, because the existing implicit government guarantee had become more explicit.

Lehman goes, Merrill draws conclusions.....

Following the GSE "rescue", markets turned the heat on Lehman. The Investment Bank had a large chunk of toxic assets on board, especially in commercial mortgage, where it had entered the market at the peak and like all Investment Banks, it lacked a deposit basis and was thinly capitalized. The market smelled blood and when talks on a capital injection with Korean Development Bank faltered, the stock was heavily sold and dropped in five session preceding September 13, from about 17 $ to 3.8 $. On Sunday 14 September, the Fed and Treasury decided, to the surprise of many, not to support Lehman and as also private sector rescue talks failed, Lehman had no other choice than filing for bankruptcy (chapter 11) on Monday morning.

The market was stunned, as it expected authorities to intervene to avoid failure and chaos in markets. It seemed authorities were afraid that another rescue operation would drag it ever more in the quagmire of government interventions and bail outs with ever more financial firms lining up for rescue. Authorities apparently decided that a Lehman bankruptcy would not cause a spiralling systemic crisis. It might also have been a warning shot before the bow of speculators. Indeed, the Freddie & Fannie rescue brought some on the idea to short equities of battered firms and to go long its debt.

Merrill Lynch boss Thain read well the tea leaves and understood that his firm was next in line if Lehman failed. So he sought for shelter by Bank of America that bought on Sunday the Investment bank for about 50 billion $ after negotiations that lasted barely 24 hours.

The Fed and other Central Banks were prepared for difficult circumstances and started an liquidityproviding operation of unprecedented scope that would last the whole week (see annexe for details). The bankruptcy caused panic though and counterparty confidence disappeared totally, leading to the complete seizure of the money markets.

Fed keeps rates unchanged, but bails out AIG

On Tuesday September 16, the FOMC against expectations of many kept its rates unchanged at its regular meeting, but less than 6 hours later, the Fed bailed out AIG, the biggest insurer, as it agreed to give the firm a of 85 billion $ loan at a punitive 850 basis points above Libor for two years. The Treasury ousted management, got 79.9% of equity and stated that the company would now be managed in the interest of taxpayers and the market, disregarding shareholders' interests. The exposure of AIG in the CDS market looks to have been the reason for the application of the too big too fail theory, but now for the first time applied to an insurer, showing the Fed was venturing ever further into uncharted territory. Markets got further confused about the authorities' case by case approach, apparently lacking a clear line in its policy.

RMC breaks the buck!

Late on Tuesday, Reserve Management Corporation said that due to the Lehman bankruptcy, the value of its sponsored Money Market Fund shares fell below par (97%). Unlike other funds, for which the sponsor banks intervened to support the money market fund, RMC money market fund was the first in a very long time that broke the buck, infecting the huge 3.5 Trln. Money Market sector, usually an oasis of calmness. Redemptions rose sharply exacerbating the liquidity problems in the Interbank market that grinded to a standstill.

Black Wednesday

The bail out of AIG couldn't restore the confidence and the bad situation worsened further. UK HBOS could no longer withstand the attacks of speculators and was taken over in a hurry by Lloyds TSB and with some help of the government. Morgan Stanley and Goldman, the two remaining Investment Banks that reported better than expected Q3 results, remained under immense selling pressure. Investors in Money Market Funds redrew their investments and looked for shelter in the T-bill markets, where 3-month rates dropped to an unprecedented low of 1 basis point. The S&P lost again 4.7%. The dollar funding market dried up completely and foreign banks paid very high rates to get even overnight liquidity. Authorities knew that something had to be done.

Central Banks open the spigot

On Thursday September 18, before markets opened, Central Banks all over the world staged an concerted action to restart money markets functioning and injected dollar liquidity worth 180 billion $ into their systems (obtained via extension of Fed swap lines). However, panic continued to cause ravage with markets attacking ever more the remaining Investment Banks and those banks that are heavy depending on wholesale funding like HBOS that was taken over in a hurry by Lloyds TSB on Wednesday. It was obvious that liquidity measures were absolutely needed to keep the financial world turning, but the market was looking for measures that addressed the root cause of the crisis, the illiquid toxic mortgage backed securities on the balance sheets of the financial institutions.

Government takes broader action

Treasury Secretary Paulson and Fed Bernanke said late on Thursday that they were working on such a more comprehensive plan that tackles one of the main problems (cf. below for a more detailed review of the plan). Markets were relieved and US equities rebounded sharply, a movement that continued on Friday.

The announcement got maximum leverage because of the extreme bearishness in the market, but authorities cleverly announced other measures. The UK FSA and the US SEC took draconic measures against short selling; forcing shorts to cover these positions on Friday in an equity market that was rallying.

The Fed and Treasury took more measures to address the problems of the Money market funds and ease tensions in the Interbank market. The Treasury established a temporary guaranty program for US money market mutual funds, by which it insures for one year the holding of any public offered eligible money market mutual fund, retail and institutional, that pays a fee to participate in the program. The amount available is 50 billion $. Maintaining confidence in money market funds is essential as they are an important savings vehicle for many Americans and an essential source of financing of the capital markets and financial institutions. It will contribute to easing global instability, said the Treasury statement. The Fed also installed an ABCP lending facility, allowing depository institutions and bank holdings to borrow from the Boston Fed on a non-recourse basis on the condition the proceeds are used to purchase certain highly rated US dollar-denominated ABCP from money market funds. The facility will expire on January 29 2009. The ABCP holdings will not fall under the capital requirement rules. The Fed plans to purchase Federal Agency discount Notes from Primary Dealers which will increase the supply of reserves in the banking system.

Some lessons from recent events

The credit crisis flared up a fortnight ago and ended it's until now most violent phase. While it was a scary and dangerous experience, it was probably a necessary phase towards a normalization of the situation on markets. The needed restructuring of the sector has accelerated.

Firstly, it seems to have decided the fate of the Investment Banks: their business model is death. The government actions suggest that it discriminates between institutions that it doesn't want to help (Lehman, Merrill....) and those that are granted conditional help because of too big to fail, even if it means these institutions, their shareholders and management pay a high price (F&F, AIG).

The banking sector has grown much too fast in the recent decade compared to the economy and needs to be shrunk. Excessive leverage, use of innovative products (securitization), complexity of the shadow banking system, deficient oversight have all been elements that have contributed to the excesses.

In this context, it seems that the future banking system will be based on better capitalized, less leveraged banks that have a more balanced funding profile (more deposits) and are much tighter regulated.

In such a world, the Investment Bank model hasn't much reason to exists, just like the monoline business model. The demise of Bear Stearns & Lehman, the all of a sudden tie up of Merrill and BoA and the relentless attacks on Goldman and Morgan Stanley, despite their relative good performance until now, suggest that the market has come to the same conclusion. It seems that both Goldman and Morgan Stanley don't want to wait for the market verdict. According to press articles, Morgan Stanley continues to talk with Wachovia and CIC on a merger. Still more telling, both Investment Banks applied to become a bank holding and the Fed approved on Monday 22 September their application. This effectively terminates the role of Investment Banks in the financial system.

If there is no place for independent Investment Banks in the new emerging financial architecture, the question arises whether hedge funds still have a place in the new financial world order. Didn't they do the most eye-striking leveraged risk taking for account of customers that often were pension funds, banks and others that were hindered by balance sheet or regulatory constraints. What was their role in the short selling of late? While they have emerged from the crisis with relatively little damage, we suspect that authorities will target them with tighter regulations and limits on leverage and funding mismatches or restraints on the compensation structure. If that's the case, also their business model would be damaged, eventually fatally.

The plan of the US Treasury to establish a fund that buys the toxic illiquid mortgage related assets might turn out to be a defining moment in the credit crisis, because it tackles one of the main problems underlying the credit crisis. As such, it is of another order than the liquidity providing measures of the Fed that was simply aimed at keeping the system working, but doesn't address the underlying problems. The plan is also comprehensive and differs from the case by case approach the government used in its actions until now.

The new plan means that authorities (also Congress) are no longer in denial about the scale of the problems and the urgency to resolve them. The pro-active attitude suggests that the US banking sector could find its health back in a few years and not like it was the case in Japan where the system was paralyzed for a decade. From an economic point of view, a recession is still likely, as is a period of a few years of sub-trend growth, but no decade of stagnation.

However, many questions remain (cf. below) and it should not prevent more banks to hit the wall and file for bankruptcy. One important question is whether a similar plan will be established and applied in Europe. Indeed, according to the IMF, about half of the losses of the credit crisis are on account of European financial institutions.

The Treasury plan to buy troubled assets

The Treasury has outlined its plan on Saturday September 20 that however needs to be approved by Congress. According to press articles, it seems that Congress wants to modify the plan in a number of aspects. Negotiations will take place this week, because the approval should be given at the end of the week, allowing Congressmen to start campaigning for the elections. The plan gives farreaching powers to the Treasury and according to sources the bill would even prevent the courts from reviewing actions taken under its authority.

The removal of troubled assets might strengthen the financial system, allowing it to restore its function of financing activity in the real economy. These illiquid mortgages now block the system and have the potential to damage the financial system and economy, undermining job creation and income growth (Treasury statement). The vicious feed back mechanism of fire-sale of toxic assets at rock bottom prices, obliging the whole sector to writedown/ book losses on similar assets on the balance sheet, leading to more sales of these assets (because of insufficient capital) may now be broken.

Besides this plan targetting private-labelled mortgage related assets, the Treasury announced that the GSE's will increase their purchases of mortgage- backed securities and the Treasury will expand its MBS purchase program announced earlier. The objective is to lower mortgage rates.

Broad outline of the plan

1) The Treasury would be authorized to issue up to 700 billion $ of Treasuries to buy troubled assets. To do this, the US debt ceiling will be raised to 11 315 billion $ from 10 615 billion $.

2) What assets? Residential and commercialmortgage related assets (MBS or loans). Other assets may be purchased after consultation of the Fed chairman, if necessary to stabilize the financial system.

3) The timing and scale of any purchases will be at the discretion of the Treasury, subject to the total cap of 700 billion $.

4) The price of the assets will be established through market mechanisms (e.g. reverse auctions).

5) The authority to purchase expires two years from date of enactment.

6) To qualify, assets must have been originated or issued on or before September 17 2008.

7) Participating financial institutions must have significant operations in the US, but a broader eligibility is possible (in consultation with the Fed chairman). According to press articles, also assets from Non-US institutions would be eligible.

8) Assets will be managed by private asset managers, but under full authority and discretion of the Treasury. The Treasury may sell the assets at its discretion or may hold them to maturity.

9) The Treasury will report on the plan after 3 months and thereafter semi-annual.

Some Democrats in Congress have made their collaboration on the subject dependable on a number of changes, even if they show determination to support the administration and want to get the thing done by the end of the week.

Some are looking for fast track authority for an overhaul of financial regulation; others want to curb executive pay for firms whose assets are bought. Others plead for a tighter oversight mechanism as the government is working with taxpayers' money and wants to put taxpayers ahead of stock- and bondholders. Some state that this plan, that would benefit the financial sector, should be supplemented by a plan to help homeowners and stem foreclosures.

Some initial observations:

The plan correctly tackles the problem of illiquid toxic MBS assets on the banks' balance sheets. The deleveraging process, a necessity to restore the health of the financial system, might occur via two ways, notably the sale of assets and the increase of capital. In current circumstances, raising capital is often impossible.

Price of sale crucial

One of the crucial aspects of the plan to buy the assets is indeed the price the Treasury will pay for the troubled assets. If it is very low, it obliges banks to additional write-downs and losses that affect their capital base. This would jeopardize the success of the plan. Some suggest that the 22% Merrill got for the sale of its portfolio could be a good starting point. Putting the price too high would lead to a high cost for the taxpayers and might be considered as a subsidy for the financial institutions. It would hinder the resumption of a healthy working secondary market, as no market clearing price is obtained. Some suggest that the purchase price should be set very low, but to address the concomitant capital problem, the Treasury could take an equity stake in the firm for the difference between the selling price and some average at which the assets are currently booked on the sector balance sheets. This might help restoring the health of the system via two ways (assets and capital). At the same time, it would also dilute the existing shareholders who should, from a moral hazard point of view, bear the cost of the mistakes of the past. We think the current plan doesn't allow the Treasury to act in such a way, but it isn't excluded. Senator Schumer seems to be a proponent of such a solution that was apparently applied in the 1930's (Reconstruction Finance Corporation) and was also the model used in the GSE's bail-out.

Whose assets will be bought? Which type of institution will be targeted? The text of the Treasury is vague on the subject. There seems to be 2 Trn. $ of private label MBS assets outstanding of which 600 billion $ is held overseas. US banks and thrifts hold about 360 billion $ of these assets, while GSE's hold another 400 billion $. The remainder is in the hands of dealers, insurers, pension funds, hedge funds and others. Will the latter be allowed to sell their troubled assets? At least the hedge funds seem to be excluded, according to some comments of Paulson. Regarding others, there is uncertainty.

So, the 700 billion $ is a big amount of money (about the cost of the Iraq war and more than the expected 2009 deficit), but not enough to buy all the troubled assets. However, applying a haircut and maybe discriminating between institutions, the amount maybe sufficient to have a big impact. As the assets may be re-sold later on, eventually even at higher prices, the ultimate cost of the operation is difficult to measure.

The government plan of a Federal-funded fund that buys troubled assets found its idea in the Resolution Trust Corporation that was created in 1989 to liquidate the assets of the bankrupt saving and loans institutions. It was effective and sold the assets fast, creating a market clearing price and finishing its job in 5 years. There are many differences with the situation now, spreading uncertainty about whether the plan will lead to the hoped results. The financial sector is much more complex now and the assets belong to functioning firms and not to bankrupt ones like in the early nineties. This might complicate things.

Disclaimer: This non-exhaustive information is based on short-term forecasts for expected developments on the financial markets. KBC Bank cannot guarantee that these forecasts will materialize and cannot be held liable in any way for direct or consequential loss arising from any use of this document or its content. The document is not intended as personalized investment advice and does not constitute a recommendation to buy, sell or hold investments described herein. Although information has been obtained from and is based upon sources KBC believes to be reliable, KBC does not guarantee the accuracy of this information, which may be incomplete or condensed. All opinions and estimates constitute a KBC judgment as of the data of the report and are subject to change without notice.