WHAT HAPPENED ON WALL STREET?

By, Adhvith Dhuddu

Shock and awe ravaged through the minds of millions from Wall Street to the Great Wall this week as tremors in the financial sector bought down industry giants Lehman, Merrill and AIG. An unfortunate convergence of ugly factors contributed to this saddening collapse leaving thousands jobless and millions a bit poorer. These are undoubtedly historic times with no precedent leaving many jittery about the future, which is why an elemental breakdown of the major factors that contributed to this crisis is vital.

The leverage factor: Investment Banks (IB's) over extended themselves with this luxury that many financial institutions used conservatively. The Bear Stearns collapse exposed the super leveraged nature of IB's where they could borrow $30-$35 for every $1 of collateral (1:35 leverage). This is primarily what IB's were armed with to maximize profitability and dampen the losses. Fearful of similar consequences Lehman frantically deleveraged their highly leveraged balance sheet by selling assets and raising capital impacting their profitability. It's important to remember that the new capital raised to decrease leverage could have been used as collateral for more capital which Lehman could have used to generate revenue.

Recapitalization and mark to market accounting: In addition to raising capital to deleverage balance sheets, Lehman and Merrill had to continue their daily activities which require large amounts of capital. Complex financial trades performed by IBs require them to put up and receive massive amounts of money (tens of billions) on a day to day basis, making them heavily cash dependent.

Because mark to market accounting forces investment banks to value assets at market prices rather than perceived or book value, it exacerbates the pain by damaging the balance sheet. These accounting practices are being heavily criticized and blamed for the crisis because they cloud the real values of assets, the balance sheets of these institutions and hence the value of these companies. This massive and unending need for cash to recapitalize and deleverage coupled with the high cost for credit literally strained these institutions to the last penny.

Access to Fed funds: Unlike commercial banks, IB's don't have direct access to federal funds. Their primary sources of capital are commercial banks for short and long term lending and cash infusions from customers, hedge funds and private equity firms. This again handicapped many IB's as the cost of borrowing surged, credit markets froze and their credit rating was slashed. For this specific reason, the existence of IB’s with the independent broker-dealer model is being questioned.

Failure of counterparty surveillance and "Self Regulation": Regulating IB's and hedge funds are complicated. The quantitative and mathematical nature of their operations require them to trade equities, bonds, debt, forex, futures and options in massive quantities at lightning speed. The positions on their balance sheet change literally everyday making the risky and highly leveraged nature of their positions tricky for regulation. Although the Federal Reserve knew of the threats posed by this due to their closely intertwined nature to the financial system, they never saw the need to regulate because of the high level of counterparty surveillance and, "self regulation" at IB's and hedge funds. Laissez-faire economists often hailed this development of, "self regulation," as something unparalleled. The unfortunate consequences of not regulating these IB's are what we now face and there sure is nothing unparalleled about the present crisis.

Credit rating agencies: The Moody's, S&P's and Fitch's of the world which are expected to be proactive and offer leading indicators were disastrously late to the party, reacting to the crisis by issuing warnings when it was no news to the financial community. These agencies share a massive portion of the blame simply because they failed to perform their fundamental duty: to accurately assess the quality of credit. A lot of pain could have been salvaged if these agencies were forthright in their assessments and exposed toxic balance sheets of troubled IB's.

Freddie, Fannie, and the underlying factor: The fall in real estate prices triggered this chain reaction, which is about half way through. Outlook in the real estate market doesn't look very sanguine either, which means this crisis could be painful and prolonged. A weak US dollar was an incentive for many overseas investors to explore real estate investments here and provide the much needed boost. But a steady strengthening of the dollar and apprehensions about the overall economy is now keeping these investors away. Local investment in real estate is not sky rocketing anytime soon as Americans are concerned more about wealth preservation than wealth creation for now.

Freddie and Fannie were taken over the by the government which could either be a boon or a bane in this situation. These two institutions are the primary sources of home mortgages underwriting a huge portion of them. If the federal government preoccupies itself in the takeover and transformation process and allows business as usual to continue at Fannie and Freddie, the required stimulant in the housing market will be absent. But if the feds recognize the need for a boost in the real estate market, ease regulations and churn out more affordable and flexible mortgages into the market this will undoubtedly attract buyers and spur the real estate market.

Financial models, illiquid markets and over the counter trading: Many of the troublesome assets that contributed to Lehman's decline were the toxic credit derivative swaps, and similar products. Most or all of these products had very illiquid markets forcing IB's to come up with complex mathematical models to price these securities. With no credible regulatory institution in place there was absolutely no accountability which led to pricing at will and pricing based on trust. The illiquidity in the secondary market only aggravated this as insufficient buyers and sellers led to a non-market math modeled and misleading pricing.

This recent implosion indicates a lot more than the dampened mood on Wall Street. This fallout clearly showed how financial engineering and innovation outpaced the federal financial market regulators who were caught off guard, desperately trying to save face and avert a lock down of the financial system in the country (and around the world).

Back to the basics: The last few decades saw the rise of a new type of bank: the investment bank. Well common sense now prevails and has proven that there is in fact only one type of bank: the normal bank where individuals park their savings which the bank then lends out at rate. Many wondered how the investment banking business model is sustainable, where short term loans are leveraged 1:30 and used in long term investments with no direct access to federal money. There was no credible regulator and the IB's had no oversight of any kind. Any venture capitalist would debunk these flaws in the investment banking business model if no IB ever existed and an ambitious entrepreneur draws up such a plan. There is talk about the new normal, because Wall Street's landscape has changed dramatically in the last six months. There will be a new normal: we will get back to the basics and have just one type of bank, the commercial bank.

The Future: Of the five major IB's which operated using the independent broker-dealer model, only two, Morgan Stanley and Goldman Sachs remain. It's very unlikely that Morgan could survive this crisis and the future looks uncertain even for Goldman in this fragile market environment. Leverage that was built up over years is hard to undo in a weeks or months. The deleveraging process will be nasty and unfortunate because the losses will be socialized and divided amongst taxpayers but profits will be privatized.

History has proven that our economy is one of the most resilient and nimble structures around the world. It has braved diverse problems from accounting scandals to bank failures and continued to roar forward. This is largely attributable to the strong foundations of America, competent regulatory institutions and the grit of the American worker. Although this down phase is looking ominously different, one can be sure that when the bad times pass, investment opportunities will open up.

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BEGINNING OF EXTENDED VERSION (ON BLOG):

The right remedies: Understanding the intricacies of the US and world financial system would take years. But here are some measures that the Fed and Treasury could have taken to diminish the volatility and lessen the panic.

1. The cost of credit for all the companies in question surged dramatically around rumors that credit rating agencies were exploring the option of downgrading their credit ratings. If some internal financial levers were pulled to stop these credit rating agencies from downgrading, this would have bought companies time, and saved billions of dollars of taxpayer money because credit could've been generated easily.

2. Mark to market accounting wrongly portrayed the balance sheets and hence the value of companies, which resulted in credit rate agencies downgrading debt and increasing the cost of borrowing. Practicing mark to market accounting when there is no market for securities is fundamentally flawed and this rule has to be scrutinized and reviewed.

3. Prevent hedge funds and investors from opening up naked Credit Default Swap positions that gamble on company's defaulting (i.e. no one should be allowed to purchase a credit default swap if the buyer of the CDS has no underlying asset to protect)

Financial or economic crisis: What started out as a financial crisis isolated to credit derivatives and the debt markets could soon transform to an economic crisis. The unfolding of events in this crisis has terrified normal folks and experts on Wall Street. For the first time in the history of Wall Street, brokers and bankers were actually asking for regulation and begging for intervention. These events have dented the confidence and questioned the sustainability our borrow-and-spend economy, which might result in a weaker US currency and the emergence of a multi-currency reserve system. In a consumer driven economy where prices of fuel, gas and food are on the rise, a simultaneous increase in the cost of borrowing will only intensify the pains on Main Street.

Large and small businesses depend on short term credit for their everyday transactions, and the dangerous freeze in the credit markets is harming the lifeline of corporate America as they operate with a broken backbone which is an illiquid credit market. Ordinary folks often use the stock market as a barometer of the economy which could be misleading sometimes. In this case especially, while the stock market recouped major losses by the end of the week, credit markets remained frozen and inaccessible which was scary and abnormal.

The Money Trail: Lots of hedge funds made massive profits in this financial crisis. Having mastered the system, there is a possibility that some firms legitimately exploited the loopholes for huge profits. With this basic understanding of CDS’s let me illustrate one instance of how this is possible.

CREDIT DEFAULT SWAPS (CDS) SIMPLIFIED
BUYER OF A CREDIT DEFAULT SWAP (or insurance): Hedge fund, investment bank or an accredited investor.	SELLER OF A CREDIT DEFAULT SWAP (or insurance): An investment bank, hedge funds and insurance companies.
Buyer purchases a CDS (or insurance) for an underlying asset (the underlying asset could be a loan, a bond, or any type of obligation). There is no requirement that the buyer of the CDS be the owner/holder of the underlying asset.	The CDS seller is selling the insurance for the underlying asset for which the seller will receive regular payments like insurance premiums.
The CDS buyer makes regular payments to the seller of the CDS, like insurance premium. So if XYZ hedge fund buys a CDS for Lehman Brothers debt from Morgan Stanley, XYZ hedge fund will make regular payments to Morgan Stanley, who in this case acts as the insurer for Lehman’s debt.	The CDS seller pockets the regular premium paid by the buyer and promises insurance in exchange. So in this case Morgan Stanley would have priced the CDS on Lehman’s debt based on complex models and sold that insurance to XYZ hedge fund. Morgan Stanley in turn receives and keeps the premiums.
XYZ hedge fund (the buyer of the CDS) is in effect, buying insurance and transferring the risk on Lehman’s debt to the seller of the insurance.	The seller of the CDS, Morgan Stanley, is in effect taking on the risk of the buyer’s underlying asset, Lehman’s debt, and is insuring it. So CDS buyer has transferred the risk to the CDS seller.
In the case of a credit event, the buyer of the CDS (XYZ hedge fund) gets a massive payout from the seller (Morgan Stanley), because the underlying asset has defaulted (i.e. Lehman’s debt defaulted).The payout can be a cash or a physical settlement based on the contract terms.	In the case of a, “credit event,” (i.e. bankruptcy, bond or credit default, obligation default, etc.) because the CDS seller has been collecting premiums and assumed the risk of the underlying asset, they are obligated to compensate the buyer for that. So Morgan Stanley compensates XYZ hedge fund proportionally.

Taking the same example used in the CDS illustration, where XYZ hedge fund buys a CDS for Lehman debt from Morgan Stanley, where the hedge fund in this case does not own or has no exposure to Lehman in any way, and it’s just a speculative play. When any bank, hedge fund or private equity firm buy a CDS on corporate bonds, on company short term or long term debt, this in turn lowers the price and value of these bonds.

Once XYZ hedge fund buys loads of CDS on Lehman’s debt, it is a good thing for this hedge fund if Lehman defaults on its debt. XYZ hedge fund can now short the stock (which was extremely easy to do before the present rules took effect, hedge funds and institutional players could short the stock naked, i.e. short massive amounts of the stock without actually owning it). Observing a rising short interest in the stock, other market players add to the downward momentum and drive down the stock price to depressed levels.

Depressed stock prices forces credit rating agencies to step in and downgrade the company’s debt, which could result in a bankruptcy filing (if sufficient capital cannot be raised for new collateral levels) or a default on their credit. Now, XYZ hedge fund, the buyer of the Credit Default Swap makes enormous profits because Lehman defaulted and Morgan Stanley, the seller of the CDS has to deliver a huge paycheck to XYZ hedge fund. Many suspect these practices could have been rampant in the last few months. One expert described this as, buying (or owning) your neighbors insurance and running his house over with your truck.

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