Wheres the Safety Net?
By: Dr. Charles Lieberman
Date: 9/15/2008
The financial system will soon find a safety net exists underneath the commercial banks, even as investment banks find themselves on the wrong side of the line. This distinction is occurring only because Treasury will find it difficult to intrude into the Fed's zone of responsibility. Treasury has made mincemeat in every area into which it has intruded. In contrast, commercial banks are protected by their ability to borrow from the Fed and deposit insurance, which further discourages runs. It is the sophisticated money that invests in securities without a safety net that is fleeing the investment banks and Treasury has done little to protect the system from these credit problems.
Treasury has wanted to avoid encouraging financial firms from taking undue risk by bailing them out of their past mistakes. That's a good principle, but it has been allowed to override all other considerations. By allowing Lehman to fail, Treasury is allowing its problems to afflict other financial firms that will now scramble to determine their exposure to Lehman. If some firms suffer large losses due to their exposure to Lehman, more capital may be needed. In effect, Treasury is accepting systemic risk to discourage moral hazard. It is not a good trade, since Treasury could be forced to spend even more money if the losses spread and other firms need to be bailed out to avoid a systemic problem. Similarly, Treasury placed the GSEs into receivership, but devastated the preferred stock market in the process, inflicting losses on banks and financial firms, while damaging their ability to tap preferred to raise capital.
Fortunately, there is an effective mechanism in place to limit losses suffered within the banking system. Depositors understand that their deposits are government insured. Aside from some people who might move some deposits around to remain within the $100,000 guarantee, the banking system should hold up despite the fears that are rampant at the moment. Washington Mutual is the large bank that is most at risk, but its retail bank franchise and depositor base is hugely valuable, so other banks will likely jump at the opportunity to buy it cheaply, if given that opportunity. So it is likely to sell out long before it fails. And, it might not even fail, since WAMU raised quite a bit of capital at the expense of diluting its shareholders. The Fed's announcement that it will accept low quality assets at the discount window helps make the point that any bank will be able to obtain as much liquidity as it requires. This will enable Lehman to unwind its positions in less of a fire sale, since it can get liquidity from the Fed.
It is very important that Merrill Lynch agreed to sell itself to Bank of America. By selling, Merrill removes the most obvious next target from the seller's cross hairs. If it hadn't sold itself, attention would have shifted to Merrill and rumors would have swirled until investors were driven away. Merrill effectively short circuited this process, simultaneously dealing a large blow to the short sellers in its stock. Since neither Goldman nor Morgan Stanley appears for the moment to be particularly vulnerable, the market may soon quiet down, if only for lack of new targets to sell short. John Thain, Merrill's CEO, is smart to take a premium for selling out. I can only presume that Bank of America is paying that premium to grab Merrill while it is vulnerable, but also as a public service. If BoA had waited, they surely could have gotten Merrill at a cheaper price, but also after yet more turmoil in the financial system. In taking this step, Bank of America is doing more to contain the credit crisis than Paulson at the Treasury. Kudos to Ken Lewis, who had pulled off a second major coup this year, acquiring Merrill after Countrywide. Bank of America emerges as the leading financial institution in the United States.
Events surrounding AIG are also unfolding fast and furious. Its problems are inherently different, since it is an insurance company. It has suffered large losses from subprime mortgage assets and credit default swaps, so it must raise capital, but it is less vulnerable to capital flight. The financial system is also far less vulnerable to a failure at AIG. Lehman had only one major asset, Neuberger Berman, to sell and it could not get a good price while under duress and there weren't many other saleable assets in the cupboard. AIG has many assets to sell. They are turning to the Fed to obtain financing in the very short-run, while they conduct an asset sale to raise capital. (Rumor also has it that Warren Buffett is very interested in investing in AIG. This suits Buffett far better than investing in a troubled investment bank, such as Lehman, which he surely turned down without hesitation.) If the rating agencies accept AIG's plans to sell off some $30 to $40 billion in assets without downgrading its ratings, AIG will get the time it needs to conduct an orderly sale.
The latest developments are sending another shudder through the financial system, but since there aren't many players left to suffer from more contagion, at least few that I see, markets should settle down fairly quickly. The arrangement by ten large banks to create a special facility funded by $70 billion to buy assets and provide liquidity to the financial system will also go far to stabilize the financial system. This is similar to the consortium that helped unwind Long Term Capital Management when it nearly failed in 1998. As occurred in 1998, these banks will likely make money from the liquidation of Lehman's assets. Notably, this is being orchestrated by the private sector without Treasury capital.
After Treasury placed the GSEs into conservatorship, mortgage rates plunged by roughly one half percentage point. That should be reflected rapidly, within two weeks if it takes that long, in new refinancing applications. Potential buyers will also benefit from the significant improvement in housing affordability. Also, oil prices have plunged, which will show up tomorrow as a decline in consumer prices, when the August consumer price index is released. Additional sizeable declines will follow in the coming months, boosting real household disposable income and supporting the consumer's ability to spend. If the markets calm down after an initial bout of nervousness, the broader damage to the economy should prove to be limited. Download this article in PDF Format
About Advisors Capital Management, LLC
Advisors Capital Management, LLC (ACM) is a provider of managed portfolios and financial services for industry professionals and their clients. As investment strategist, Dr. Lieberman oversees the company's "Portfolio Partners" investment program. Additionally, he provides guidance to the ACM Wealth Coordinators who integrate the work of financial advisors, financial planning, tax, estate and portfolio management professionals to build, protect, and maintain clients' wealth. Although the information included in this report has been obtained from sources Advisors Capital Management, LLC believes to be reliable; we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.
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