I didn't see any specific threads on this topic. I thought this article from WSJ put it in clear language. I'll leave it to our financial heads to explain further but as I understand it this was the ultimate in socialized loss protection. Though if there hadn't been a bailout we could be facing a global financial catastrophe.
quote:
Worst Crisis Since '30s, With No End Yet in Sight
by Jon Hilsenrath, Serena Ng and Damian Paletta
Wednesday, September 17, 2008
provided by WSJ
The financial crisis that began 13 months ago has entered a new, far more serious phase.
Lingering hopes that the damage could be contained to a handful of financial institutions that made bad bets on mortgages have evaporated. New fault lines are emerging beyond the original problem -- troubled subprime mortgages -- in areas like credit-default swaps, the credit insurance contracts sold by American International Group Inc. and others firms. There's also a growing sense of wariness about the health of trading partners.
The consequences for companies and chief executives who tarry -- hoping for better times in which to raise capital, sell assets or acknowledge losses -- are now clear and brutal, as falling share prices and fearful lenders send troubled companies into ever-deeper holes. This weekend, such a realization led John Thain to sell the century-old Merrill Lynch & Co. to Bank of America Corp. Each episode seems to bring intervention by the government that is more extensive and expensive than the previous one, and carries greater risk of unintended consequences.
Expectations for a quick end to the crisis are fading fast. "I think it's going to last a lot longer than perhaps we would have anticipated," Anne Mulcahy, chief executive of Xerox Corp., said Wednesday.
"This has been the worst financial crisis since the Great Depression. There is no question about it," said Mark Gertler, a New York University economist who worked with fellow academic Ben Bernanke, now the Federal Reserve chairman, to explain how financial turmoil can infect the overall economy. "But at the same time we have the policy mechanisms in place fighting it, which is something we didn't have during the Great Depression."
Spreading Disease
The U.S. financial system resembles a patient in intensive care. The body is trying to fight off a disease that is spreading, and as it does so, the body convulses, settles for a time and then convulses again. The illness seems to be overwhelming the self-healing tendencies of markets. The doctors in charge are resorting to ever-more invasive treatment, and are now experimenting with remedies that have never before been applied. Fed Chairman Bernanke and Treasury Secretary Henry Paulson, walking into a hastily arranged meeting with congressional leaders Tuesday night to brief them on the government's unprecedented rescue of AIG, looked like exhausted surgeons delivering grim news to the family.
Fed and Treasury officials have identified the disease. It's called deleveraging, or the unwinding of debt. During the credit boom, financial institutions and American households took on too much debt. Between 2002 and 2006, household borrowing grew at an average annual rate of 11%, far outpacing overall economic growth. Borrowing by financial institutions grew by a 10% annualized rate. Now many of those borrowers can't pay back the loans, a problem that is exacerbated by the collapse in housing prices. They need to reduce their dependence on borrowed money, a painful and drawn-out process that can choke off credit and economic growth.
At least three things need to happen to bring the deleveraging process to an end, and they're hard to do at once. Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets.
But many of the distressed assets are hard to value and there are few if any buyers. Deleveraging also feeds on itself in a way that can create a downward spiral: Trying to sell assets pushes down the assets' prices, which makes them harder to sell and leads firms to try to sell more assets. That, in turn, suppresses these firms' share prices and makes it harder for them to sell new shares to raise capital. Mr. Bernanke, as an academic, dubbed this self-feeding loop a "financial accelerator."
"Many of the CEO types weren't willing...to take these losses, and say, 'I accept the fact that I'm selling these way below fundamental value,'" says Anil Kashyap, a University of Chicago Business School economics professor. "The ones that had the biggest exposure, they've all died."
Borrowing Slowdown
Deleveraging started with securities tied to subprime mortgages, where defaults started rising rapidly in 2006. But the deleveraging process has now spread well beyond, to commercial real estate and auto loans to the short-term commitments on which investment banks rely to fund themselves. In the first quarter, financial-sector borrowing slowed to a 5.1% growth rate, about half of the average from 2002 to 2007. Household borrowing has slowed even more, to a 3.5% pace.
Goldman Sachs Group Inc. economist Jan Hatzius estimates that in the past year, financial institutions around the world have already written down $408 billion worth of assets and raised $367 billion worth of capital.
But that doesn't appear to be enough. Every time financial firms and investors suggest that they've written assets down enough and raised enough new capital, a new wave of selling triggers a reevaluation, propelling the crisis into new territory. Residential mortgage losses alone could hit $636 billion by 2012, Goldman estimates, triggering widespread retrenchment in bank lending. That could shave 1.8 percentage points a year off economic growth in 2008 and 2009 -- the equivalent of $250 billion in lost goods and services each year.
"This is a deleveraging like nothing we've ever seen before," said Robert Glauber, now a professor of Harvard's government and law schools who came to the Washington in 1989 to help organize the savings and loan cleanup of the early 1990s. "The S&L losses to the government were small compared to this."
Hedge funds could be among the next problem areas. Many rely on borrowed money to amplify their returns. With banks under pressure, many hedge funds are less able to borrow this money now, pressuring returns. Meanwhile, there are growing indications that fewer investors are shifting into hedge funds while others are pulling out. Fund investors are dealing with their own problems: Many have taken out loans to make their investments and are finding it more difficult now to borrow.
That all makes it likely that more hedge funds will shutter in the months ahead, forcing them to sell their investments, further weighing on the market.
History of Trauma
Debt-driven financial traumas have a long history, from the Great Depression to the S&L crisis to the Asian financial crisis of the late 1990s. Neither economists nor policymakers has easy solutions. Cutting interest rates and writing stimulus checks to families can help -- and may have prevented or delayed a deep recession. But, at least in this instance, they don't suffice.
In such circumstances, governments almost invariably experiment with solutions with varying degrees of success. Franklin Delano Roosevelt unleashed an alphabet soup of new agencies and a host of new regulations in the aftermath of the market crash of 1929. In the 1990s, Japan embarked on a decade of often-wasteful government spending to counter the aftereffects of a bursting bubble. President George H.W. Bush and Congress created the Resolution Trust Corp. to take and sell the assets of failed thrifts. Hong Kong's free-market government went on a massive stock-buying spree in 1998, buying up shares of every company listed in the benchmark Hang Seng index. It ended up packaging them into an exchange-traded fund and making money.
Today, Mr. Bernanke is taking out his playbook, said NYU economist Mr. Gertler, "and rewriting it as we go."
Merrill Lynch & Co.'s emergency sale to Bank of America Corp. last weekend was an example of the perniciousness and unpredictability of deleveraging. In the past year, Merrill has hired a new chief executive, written off $41.4 billion in assets and raised $21 billion in equity capital.
But Merrill couldn't keep up. The more it raised, the more it was forced to write off. When Merrill CEO John Thain attended a meeting with the New York Fed and other Wall Street executives last week, he saw that Merrill was the next most vulnerable brokerage firm. "We watched Bear and Lehman. We knew we could be next," said one Merrill executive. Fearful that its lenders would shut the firm off, he sold to Bank of America.
This crisis is complicated by innovative financial instruments that Wall Street created and distributed. They're making it harder for officials and Wall Street executives to know where the next set of risks is hiding and also contributing to the crisis's spreading impact.
Swaps Game
The latest trouble spot is an area called credit-default swaps, which are private contracts that let firms trade bets on whether a borrower is going to default. When a default occurs, one party pays off the other. The value of the swaps rise and fall as market reassesses the risk that a company won't be able to honor its obligations. Firms use these instruments both as insurance -- to hedge their exposures to risk -- and to wager on the health of other companies. There are now credit-default swaps on more than $62 trillion in debt, up from about $144 billion a decade ago.
One of the big new players in the swaps game was AIG, the world's largest insurer and a major seller of credit-default swaps to financial institutions and companies. When the credit markets were booming, many firms bought these instruments from AIG, believing the insurance giant's strong credit ratings and large balance sheet could provide a shield against bond and loan defaults. AIG believed the risk of default was low on many securities it insured.
As of June 30, an AIG unit had written credit-default swaps on more than $446 billion in credit assets, including mortgage securities, corporate loans and complex structured products. Last year, when rising subprime-mortgage delinquencies damaged the value of many securities AIG had insured, the firm was forced to book large write-downs on its derivative positions. That spooked investors, who reacted by dumping its shares, making it harder for AIG to raise the capital it increasingly needed.
Credit default swaps "didn't cause the problem, but they certainly exacerbated the financial crisis," says Leslie Rahl, president of Capital Market Risk Advisors, a consulting firm in New York. The sheer volumes of outstanding CDS contracts -- and the fact that they trade directly between institutions, without centralized clearing -- intertwined the fates of many large banks and brokerages.
Few financial crises have been sorted out in modern times without massive government intervention. Increasingly, officials are coming to the conclusion that even more might be needed. A big problem: The Fed can and has provided short-term money to sound, but struggling, institutions that are out of favor. It can, and has, reduced the interest rates it influences to attempt to reduce borrowing costs through the economy and encourage investment and spending.
But it is ill-equipped to provide the capital that financial institutions now desperately need to shore up their finances and expand lending.
Resolution Trust Scenario
In normal times, capital-starved companies usually can raise money on their own. In the current crisis, a number of big Wall Street firms, including Citigroup, have turned to sovereign wealth funds, the government-controlled pools of money.
But both on Wall Street and in Washington, there is increasing expectation that U.S. taxpayers will either take the bad assets off the hands of financial institutions so they can raise capital, or put taxpayer capital into the companies, as the Treasury has agreed to do with mortgage giants Fannie Mae and Freddie Mac.
One proposal was raised by Barney Frank, the Massachusetts Democrat who chairs the House Financial Services Committee. Rep. Frank is looking at whether to create an analog to the Resolution Trust Corp., which took assets from failed banks and thrifts and found buyers over several years.
"When you have a big loss in the marketplace, there are only three people that can take the loss -- the bondholders, the shareholders and the government," said William Seidman, who led the RTC from 1989 to 1991. "That's the dance we're seeing right now. Are we going to shove this loss into the hands of the taxpayers?"
The RTC seemed controversial and ambitious at the time. Any analog today would be even more complex. The RTC dispensed mostly of commercial real estate. Today's troubled assets are complex debt securities -- many of which include pieces of other instruments, which in turn include pieces of others, many steps removed from the actual mortgages or consumer loans on which they are based. Unraveling these strands will be tedious and getting at the underlying collateral, difficult.
In the early stages of this crisis, regulators saw that their rules didn't fit the rapidly changing financial system they were asked to oversee. Investment banks, at the core of the crisis, weren't as closely monitored by the Securities and Exchange Commission as commercial banks were by their regulators.
The government has a system to close failed banks, created after the Great Depression in part to avoid sudden runs by depositors. Now, runs happen in spheres regulators may not fully understand, such as the repurchase agreement, or repo, market, in which investment banks fund their day-to-day operations. And regulators have no process for handling the failure of an investment bank like Lehman Brothers Holdings Inc. Insurers like AIG aren't even federally regulated.
Regulators have all but promised that more banks will fail in the coming months. The Federal Deposit Insurance Corp. is drawing up a plan to raise the premiums it charges banks so that it can rebuild the fund it uses to back deposits. Examiners are tightening their leash on banks across the country.
Pleasant Mystery
One pleasant mystery is why the crisis hasn't hit the economy harder -- at least so far. "This financial crisis hasn't yet translated into fewer...companies starting up, less research and development, less marketing," Ivan Seidenberg, chief executive of Verizon Communications, said Wednesday. "We haven't seen that yet. I'm sure every company is keeping their eyes on it."
At 6.1%, the unemployment rate remains well below the peak of 7.8% in 1992, amid the S&L crisis.
In part, that's because government has reacted aggressively. The Fed's classic mistake that led to the Great Depression was that it tightened monetary policy when it should have eased. Mr. Bernanke didn't repeat that error. And Congress moved more swiftly to approve fiscal stimulus than most Washington veterans thought possible.
In part, the broader economy has held mostly steady because exports have been so strong at just the right moment, a reminder of the global economy's importance to the U.S. And in part, it's because the U.S. economy is demonstrating impressive resilience, as information technology allows executives to react more quickly to emerging problems and -- to the discomfort of workers -- companies are quicker to adjust wages, hiring and work hours when the economy softens.
But the risk remains that Wall Street's woes will spread to Main Street, as credit tightens for consumers and business. Already, U.S. auto makers have been forced to tighten the terms on their leasing programs, or abandon writing leases themselves altogether, because of problems in their finance units. Goldman Sachs economists' optimistic scenario is a couple years of mild recession or painfully slow economy growth. http://finance.yahoo.com/banking-bu...nd-Yet-in-Sight
Here's an article about the meeting with Bernanke and Paulson.
quote:
“When you listened to him describe it you gulped," said Senator Charles E. Schumer, Democrat of New York.
As Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the Banking, Housing and Urban Affairs Committee, put it Friday morning on the ABC program “Good Morning America,” the congressional leaders were told “that we’re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally.”
Sucks for those of us that actually prepared for this moment only to end up getting ed in the ass. the government. Democrats. Republicans. unelected officials that don't understand what they're doing.
LatinLover
IMO, homeowners and the financial institutions deserve what they are going through. Financial institutions for their unethical business practices and the cosumers for being uneducated consumers.
It is sad that do bail these individuals for their irresponsibility it has to be done in the expense of the tax payer. I truly dont know if these resolution with the treasury and the federal govt can be succesful in the long run. But it would give some air to the banks and consumers.
I too feel the pain of this financial downturn. As my work revolves in the real estate and construction industry. Hopefully this could speed up the recovery. We will see! Hey what do i have to do to bitch about... if this action by the treasury will benefit the industry i work in :p
Shakka
IMHO, an RTC type bailout was somewhat inevitable--people simply didn't (and still don't) realize how serious and bad this problem is. What pisses me off is the arbitrary banning of short selling 2 days before options expiration in concert with everything else that is going on--it is nothing less than a premeditated plan to blow any and all shorts out of the water. Furthermore, assigning blame to those who have been trying to point out these very problems for years is just asanine. Will the SEC ever investigate AIG, Lehman, etc., for building massive balance sheets based on thin capital levels, exotic illiquid, impossible to value assets and the like? Of course not. Shorts are to blame for everything. They are setting a very bad precedent based on no precedent. Chris Cox should be thrown in jail.
Groundhog Boy
quote:
Originally posted by Shakka
IMHO, an RTC type bailout was somewhat inevitable--people simply didn't (and still don't) realize how serious and bad this problem is. What pisses me off is the arbitrary banning of short selling 2 days before options expiration in concert with everything else that is going on--it is nothing less than a premeditated plan to blow any and all shorts out of the water. Furthermore, assigning blame to those who have been trying to point out these very problems for years is just asanine. Will the SEC ever investigate AIG, Lehman, etc., for building massive balance sheets based on thin capital levels, exotic illiquid, impossible to value assets and the like? Of course not. Shorts are to blame for everything. They are setting a very bad precedent based on no precedent. Chris Cox should be thrown in jail.
Posted in the Marketocracy thread
quote:
Originally posted by Groundhog Boy
Would any of you touch GS (or even MS if it dips low again, not after the 100% range today) right now to reinvest the proceeds? Do you think that the fear-laden free-fall in financials might have been curbed by today's rumors or that we're heading much further south soon?
UK bans short selling financials. Wouldn't just reinstating the uptick rule have been a more moderate move?
And I agree - as much as I loved the action today, the no short rule was too heavy handed. I did like the company buyback policy today, though. Too many of these companies have been overly sold lately (seriously, Goldman at $86.xx yesterday) and if they can do buybacks to instill confidence by boosting price, good for them.
jerZ07002
necessary but unfortunate.
i saw this coming since before the stimulus checks (i think i posted that in a thread a few months ago - but i'm too lazy to search for it). The stimulus checks were trying to throw money at the symptoms and not the disease. At least this bailout gets rid of the disease. However, I would still like to see people's home foreclosed upon, and bankers lose their jobs. The people who took the risks need to bear the burden of their actions. how else will they learn not to do it again.
Groundhog Boy
quote:
Originally posted by jerZ07002
The people who took the risks need to bear the burden of their actions. how else will they learn not to do it again.
If these were the only people being ed, i'd be completely on board with you. Instead, we'd have watched the entire US (and world, tbh) suffer, even though most never had any problems with making loan payments. I'd rather suffer the bailouts, though I think they far overstepped last night, than suffer the far more massive fallout for mainstream America.
And honestly, this AIG "bailout" looks pretty profitable to the US government to me. Hell, their 80% stake just doubled in value today.
jerZ07002
quote:
Originally posted by Groundhog Boy
If these were the only people being ed, i'd be completely on board with you. Instead, we'd have watched the entire US (and world, tbh) suffer, even though most never had any problems with making loan payments. I'd rather suffer the bailouts, though I think they far overstepped last night, than suffer the far more massive fallout for mainstream America.
And honestly, this AIG "bailout" looks pretty profitable to the US government to me. Hell, their 80% stake just doubled in value today.
i agree, that's why i said necessary but unfortunate. That doesn't mean i think the people who created the mess should get away with it. bankers should lose their jobs, and people who can't pay their mortgages should be foreclosed upon. The governmental entity, being tax exempt (i think - there is a strong argument that if it takes ownership of the foreclosed houses it wouldn't be subject to property taxes), could hold onto the properties and wait for appreciation. Of courses, then it would lose on interest rate risk.
In one of the other threads i posted an article about how the government will probably profit from these bailouts like it did in the S&L crisis.
the government won with AIG because it isn't providing equity but in return for debt financing, is getting interest at an extremely high rate as well as a 80% equivalent equity interest in the liquidation proceeds. forget the stock value, i don't think the government is getting stock in AIG that it could sell (i could be wrong), it is getting a super preferred interest.
MisterOpus1
Welp, now that us taxpayers own so much of Wall Street, we taxpayers have much more pull and more say on what goes on there, right?
And you know, $700 billion just the first figure they are giving us. If typical government cost estimates are anything to go by, this could end up costing taxpayers $2 trillion.
And you know, $700 billion just the first figure they are giving us. If typical government cost estimates are anything to go by, this could end up costing taxpayers $2 trillion.
bailouts of this type usually end up earning money for the treasury. the article below pertains to the AIG bailout, but it applies equally to this bad bank bailout.
quote:
The Financial Crisis: A Big Unknown: Cost of Bailouts --- Profit Is Possible For Government If Firms Do Well
By Sudeep Reddy and John D. McKinnon
1245 words
18 September 2008
The Wall Street Journal
A3
English
(Copyright (c) 2008, Dow Jones & Company, Inc.)
The federal government, now in control of a trio of giant U.S. companies, faces the challenge of managing the troubled firms while trying to protect American taxpayers from losses.
Even as the financial crisis deepened Wednesday, government officials tried to figure out the implications of their $85 billion loan to American International Group Inc., a move that came 10 days after the federal takeover of mortgage giants Fannie Mae and Freddie Mac.
The financial consequences of the government actions will depend on how the companies ultimately perform. Fannie and Freddie are expected to be overhauled and subject to new regulations and oversight. AIG is expected to sell off several business lines, with its ultimate fate uncertain.
When the White House budget office releases its budget proposal early next year, the short-term budget impacts from the bailouts of Bear Stearns Cos., Fannie and Freddie, and AIG could range from zero to tens of billions of dollars, administration officials said. In the context of a 2009 budget deficit that already is projected to reach $500 billion, even big losses could look relatively insignificant. Over the longer term, the government could make money, particularly on the AIG deal.
A slowdown in tax revenue in 2009 could do more damage than the bailouts, a senior administration official said. "The much larger effect is what's going on with the overall economy and the effect on receipts," the official said. "It traditionally has gone up or down by hundreds of billions" based on swings in the economy. "That's what we're most concerned about anytime we estimate."
Calculating the longer-term outlook for Fannie and Freddie, in particular, is "like throwing darts in a dark room," said Sen. Judd Gregg of New Hampshire, the top Republican on the Senate Budget Committee. "No one has any idea what the cost is." He said the new president will face tight fiscal restraints on any new proposals in any case, and those could be made much worse by Fannie and Freddie.
The government interventions are the latest in a series of historic moves to resolve financial crises. The biggest was the government bailout of the savings-and-loan industry that began in 1989 and ultimately cost almost $500 billion. Other rescues led to profits, including a $250 million loan guarantee to Lockheed Aircraft Corp. in 1971; $1.2 billion in loan guarantees to Chrysler Corp. in 1979; and more than $6 billion in cash and loans to airlines in 2001.
"In individual company interventions in the modern era, the federal government generally did not lose money," said Roger Altman, a top Treasury official in both the Clinton and Carter administrations and an architect of the 1979 Chrysler loan. "They were structured very well, and the government's interest was well protected."
Mr. Altman said the structure of the AIG agreement could protect the federal government in a similar fashion. While the U.S. is in a "dangerous financial-market environment," he said, "it is entirely possible that after this interim period the federal government ultimately is repaid."
Key questions and complications remain. Treasury Secretary Henry Paulson installed a new chief executive at AIG; Mr. Paulson's level of involvement, and that of his successor come January, isn't clear. Federal Reserve Chairman Ben Bernanke and other top officials presumably will be forced to spend considerable time overseeing the AIG loan while also handling monetary policy. And the exit plan for the government, and the taxpayer, is unknown.
Treasury and Fed officials "are doing what they have to do to keep the dominos from falling, and I support it," said Rep. John Spratt, the chairman of the House Budget Committee. "But the outlays are getting pretty big."
He said recurring federal-budget deficits already have raised alarms with foreign investors; that is one reason the government had to move decisively.
The Fed and Treasury devised the AIG loan package, which provides as much as $85 billion to the insurance giant, with only a couple of days of planning. They rushed to avert potentially disastrous consequences in financial markets. In return, the Fed took an equity stake of nearly 80% and is charging the company a high interest rate -- 8.5 percentage points above the London Interbank Offered Rate. The loan is designed to allow AIG to finance itself while selling off businesses.
The term of the loan -- two years -- indicates that the government designed the package to force the insurer to liquidate as quickly as possible, said Tom Gallagher, an analyst at ISI Group in Washington. "The risk is higher the longer-term the arrangement is," he said.
The government's role in handling the two mortgage giants is likely to be more political. Lawmakers are discussing how to protect some homeowners by modifying mortgage loans and minimizing foreclosures.
Fannie and Freddie own or guarantee more than $5 trillion of mortgages, underpinning the nation's housing market. The government's actual cost of bailing out the mortgage titans could be relatively small next year if the housing market doesn't deteriorate significantly.
But lawmakers also are mulling over worst-case scenarios from some analysts who say the government's exposure might be as much as $300 billion if the housing market fails to recover -- an amount that could damage the government's finances just as the fiscal pressure from baby-boomer retirements begins.
Given the uncertainties surrounding the bailouts, "this is a coin flip," said Robert Reischauer, who was director of the Congressional Budget Office during the savings-and-loan crisis in the late 1980s and early 1990s.
This time around, doubts arise from the economic outlook, as well as the actions of the federal government, international investors and other players. "There's obviously a lot more uncertainty about who's going to step in and backstop the system," said Mr. Reischauer, president of the Urban Institute, a Washington think tank. "There was no question with the S&L's." This crisis could be worse, he said, especially if international investors decide to pull back.
The reason for some optimism over the AIG deal is that the $85 billion loan is backed by some strong collateral: AIG's insurance businesses. It also carries a high interest rate. The government's 79.9% equity stake could turn a profit if the company rebounds.
In the case of the Bear Stearns bailout in March, the government accepted less-robust mortgage-backed securities as collateral for the $30 billion it offered to facilitate Bear's takeover by J.P. Morgan Chase & Co. Those assets could perform well, depending on the strength of the economy and the housing market over the next several years. In addition, J.P. Morgan is on the hook for the first $1 billion in losses, softening the blow to the government if the mortgage assets don't do well.
For a second straight day, President George W. Bush kept a low profile on the crisis.
"There are times, believe it or not, when policy makers actually need to, like, work on making some policy," said White House press secretary Dana Perino, explaining Mr. Bush's public silence. Mr. Bush sought to reassure the public Monday, but his comments appeared to have little effect on markets.
