Investment Management Blog - Montague Capital

Have we now heard the name Ken Rogoff had in mind when on August 19^th he warned “We’re not just going to see mid-sized banks go under in the next few months, we’re going to see a whopper”?  (See Daily 090820.)  Which category does Lehman or Merrill Lynch fall into?  And AIG isn’t even a bank.  Yesterday’s trio of horrors tell us that the rules of the game have changed and not for the better.

Firstly, moral hazard is not completely dead after all.  A few months ago the consensus would have been that Lehman, or any other of Wall Street’s big names, would be rescued in these circumstances.  Banks should be allowed to take bigger and ever loonier bets and, if they went wrong, the taxpayer would bail them out.  Shareholders would have the value of their investments protected and executives would keep both their jobs and their huge bonuses.  The unfairness of this has always been obvious, but the consequences of failure were deemed too awful to contemplate.

Not any more they’re not, although we will return later to the question of whether we have the full list of unintended consequences.  There is a sense in which Lehman is a victimless crime in a way that Northern Rock would not have been.  Lehman is not a major deposit-taking institution, with thousands or ordinary people exposed to the risk of losing their life savings.  Its customers, both companies and individuals, are instead supposed to be both financially sophisticated and sufficiently well-off to understand the risks associated with Lehman’s products and services and to take the hit when things go wrong.

But what is telling here is that no institution, either domestic or foreign, was prepared to step up to the plate to snap up this “bargain opportunity” and that this time the federal government was not prepared to guarantee the buyer’s risk in doing so.  This is very different from Bear Stearns, where JP Morgan Chase effectively received a multi-billion cheque to keep the rescue job out of the US Treasury’s “in” tray.  The Korea Development Corporation had spent weeks looking over Lehman’s books, but still couldn’t come up with a number that made acceptable financial sense.  Bank of America had been teed up in the media most of last week as the home-grown saviour.  Even Barclays had been put forward as a buyer, which made even less sense than its lucky escape from buying ABN Amro.  In other words, the precedent has now been set that the US authorities have a clear idea of banks which are “worth” saving.  If we look at Lehman’s characteristics we will now have a far better idea of the names which will also be allowed to fail when they get into too deep waters.

By contrast, Bank of America was lined up pretty quickly to launch a US$50bn rescue of Merrill Lynch.  This speed is alarming and does not inspire confidence.  Officially, top-level contact between the two banks only began on Saturday.  BofA’s technocrats may think they’re very bright, but can they really have analysed the target to the n^th degree in so short a time?  Remember, it is Merrill that, with each succeeding set of quarterly results and in full and ghastly, but private, knowledge of its own “book”, has had to resort to ever dafter self-help measures, such as lending buyers the money to buy its own assets at huge mark-downs.  BofA’s CEO Ken Lewis has also famously gone on record as saying he had no idea how anyone could make money out of investment banking, yet here he is buying one of the biggest operators.  Was he wrong then (no, given the write-offs these boys have been making) or is he wrong now?  There is truly grim hubris in Lewis’ statement that “This is the strategic opportunity of a lifetime…..  to create the premier financial services company in the world.”  It really is no surprise that this brilliant (not) strategic step by Lewis wiped 15% off the value of his company yesterday.  There is a very real chance that he will not obtain the necessary shareholder approval to proceed with the deal if this is how his initiative continues to be rewarded.  So, unintended consequence number one: being helpful causes you more harm than good.  Will all potential rescuers want that?

The second major point is that, now the boil has been lanced, the rot is spreading fast.  With their customary skill in anticipating the problems that lie ahead, the debt-rating agencies have finally cut their views on the world’s largest insurer AIG.  The company had been hoping to cobble together up to US$40bn in fresh capital to try to keep its operation on an even keel, but has only been able to squeeze US$20bn in support from the New York state insurance regulators.  If this is what happens to the big guys, what chance for the little people?  This is the second unintended consequence and where things could get really messy.  It is bad enough that the investment banks have been writing off billions in ill-advised “investment strategies”.  Most of these things were insured, but the policies were then either used as collateral against further bright ideas or traded around for profit.  Bankruptcies like Lehman or rescues like Merrill Lynch will only add to the mountain of “assets” that have to find a buyer.  There will be more calls of the insurance which supposedly protected them, just AIG is less able to meet its obligations.  Don’t forget that most of these “assets” are based on the US housing market, which isn’t going up.  Basically, what happens to the casino when the banker, as well as all the punters, manages to go bust?

The last (for now) major point is the impact upon money markets.  Even before AIG suffered its rating cuts yesterday, US overnight interbank interest rates were three times the Fed funds rate with which they are supposed to be in virtual alignment.  Cutting interest rates, as many observers believe the Fed will do again today, is completely and utterly pointless when the banks themselves won’t play the game.  If they hadn’t realised it before the disappearance of Lehman and Merrill, the banks that still survive this morning now know what risk really is.  It really doesn’t matter how low Fed funds goes if you don’t trust the counterparty.  Which is probably why ten US banks clubbed together yesterday to pledge a US$70bn self-help rescue kitty should any of them find themselves short of cash.  Each of the ten is entitled to draw down one-third of the fund.  Do the sums.  Haven’t these people learned anything at all?  What happens when they all ask to draw on their one-third entitlement?  Who stumps up the extra US$163bn?  Which brings us to the last (again, for now only) unintended consequence.  It may have taken almost exactly a year, but Deutsche Bank’s CEO Josef Ackermann has been completely vindicated in his call that everyone should have come clean about their true positions.  Now there is nowhere to hide.  Whether it is the liquidators trying to realise such assets as they can, or rescuers dumping their acquired toxic waste before it fatally contaminates their own balance sheets, this stuff has got to go and at any price possible.  The insurers will be called upon to play their part.  Bottom line: there will be much less money in the system to go around, seriously handicapping any attempt at economic recovery.  If there ever had been any mileage in the glib proposition that the credit crunch would soon be over and that things would return to normal, there certainly isn’t now.