ss_blog_claim=bd50edc517cf0b7549fe6b5f63b6b5f8 The SLS Business Finance Blog: September 2008

Friday, September 26, 2008

Anatomy of a Bank Failure: Washington Mutual

So how does a bank like Washington Mutual fail and then need to be acquired by the Feds or another co like JPMorganChase ??

Banker A lends $100,000 to Borrower B in the form of a mortgage so Borrower B can buy a house valued at $100,000. The bank has the property to back the loan and the borrower gets the house thanks to the mortgage to pay off the seller. Borrower B can no longer pay his mortgage and the house goes into Foreclosure. So what happens to the bank?

The Bank now has 3 things they have to account for:

1) Loan loss provisions and Reserve Requirements
2) Tax and Financial Statement implications
3) The Property

As stated before, banks have loan loss provisions, which means that now this loan for $100,000 has gone bad, the bank must set aside $90,000 in cash. This means that $90,000 is taken out of lending circulation reducing the bank's liquidity and lending capacity. Why $90,000? The Federal Reserve has a reserve requirement on transactional loans of 10%. This means 10% of the value of the loan must be kept on deposit either at the bank or at the Fed. When a loan goes bad, this $$ has to still be set aside. but now, they have to set aside all 100% not just the 10% set aside when the loan was made. So problem # 1 for the bank is less $$ to lend to good credit customers.

Financial Statement implications seem like they wouldn't affect those of us not in the banking world that much but it does and certainly did in this case. Bad loans are 'marked to market', which means they are adjusted every year to their market value. A foreclosed loan is a loan with zero value since its non-performing and as a result, they now have a liability of a $100,000 loan that foreclosed and now immediately have $100,000 less in assets than they had when the loan was performing. The bank does have the property but needs to get rid of it in order to get this bad loan off their books. Is this loan really worth zero? No, its not but the problem for the bank is that no one wants to buy this loan even at a deep discount so on its books, it now looks immediately $100,000 less solvent than it was. So problem # 2 for the bank, is having to get rid of the property when property values are declining and a clear market value cannot be established.

This implication on financials seems only theoretical in that the loan has some value to someone but until the marketplace stabilizes and the loan can be sold, even at a loss, then this implication is very real and shows why a bank as large as WaMu can fail when they have the double whammy of $$ set aside against bad loans and loans marked down to a value of zero, even if temporarily.

The property is supposed to be the security against the loan but property values are declining. If the best offer the bank gets for the home with the $100,000 mortgage on it is only $60,000, does the bank accept? Problem # 3 for banks is a market of declining property values where the value of their security is unknown.

So does the bank really have $100,000 fewer assets because its value was marked to market at zero? No it doesn't but because the loan loss provisions have to be set aside and such an unstable marketplace exists for selling the underlying home, its impossible to assess the value of this loan and the underlying property and its for these reasons why a bank as large as WaMu can and did fail.

Monday, September 22, 2008

The Death of Investment Banks

At the beginning of 2008, there were 5 major investment banks: Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs, and Morgan Stanley. What set these 5 banks apart from conventional banks was that they did not accept or solicit bank deposits, the kinds of deposits insured by the Feds through the FDIC insurance program. These banks raised capital for other companies, made markets in stocks and bought and sold securities of all types. In return for not accepting deposits as commercial banks do, for their entire history they have been subject to significantly less regulation than the banking sector. This is primarily due to the fact that the banking sector has had more of a responsibility to the public trust. That was until Sun night 9/21/08.

Things have changed. All 5 banks are different now than the investment banking entities they used to be.

1) Bear Stearns, acquired by JP Morgan Chase and subject to stiffer merchant and commercial banking regulations.
2) Merrill Lynch, acquired by Bank of America and subject to stiffer commercial banking regulations.
3) Lehman Brothers, filed for bankruptcy protection and liquidation
4) Goldman Sachs, allowed by the Federal Government to accept deposits and convert into a commercial bank in order to stay alive and be subject to stiffer commercial banking regulations.
5) Morgan Stanley, allowed by the Federal Government to accept deposits and convert into a commercial bank in order to stay alive and be subject to stiffer commercial banking regulations.

Yesterday, the decision on Goldman and Morgan, the last 2 remaining investment banks made it official that no independent and lesser regulated investment banks are going to remain on Wall Street.

How this will affect companies trying to use the public markets to raise capital through the issuance of stocks or bonds remains to be seen but suffice it to say, it will be different.

Monday, September 15, 2008

Wall Street Awakes to 2 Storied Firms Failing

Reprinted from Yahoo News from the Associated Press


When Wall Street woke up Monday morning, two more of its storied firms had fallen.
Lehman Brothers, burdened by $60 billion in soured real-estate holdings, filed a Chapter 11 bankruptcy petition in U.S. Bankruptcy Court after attempts to rescue the 158-year-old firm failed. Bank of America Corp. said it is snapping up Merrill Lynch & Co. Inc. in a $50 billion all-stock transaction.

The demise of the independent Wall Street institutions came as shock waves from the 14-month-old credit crisis roiled the U.S. financial system six months after the collapse of Bear Stearns.

The world's largest insurance company, American International Group Inc., also was forced into a restructuring. And a global consortium of banks, working with government officials in New York, announced a $70 billion pool of funds to lend to troubled financial companies.
U.S. stocks were headed for a sharply lower open and Treasury bond prices soared as the market reacted to the news.

The aim of the bank consortium, according to participants who spoke to The Associated Press, was to prevent a worldwide panic on stock and other financial exchanges.
Ten banks — Bank of America, Barclays, Citibank, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan, Merrill Lynch, Morgan Stanley and UBS — each agreed to provide $7 billion "to help enhance liquidity and mitigate the unprecedented volatility and other challenges affecting global equity and debt markets."

The Federal Reserve also chipped in with more largesse in its emergency lending program for investment banks. The central bank announced late Sunday that it was broadening the types of collateral that financial institutions can use to obtain loans from the Fed.

Federal Reserve Chairman Ben Bernanke said the discussions had been aimed at identifying "potential market vulnerabilities in the wake of an unwinding of a major financial institution and to consider appropriate official sector and private sector responses."

The European Central Bank, the Bank of England, and the Swiss central bank also made more short-term credit available to banks. European stocks fell sharply, with the FTSE 100 Index off 3.42 percent in London, the CAC-40 down 4.27 percent in Paris, and Germany's blue-chip DAX 30 falling 3.38 percent. Asian stock markets also tumbled, with India's Sensex sinking more than 3 percent. Japan and Hong Kong were closed for holidays.

Financial stocks were hard hit and the dollar fell against the pound and the euro.
Futures pegged to the Dow Jones industrial average fell more than 250 points in electronic trading Sunday evening, pointing to a sharply lower open for the blue chip index Monday morning. The stunning weekend developments took place as voters, who rank the economy as their top concern, prepare to elect a new president in seven weeks. It likely will spur a much greater focus by presidential candidates — Republican John McCain and Democrat Barack Obama — and members of Congress on the need for stricter financial regulation.
Samuel Hayes, finance professor emeritus at Harvard Business School, said the Bush administration may get a lot of blame for the situation, which could benefit Obama.
"Just the psychological impact of this kind of failure is going to be significant," he said. "It will color people's feelings about their well-being and the integrity of the financial system."

Lehman Brothers' announcement that it is filing for bankruptcy came after all potential buyers walked away. Potential suitors were spooked by the U.S. Treasury's refusal to provide any takeover aid, as it had done six months ago when Bear Stearns faltered and earlier this month when it seized Fannie Mae and Freddie Mac.

In an effort to calm the markets, Lehman pre-announced third-quarter results on Wednesday. In an affidavit filed with the bankruptcy court, Lehman Chief Financial Officer Ian Lowitt said that action "did little to quell the rumors in the markets and the concerns about the viability of the company." He said the uncertainty made it impossible for Lehman to continue.
Employees emerging from Lehman's headquarters near the heart of Times Square Sunday night carried boxes, tote bags and duffel bags, rolling suitcases, framed artwork and spare umbrellas. Many were emblazoned with the Lehman Brothers name.

TV trucks lined Seventh Avenue opposite the building, while barricades at the building's main entrance attempted to keep workers and onlookers from gumming up the steady flow of pedestrians flowing in and out of Times Square.

Some workers had moist eyes while a few others wept and shared hugs. Most who left the building quietly declined interviews.
People snapped pictures with cameras and their phones. Observers pressed up against a police barricade drew the ire of one man who emerged from the building and shouted: "Are you enjoying watching this? You think this is funny?"

Its businesses in Britain were placed in administration Monday, said the administrator, accounting firm PricewaterhouseCoopers, and employees carrying boxes and bags were walking out of Lehman's London offices.

Merrill Lynch, another investment bank laid low by the crisis that was triggered by rising mortgage defaults and plunging home values in the U.S., agreed to be acquired by Bank of America for 0.8595 shares of Bank of America common stock for each Merrill Lynch common share.

That values Merrill at $29 a share, a 70 percent premium over the brokerage's Friday closing price of $17.05, but well below what Merrill was worth at its peak in early 2007, when its shares traded above $98.

Charlotte, N.C.,-based Bank of America has the most deposits of any U.S. bank, while Merrill Lynch is the world's largest brokerage. A combination of the two would create a global financial giant to rival Citigroup Inc., the biggest U.S. bank in terms of assets.

Strategically, most industry analysts say it's a good fit. If the deal goes according to plan, Bank of America will be able to offer Merrill's retail brokerage services to its huge customer base. There is not a great deal of overlap between the two companies — Bank of America does have an investment bank already, but it has never been terribly strong.

Where there is duplication, however, the combination of the two companies could result in more layoffs. Both Merrill and Bank of America have already cut thousands of investment banking jobs over the past year.

The deal would not come without risks, however. Merrill Lynch, like many of its Wall Street peers, has been struggling with tight credit markets and billions of dollars in assets tied to mortgages that have plunged in value. Merrill has reported four straight quarterly losses.
Bank of America's own finances are far from robust. As consumer credit deteriorates, the bank has seen its profits decline, and the company is still in the midst of absorbing the embattled mortgage lender Countrywide Financial, which it acquired in January.

Insurer AIG, hit hard by deterioration in the credit markets, said Sunday it is reviewing its operations and discussing possible options with outside parties to improve its business after a week when its stock dropped 45 percent amid concerns about the company's financial underpinnings.

The Wall Street Journal and The New York Times both reported early Monday on their Web sites that the American International Group is seeking an additional $40 billion in emergency funds — possibly from the Federal Reserve — to help it avoid a credit rating downgrade, which would make it more expensive for AIG to raise money. The insurer has already raised $20 billion in fresh capital this year.

AIG was working with New York Insurance Superintendent Eric Dinallo and a representative of the governor's office through the weekend to craft a solution that protects policyholders, according to Dinallo's spokesman David Neustadt.
"It's clear we're one step away from a financial meltdown," said Nouriel Roubini, chairman of the consulting firm RGE Monitor.

The meetings that began Friday night were a who's who of financial heavyweights: Treasury Secretary Hank Paulson, Timothy Geithner, president of the New York Fed, Securities and Exchange Commission Chairman Christopher Cox, and a host of CEOs, including Vikram Pandit of Citigroup Inc., Jamie Dimon of JPMorgan Chase & Co., John Mack of Morgan Stanley, Lloyd Blankfein of Goldman Sachs Group Inc., and Merrill Lynch & Co.'s John Thain.
For all their efforts, Lehman had to file for bankruptcy.

The end of Lehman may not stop the financial crisis that has gripped Wall Street for months, analysts said. More investment banks could disappear soon.
The independent broker-dealers "are going the way of the dodo bird," said Bert Ely, an Alexandria, Va.,-based banking consultant.
That's partly because some of the firms, particularly Merrill, made bad bets on real estate. But several analysts said that investment companies will need the deep pockets of commercial banks to survive the next few years.
On Sunday, there was also an emergency trading session being held at the International Swaps and Derivatives Association to "reduce risk associated with a potential Lehman Brothers Holdings Inc. bankruptcy." The ISDA, which arranges trades for derivatives, said it was allowing customers to make trades and unwind positions linked to Lehman.
Roubini said it's difficult to accurately gauge the health of companies like Merrill because their financial health depends on how they value complex securities. As a result, their finances aren't very transparent, he said.
That can lead to a loss of confidence in the financial markets, he said, which can overwhelm an investment bank even if it is financially healthy by some measures.
"Once you lose confidence, the fundamentals matter less," he said.
The common denominator of the financial crisis, analysts said, is the bursting of the housing bubble. Home prices have dropped on average 25 percent so far. Roubini predicted they could drop another 15 percent.
The crisis has begun to slow the broader economy as banks make fewer loans and consumers have begun cutting spending. Many economists are now forecasting that the economy could slip into recession by the end of this year and early next year.
That, in turn, could cause additional losses for commercial banks on credit cards, auto loans and student loans.
The Fed is widely expected to keep interest rates steady at 2 percent, below inflation, when it meets Tuesday. It was possible, however, that the central bank might decide in coming weeks to cut rates if such a move is seen as needed to calm turbulent financial markets.
The International Monetary Fund predicted earlier this year that total losses from the credit crisis could reach almost $1 trillion. So far, banks have only taken about $350 billion in losses.
Commercial banks are also starting to feel the pinch. Eleven have closed so far this year, including Pasadena, Calif.-based IndyMac Bank, which had $32 billion in assets and $19 billion in deposits.
Christopher Whalen, managing director of Institutional Risk Analytics, a research firm, predicts that approximately 110 banks with $850 billion in assets could close by next July. That's out of 8,400 federally insured institutions, he said, which together hold $13 trillion in assets.
Individual customers are starting to get nervous about the financial health of their banks for the first time in generations, he said. Whalen's firm analyzes the safety and soundness of banks for business clients, but began receiving inquiries from individuals in the past two months for the first time, he said.
"If we don't get ahead of this, we are going to face a run on the retail banks by election day," he said.

Editor's Note: While the losses are immense, the true issue across the board of the financial industry is liquidity, the access to capital/funds to lend. Loan loss provisions have some $$ on the sidelines already and no new growth in funds/deposits/cash means no additional liquidity in the marketplace. This is a sign its likely to get worse before it gets better, at least for the financial sector.

Tuesday, September 2, 2008

Banks to See Rising Costs of Funds in the Months Ahead

Reprinted from The Monitor Daily Online

The Wall Street Journal noted yesterday that with about $800 billion in floating rate notes and other medium-term obligation coming due over the next 12-18 months, banks will likely be less willing to make new loans to borrowers as investors will be demanding higher interest rates for new bank borrowings.

And for some of the larger banks that have agreed to buy back some $42 billion in auction rate securities, the problem is exacerbated even further. To provide a glimpse of what may be in store, we checked out recent prices for 5-year obligations on JB Hanauer & Co.’s website for a mix of banks and finance companies. And even though many of these companies are currently holding investment grade ratings, the price-to-yield data was indicative of investor sentiment with regard to the real or perceived risk of lending to some of these banks. For example, KeyCorp’s 5-year maturities with a coupon of 6.5% were priced to yield almost 10.5% or something close to a 750 basis point spread over like-term Treasuries. National City’s notes maturing in February 2011 were priced to yield 14.4%, which would translate into a spread of 1170 basis points over similar term Treasuries.

As a contrast, GE Capital’s 5-year notes with a coupon of 5.40% were trading at prices to yield about 4.6%, a spread of about 150 basis points over like-term Treasuries. Similarly Cat Financial’s 5-year notes with a coupon of 4.9% were priced to yield about 4.2%. However, beleaguered CIT showed several 5-year obligations with coupon rates ranging from 4.65% to 5.50%, which were selling at prices to yield about 12.4%, a spread of over 900 basis points. It would also indicate what may be at the root of why CIT’s vendor finance business showed substantially reduced profits of 17.6 million for the first half of 2008 versus 146.5 million, for the same period in 2007.

What this picture would suggest is a significant market advantage or disadvantage, depending on where you sit, when pricing on a match-funded basis in a competitive situation. It occurs to us that sustaining a vendor program, for example, would become increasingly more difficult to expect returns that were anticipated at program inception. And unless subsidized for the long-term, this phenomenon would seemingly preclude an aggressive run at a new vendor prospect.

Editor's Note: As bank costs of funds rise, that affects not just bank lending but equipment finance companies who are reliant on bank loans and lines in order to fund their deals with GE, CIT and KeyCorp listed among them. This is an example of why commercial finance rates are tied to costs of funds and not tied to Prime, as many expect that it is.

Monday, September 1, 2008


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