Is It Over Yet?
Now and then I put posts up here not so much for other people to read (although if they do that’s why this is on the web!), but more so I can remember events in case I ever want to look back on them.
I don’t think too many people will argue with me that our modern financial system runs on credit. Banks extend credit to people so they can buy a house. Investment banks extend credit to hedge funds so they can lever their positions and improve their performance. Asset managers extend credit to their counterparties when they enter into OTC positions, and vice versa. It’s all about credit. And this last week and a half no one wanted to extend credit to anyone else. Fear overtook greed for a little while and everyone was just trying to escape with the shirt on their backs.
There were a lot of firsts during the past week and a half. The VIX topped 40 for the first time since after the World Trade Center terrorist attacks. Lehman Brothers declared bankruptcy (I’ll get back to this) and Merrill Lynch was forced by the Fed to be acquired by Bank of America (about which I think Bank of America is laughing all the way to the, well, the bank!). Fannie Mae and Freddie Mac, two organizations that have long operated under the auspices of private companies with an implied government guarantee for their credit, finally hit the skids and were placed into a government conservatorship (read taken over by the federal government). AIG, the largest insurance company in the world, was similarly rescued by the federal government when, unlike the actions taken with respect to Lehman, the Fed decided that AIG was just too big to fail. Retail investors started running on money market funds resulting in the Fed again stepping in to guarantee these instruments should they contain any toxic debt. I could go on… Needless to say I don’t think I’ll ever experience a week like it again in my lifetime.
What never ceases to amaze me in times like these, when the markets are in a panic and extreme risk aversion comes into play, is the immense power of rumors and media headlines. In panic-stricken times all it takes is one bad headline or one (false or true) rumor and the withdrawal of capital on institutions begins a domino-like run which, as we’ve seen this week, can bring down century-old Wall Street titans like Lehman Brothers and Merrill. Lehman’s stock price from September 4th through 17th is pictured to the right (click it if you can’t make it out). What we’ve been witnessing over the past week and a half can be likened to the run on banks during the savings and loans crisis that saw the birth of all this mortgage securitization in the first place… Below are some other plots from the past week or two that want to make sure I keep, maybe I’ll show them to my kids one day!
There are a plethora of other pricing charts I could have grabbed to make your jaw drop, above are just a few. The currency forward swaps above right is a really scary one. The FX market is the most liquid market in the world; I forget the exact number from the last BIS survey, but it’s something like $3 trillion USD a day that gets traded in the FX market. Of all the currencies Euro is by far the most liquid. If you look at the above forward swaps the 1M to 3M Euro swap, both normally extremely liquid tenors, is quoted at almost 10 pips wide. That’s probably around 20X it’s normal spread; and who knows if the price above is even real! Ever since this credit crisis has started dealers have been playing hot potato with forward exposure in the FX markets, they don’t want to sit on the risk like the good old days, they want to get out of it as quickly as possible. The last few days the potato has been just too hot, sometimes there was just no price in the market to be quoted.
Back to the power of rumors and media headlines… On Thursday morning a story hit the feeds about a BNY Mellon fund having exposure to Lehman debt. That’s all it took, "Lehman" and "BNY Mellon" in the same headline sent BNY Mellon stock tumbling in a freefall. This is one of the largest custodians and asset managers in the world. One headline about about one BNY Mellon fund. It turned out that the exposure was associated with a specialized money-market-like fund that formed only a miniscule percentage of BNY’s asset base, and shortly after (as you can see left) BK was back right where it started. A similar chain of events befell State Street (plot below) on the same day shortly after BNY tumbled. I can’t quite recall the exact headline, no doubt something associated with Lehman, Merrill or toxic debt, but in a matter of minutes the largest custodian bank in the world had its value cut in half. When the markets opened on Thursday State Street was worth around $29.35 billion; at 10:00am States Street had had its market capitalization chopped to $12.54 billion; then by the time the markets closed on Thursday and the powers that be had had time to determine a realistic valuation for the company it had regained the majority of its value to close at $25.47 billion. One of these two could have easily been shopping itself around under the protection of bankruptcy this weekend if their stock prices didn’t revert quickly…
Psychotic, irrational, nonsensical, they’re some words that could be used to describe the behavior of the global financial markets over the past week and a half. A lot of people are left wondering if it’s over. On Friday the Fed stepped in to bail out AIG, sending a clear message to the world that the United States government would do everything in its power to prevent a global financial meltdown. The markets took it well, sending every major global financial index soaring along with a massive application of risk placement across strategies like currency carry trades. Greed had overtaken fear once again. But is it really over? Can we get back to ‘normal’ liquidity and reasonable spreads? Personally I’ll still be a little worried until the CDS spreads (below) for behemoths like Morgan Stanley and Goldman Sachs get back down to semi-reasonable 200-300 levels; until then I think a lot of people are still going to be edgy. Another poignant chart is the TED spread pictured below the CDS graph, I don’t need to say much about this one…