Bear Stearns Threatened One-Thread Unraveling the Banking System…Now Facing Multiple-Threads Unraveling the Banking System

Pulling the Bear Stearns thread in March threatened a broad unraveling of the banking system via failed counterparty commitments in spot, futures and derivatives markets that surely would have created chaos in capital markets and sinking asset prices (higher gold price). The Fed moved swiftly to cauterize the risk Bear presented to the banking system, and no doubt not without mistakes. But on balance the run was averted. Pulling the Bear Stearns thread in March threatened a broad unraveling of the banking system via failed counterparty commitments in spot, futures and derivatives markets that surely would have created chaos in capital markets and sinking asset prices (higher gold price). The Fed moved swiftly to cauterize the risk Bear presented to the banking system, and no doubt not without mistakes. But on balance the run was averted.

The question I have is whether this is a permanent fix to the bank run risk or are we facing ongoing systemic risks that will require much greater support from central banks and governments across the globe. I think this is the same question that many in Washington, DC hope to answer starting with Friday’s G7 meeting and continuing into next week at the IMF and World Bank meetings.

And the more I look around the more there is evidence of many (smaller than Bear) loose threads in the capital markets that are being pulled and together could see a broad unraveling of the financial system.

To begin with banks are at most a little over half way through writing down bad assets. They need more capital and it is not clear where this will come from outside of dividend cuts and asset sales…I have questions about Sovereign Wealth Funds stepping up to the plate to buy preferred shares in financials given the haircuts from the Q4/Q1 investments. And I have yet to read of any takers in size at the UBS $15bln-recapitalization road show currently underway. We all know where the hits to bank capital will come from ahead in light of the US recession (and this grows the longer and deeper the recession)…illiquid leveraged bank loans and ABS in commercial mortgages, auto loans, credit card, leases, student loans and home equity lines of credit. And there are still more write downs ahead in the residential space with home prices falling and foreclosures rising amidst large ARM resets (Fed has helped here by taking funds down to 3%, but little relief is offered in fixed mortgage rates despite Fed easing).

Okay this is all known and all we need to do is wait for the banks to mark-to-market as remittance data come in and models spit out values and allow Goldman economists to generate $1.2trln in write downs when all is said and done while Credit Suisse says $650bln in write downs. But what isn’t priced?

Well General Electric today is a warning that the web of credit losses spreads throughout the capital markets. Regional banks, school districts, Jefferson County in Alabama (with large counterparty credit derivative exposure with major Wall Street names), IKB/KFW in Germany, FHLB of Chicago, regional discount US airlines folding like lawn chairs (some of which is not fuel-related), WAMU is on life support, frozen auction-rate securities market, Marblehead Finance-TERA nightmare, Fannie and Freddie are free to add mortgages and above and beyond conforming limits (methadone treatment), corporations are running up revolving lines of credit bloating money supply data in US and Europe and…out of breath and this is one time I am comfortable using etcetera.

The capital markets are handicapped and in a world without handicapped parking and handicapped entrances. How on earth can asset prices rally in sustained fashion, the dollar recover and the economy rebound with a severely strained capital market that is now showing up at consumers’ front door, the local school district, 401K, state budgets and now GE (asset sales failed as buyer could not get financing).

Sure there are some signs of progress – Citi sold some $12bln in leveraged loans (heard everything from $0.65-0.80 cents on the dollar), distressed funds are taking up more munis and mortgage-backed securities, and the Fed has underwritten large bank solvency.

That said the very fact that the Fed, as Greg Ip reported this week, is looking at ways to expand its balance sheet from $800bln currently tells me that the Fed needs to widen the safety net as it is not confident that the run risk is over. Indeed the Fed is asking Congress to approve Treasury debt financing above and beyond budget needs to bring new money to the Fed’s balance sheet. Keep in mind Bear Stearns “cost” the Fed $29bln. If it were to happen again what would it “cost” the Fed? Volcker said this week that the Fed is on the edge of legality in its recent solvency operations…suggesting where is the government in this crisis? Bush admin seems to be saying it is our financial system and your problem the Federal Reserve System – maybe the Fed asking for funds from Treasury debt financing is Fed’s way of pushing back and saying it is your problem too.

And it is increasingly clear that this is not purely a US problem…the banking crisis in Iceland is unfolding – massive deleveraging ahead for this sector if not insolvency. And Spain’s banks remain very much exposed to a declining real estate market (bubble) and many of the same securitization problems that arose in the US derivatives market. Ireland and UK property market bubbles bear watching and look vulnerable to a bursting ahead with the consequent problems for the domestic financial systems.

And few are talking about the risks in the financial system to the Credit Default Swaps (CDS) market. As of June 2007 the BIS put the OTC CDS market at a notional value of $42.58trln dollars with a gross market value of $721bln. This is a house of cards waiting to collapse if corporate default rates rise – well a glance at low cost US air carriers bankruptcies this week and rising bankruptcies in the US retail space (Bed and Linens today) as the US recession unfolds suggests this market will be tested every bit as much as the mortgage-backed derivatives market was starting last summer.

I am not calling the end of capitalism and free markets. I am saying that the drivel that passes as news at most major media outlets (reflecting the average “professional” view) is a fantasy. The only light in the tunnel is from looking back at the entrance of the tunnel that markets entered last summer.

In time the dog, credit markets, will wag the tail, equity markets, and violently.

David Gilmore

Foreign Exchange Analytics has it's roots in both the emerging information technologies and the global economy that characterized the last two decades.  As currency transaction volumes soared in the wake of the 1985 Plaza accord, the need for timely concise information on what forces were driving and would drive exchange rates became critical.   David Gilmore was one of a new breed of analyst that saw a void of relevant, market moving... More