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Anniversary of the Lehman collapse! WRONG ANNIVERSARY!

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SEATTLE GRAFFITTI

a blueprint of crisis

INTRODUCTION

This seems to be a moment of reflection, 9/11 will 'until the end' do that for me, at this time of year. But I don't believe that the anniversary of the Lehman collapse is the right anniversary to ruminate on the catastrophe in financial markets. Right time of year maybe, just wrong year! For anyone who has had 'line of sight' on credit markets and the other related markets for as many years as I have, the game was up in September 2007! The anniversary is the boxing gloves between Bear Stearns, Merrill Lynch and Paribas in August 2007. From then on it was a one-way trip, the scariest moment being the concerted action of the central banks on 12th December 2007 and again on Christmas Eve. Mostly the news media was reporting nothing at that time, it was only screen-staring nerds like me who could see what was going on. The Lehman event is only the public 'tip of the iceberg'. It had all gone horribly wrong a year earlier. 

As part of some advisory work at the time I prepared a diary of the cataclysmic events of the period of late summer / fall through to year end of 2007; the events in the global credit markets and markets for bank-equity I mean. This diary is almost daily, it illustrates just how precipitously quickly contagion flows through the banking system globally from credit markets concerned about assets to inter-bank liquidity and ultimate reckoning. 

I am re-posting this here in the hope it may be useful.

 

AUGUST 2007: THE BEGINNING OF THE CREDIT CRUNCH

In June of 2007, the assets of two funds managed by Bear Stearns were seized and sold by a number of lenders to the funds, including Merrill Lynch. These assets of the BS funds were collateralized debt obligations, or CDOs. Many of the CDOs the Bear Stearns funds had were backed by mortgage securities. 

The Bear Stearns events of the summer of 2007 still looked to the global markets as if they were US specific at that time; it was not until the BNP Paribas issue that the problem looked to be global. In August 2007 at the time of the BNP Paribas issue, arguments were made in the media to the effect that panic had occurred because inexperienced assistants were at the helm of the trading desks whilst the experienced managers were at the helms of their yachts! Hedge Funds in Australia and the UK were impacted by the Paribas and Bear fallout and the small German bank IKB was supported by its local state. It still remained possible to believe in the early summer of 2007 that the issue was sub-prime in the US, an idea (a semantic confusion) which the mass media became fixated upon for the remaining period of the crisis.

 Arguably, the CC as a global phenomenon became apparent on 9 August 2007 when BNP Paribas was forced to suspend three of its funds as recent debt market concerns had dried up liquidity to the extent where it had become impossible to calculate the net asset value of the funds. In a move that rocked the European markets, BNP Paribas, blamed a "complete evaporation of liquidity in certain market segments of the US securitisation market" for the decision to temporarily stop redemptions from the three funds. Collapse of demand for some forms of securitised debt made their assets impossible to value, the bank said. Freezing the funds, which invest in asset-backed securities, was the best way to "protect the interests and ensure the equal treatment of our investors". The bank said their combined value was €1.6bn, down from about €2bn on 27 July.

THE ECB EMERGENCY LIQUIDITY INJECTION OF AUGUST 2007

 As Gillian Tett et al reported that day in the FT: "The European Central Bank scrambled to head off a potential financial crisis on Thursday (9 August 2007) by pumping an emergency €94.8bn ($131bn) into the region's banking system after liquidity in the interbank market started to dry up, threatening banks' access to short-term funds.

 The cash injection was the biggest in the ECB's history, exceeding the €69bn provided the day after the terrorist attacks of September 11 2001. The ECB also made an unprecedented one-day pledge to meet 100 per cent of all funding requests from financial institutions." Effectively the ECB 'frontloaded' their supply of credit for the August maintenance period, injecting €94.8 billion, which along with further operations in the following weeks, achieved the aim of returning overnight (LIBOR / EURIBOR) rates to the policy rate. This additional liquidity was then drained from the Euro money market before the maintenance period ended on 5 September, thus ensuring that the average liquidity supply across the month remained unaffected.

ABS AND MBS INDICES SUMMER 2007

The FT (Gillian Tett) reported on a technical mechanic in the ABS markets whereby issuers of asset-backed commercial paper yesterday failed to roll over a large proportion of these notes in the European market - a development, Ms Tett argued that suggests more financial institutions could face a funding squeeze in the coming days.

The ABS and MBS markets are complex with many interlocking parts but this reportage itself was enough of a clue for market participants and experts to understand that a serious challenge had arisen to the wholesale funding aspect of the US and European banking system. In this instance the re-funding of the relatively longer term off balance sheet vehicles holding mortgage and other asset backed securities (such as SIVs) using short term commercial paper by the sponsoring banks had begun to cease; a crisis was inevitable.

The ABX index is an index of the absolute value of structured instruments. It has a parallel and complimentary sister index known as the CDS index or the index of Credit Default Swap prices which represents the price of risk, or quantification of risk appetite. The indices of CDS prices published by the iTraxx company are the general industry benchmark. As the ABX fell in general the iTraxx indices or notional CDS index would rise.

RE-VALUING STRUCTURED PRODUCTS

On 24 August, the FT (Gillian Tett) speculated that the process of unwinding complex off balances sheet structured instruments might be beginning because sentiment had turned against them as a result of no one really understanding the risk in the vehicles. This would begin her critique of this activity which she would later describe as 'shadow banking' by a plethora of opaque institutions and vehicles which have sprung up in American and European markets this decade. As usual Ms Tett was bang on the money. During the US Senate Banking Committee hearings in April 2008 into the Bear Stearns rescue, the term "Shadow Banking" was commonly used to describe Structured Investment Vehicles generally.

The banks were exercising a process of re-valuation of the structured instruments they held, particularly RMBS (residential mortgage backed securities and more complex securities constructed of them). This process is known as "write-down" of the value of the assets on the balance sheet of the bank; each write down encapsulates a loss which crystallizes as a deduction in the value of the bank's capital. Uncertainty about the scale and location of losses led to concerns about the adequacy of bank capital and hence the key measure of risk in the banking system - the spread of LIBOR and EURIBOR over the comparable index swap rate - was rising precipitously. Not just the market in structured instruments was seizing up; the markets and consequent pricing of all assets across the liquidity spectrum were seizing up.

FURTHER ECB EMERGENCY LIQUIDITY AUGUST 2007

On 22 August the ECB provided Euro 40 billion in a supplementary longer-term refinancing operation aimed at supporting the normalization of the functioning of the euro money market. The concern was really the cost of short-term (overnight to 3-month) money rising precipitously, particularly in relation to the spreads of international three-month interbank rates to three-month expected policy rates, i.e. three-month Euribor / Libor spreads over comparable overnight index swap rates. That spread reflecting the risk profile of the banking system as perceived by itself, was rising past 110 basis points in sterling and towards 100 bps in euros. The Bank of England did not intervene at this point

RE-PATRIATING OBSI

On 23 August the FT reported that HBOS plc had taken back on balance sheet one of Europe's biggest off balance sheet vehicles known as Grampian. In the past five years Bank of Scotland and later HBOS have led the way in the UK in the deployment of this type of financial technology to source wholesale funding for its commercial and residential mortgage lending activities, in the main. In that article an analyst was quoted as estimating this action would impact HBOS' core capital by as little 0.4%. The Governor of the Bank of England commented later to the UK Treasury Select Committee (UKTSC) that this was a prudent and appropriate thing for a well capitalized bank to do.

UK HOUSE OF COMMONS COMMITTEE INVESTIGATION

The UK Treasury Select Committee (UKTSC) describes the position the banks in the UK and Europe found in the markets in regard to Structured Investment vehicles generally: the credit re-pricing process was "hindered by the break down in the price discovery process for some classes of complex financial instruments including but not limited to sub-prime mortgages and their derivatives such as CDOs" and that as "the markets for such instruments became illiquid, the price discovery process was further impaired". The report quotes William Mills (Head of Citibank, Western Europe-MEA) describing the situation in August: "What occurred in August and September was the fact that these markets stopped functioning and so there was no visible trading taking place. Typically, investment banks set their prices on their inventory and their positions based on the visibility of other trades that are taking place in the marketplace. Therefore for a period of time roughly two or three weeks, investment and commercial banks had to come up with a different methodology for establishing values on their portfolios and fundamentally had to deconstruct these complex securities, look at the underlying collateral and come up with a valuation"38.

BANK OF ENGLAND EMERGENCY LIQUIDITY SEPTMEBER 2007

Overnight 12 / 13 September the Bank of England injected an emergency 4.4bn sterling and the ECB made EURO 75bn available. The Bank of England (after some heavily reported reluctance, rooted in Moral Hazard concerns) then began making liquidity available to the general UK banking system against a wider range of collateral than normal standards through a sequence of monthly term auctions of 10bn sterling, the first of which took place on 26 September. This was in addition to it its normal operations in short-term money markets aimed at delivering overnight interest rates in line with Bank Rate). These auctions were restricted in overall size and set at a minimum rate of 100 basis points above Bank Rate, to relieve liquidity problems at a price which would encourage firms to adopt more prudent approaches to liquidity management in the future.

THE WRITEDOWNS of 2007

On 30 September 2007, UBS announced it had written down its fixed-income portfolio by SFr4bn ($3.4bn), mainly because of losses on US mortgage-related securities, triggering a third-quarter loss of SFr600m-SFr800m. The FT reported UBS at that point as the biggest casualty so far of the turmoil in the global financial markets.

On 1 October the FT reported Citigroup as having $3.3bn of losses and write-downs in its markets and banking business consisting of $1.4bn of writedowns on leveraged loan commitments, $1bn of net writedowns on mortgage-backed securities, $250m of writedowns on collateralised loan obligations and $600m of other credit trading losses; Citi also announced a 2.6bn rise in credit costs in the consumer arm.. The biggest losses (at Citi) came in the business that accumulated pools of mortgages or mortgage-backed securities (mostly subprime) to bundle them into collateralised debt obligations for sale to investors.

Citigroup would revise these figures on 15 October as follows: mortgage and banking pre-tax writedowns of $1.35bn on funded and unfunded highly leveraged loans; $1.56bn losses from the drop in value of warehoused subprime mortgage-backed securities; and losses of $636m in fixed income credit trading due to market volatility. At that point Citi announced a summary position whereby Credit costs increased $2.98bn in the quarter, driven by an increase in net credit losses of $780m and a charge of $2.24bn to increase loan loss reserves. This resulted in the later widely reported figure of a $5bn (and sometimes 6$bn) writedown at Citigroup. In the City of London at that time the Citigroup figures in particular were undoubtedly a wake up call to experienced practitioners and senior management.

On 3 October, Deutsche Bank said its investment banking unit took €2.2bn of charges relating to leveraged loans, structured credit products and trading.

On the same day Merrill Lynch announced it had dismissed the executive who headed fixed-income trading and the head of structured credit products. Two days later Merrill Lynch said it would take a $5bn writedown in that space. But on 24 October, following the writedown revisions at Citigroup, Merrill seriously spooked the markets by announcing revisions to its own writedowns. It said it had written down $7.9bn because of failed bets on subprime mortgages and the credit markets, pushing it to a much bigger than expected third-quarter loss. The revelation raised by $2.9bn the total amount of write-downs taken on to Merrill's books. Merrill said it had taken the writedowns on CDOs and subprime mortgages in its fixed income business; the bank was a leading originator of CDOs. Merrill said it had cut its exposure to asset-backed securities in CDOs by 53%  to $15.2bn. Subprime mortgage exposure was down by 35% to $5.7bn. Total CDO exposure was written down by $6.8bn in the quarter, while subprime mortgage exposure was written down by $1.1bn.

Prior to the ML writedowns Bank stock prices had responded resiliently if not perversely to writedown announcements. However, the ML announcement got the bank equity analysts scratching their heads an they noted that the riskiest slice of the ABX derivative index, which tracks a basket of subprime mortgage bonds, had fallen about 30% since the end of September when banks closed their books for the third quarter. In the complex market for mortgage-backed bonds, valuations are difficult to come by. The ABX is the only public proxy for the pricing of such debt. It left the index of subprime bonds rated BBB- trading at about 20 cents on the dollar, a record low, down from 28 cents. If that index kept falling, the argument ran, then further writedowns at Merrill (and other institutions) were highly likely. The FT reported that David Ader, strategist at RBS Greenwich Capital (a world recognized expert in these markets) had stated that "We are looking at credit spreads, the ABX and how the financials and insurers are trading and things are not looking good".

Later that month (18th ), J P Morgan reported a smaller hit of $1.3bn while Bank of America wrote down $247m related to leveraged buy-out loans and recorded $607m of trading losses; it also set aside $2.03bn in credit-loss provisions.

CREDIT DERIVATIVES MARKETS NOVEMBER 2007

By 2 November, the mood in credit derivatives markets turned ugly, the cost of insuring corporate debt hitting multi week highs on both sides of the Atlantic. Speculation was rife that leading major investment banks were facing additional losses linked to complex mortgage-backed securities, while worries mounted over the health of major financial guarantors. The credit crunch was spreading like wildfire (contagion) to yet another market or sub-market (known as the monolines). Confidence in Citigroup and Merrill Lynch, as measured by their credit default swaps, slumped to lows not seen since the height of the credit squeeze in August. CDS on MBIA Insurance rocketed to a four-year high, rising 28bp to 380bp, CMA Datavision said. Contracts on the bond insurance unit of Ambac Financial climbed 26bp to a five-year high of 315bp. The iTraxx Crossover index, (of 50 high-yield companies), widened by 18bp to 338bp; the biggest rise since August; according to Deutsche Bank data.

THE 2007 WRITEDOWNS CONTINUE: CITI AND MORGAN STANLEY

On Sunday, 4 November 2007, Chuck Prince, Chairman and Chief Executive of the largest US bank Citigroup, resigned after Citi revealed it was facing losses of an additional $8bn-$11bn on its subprime-related investments. This came on top of the Merrill Lynch announcements and was a revision to Citi's estimates at the beginning of October. In the UK and the US banking and financial services stock prices fell significantly immediately on Monday morning. The UK and US governments attempted to reassure markets and their populace. The FT reported that Citi was writing down the value of the senior tranches of the structured vehicles it held (to the value of $43bn of highly rated (triple A) CDO exposure pre-write down) and that the range of the write down (between $8 and 11bn) reflected the complexity of valuing them in terms of how the default rates of the different securities correlate, a crucial technical aspect of the challenge of the credit crisis which we will analyse later in this paper.

On 7 November, the incoming CFO at Morgan Stanley, Colm Kelleher described a loss of $3.7bn as a consequence of a big bet at the end of last year that subprime securities prices would fall. For some months this looked highly profitable but as subprime prices fell far more than the traders expected, the investment became heavily loss-making, because of a phenomenon known as "negative convexity". Mr. Kelleher commented that the estimated losses implied defaults in the range of 40 to 50% for outstanding mortgages written in 2005 and 2006. Morgan Stanley took a radical approach - its reported $6bn exposure (to mortgage baked structured products) represents the most it could lose if the underlying collateral defaulted and the bank recovered nothing.

FURTHER ECB EMERGENCY LIQUIDITY

On 8 November the ECB announced further liquidity facilities to the interbank market, each of € 60bn - the first operation on 23 November 2007 and the second on 12 December 2007, each of three months term. Market nerves were stretched thin. The key measure of risk in the banking system (the spread of LIBOR and EURIBOR over the comparable index swap rate) remained stubbornly high (the banks were not lending to each other) and the other indicators (ABX and CDX) were not only historically extreme but were also indicating that writedowns were set to continue and indeed, worsen.

MORE GLOBAL WRITEDOWNS

As November progressed, Wachovia wrote down $1.3bn in the third quarter and Bank of America said it faced a $3bn writedown in the fourth quarter. Lloyd Blankfein, Chief Executive of Goldman Sachs, relieved concerns by confirming that the company did not expect to take any significant mortgage-related writedowns in the fourth quarter. HSBC recorded a $3.4bn charge for the three months to end of September against its US consumer finance business. HSBC also announced writedowns in debt trading; the bank set aside $925m against leveraged loans and its credit-trading business, reflecting the values of structured instruments held in the Trading Book as available for sale.

On 13 November the FT reported that International Securities Trading Corporation (ISTC) had become the latest victim of the CC. The specialist Dublin- based lender suspended its shares in the grey market and announced it expected to take a €70m (£49m) writedown related to its portfolio of structured investment vehicle capital notes.

Bear Stearns reported, on 14 November that it had taken $1.2bn in writedowns for the quarter and the shares surged after Sam Molinaro, Chief Financial Officer and Chief Operating Officer, said the latest writedowns should "suffice" in accurately valuing its credit portfolio! He reported that Bear had cut its holding of collateralised debt obligations by more than half since the end of August and the company was "pretty positive" about its investment banking business.

Barclays announced a £1.3bn ($2.6bn) write-off on 15 November - the bank had acted early to spot the subprime difficulties, and hedged its exposure more effectively than some of its rivals. In spite of the writedowns, Barclays Capital's exposure to CDOs is £5bn. Its loan and trading book is valued at £5.4bn, of which £2.6bn is in Equifirst, the US subprime mortgage originator that Barclays bought this year (2007 or 2008?). The bank still has £7.3bn in unsold private equity loans.

Even Swiss Re emerged as a casualty of the subprime crisis when it reported a SFr1.2bn ($1.07bn) loss on two complex credit default swaps. George Quinn, Chief Financial Officer, described the writedown as the result of a "once in every 30 years" credit event. At the end of the month HSBC became the latest bank to reveal the impact when it said that it would take $45bn in mainly complex debt instruments onto its balance sheet (much as HBOS had done at the beginning of this process).

On 7 December Royal Bank of Scotland (RBOS) announced it had set aside £1.5bn as a result of the financial markets meltdown - much less than the market share of itself or recently acquired ABN Amro in structured finance markets would have implied. Three days later Washington Mutual (WAMU) announced it was to write down the value of its home lending unit by $1.6bn in the fourth quarter and raise $2.5bn to shore up its capital by selling convertible preferred stock. On the same day Lloyds TSB said it was taking an £89m writedown in its holdings in CDOs (collaterised debt obligations) and £22m on its SIVs (structured investment vehicle notes). Its Corporate Markets Division also saw profit fall by £90m as a result of mark-to-market adjustments in the bank's trading portfolio. The bank also informed the market that Cancara, its asset-backed commercial paper conduit, continued to fund itself and there had been no default on any asset. Helen Weir (the Finance Director) said the $26bn (£12.8bn) vehicle was regarded in the market as "the Rolls-Royce of conduits".

UBS: SPECIAL INVESTOR UPDATE DECEMBER 2007

Following a "Special Investors Update" on the Friday 6 December, UBS announced on Monday morning 9 December $10bn of losses on top of the $4bn writedown announced in October; the bank had previously announced a planned $11.5bn injection of new capital from two strategic investors. The Financial Times opined that the UBS chairman should fire himself! Perversely the UBS stock price performed positively in response (as it was to do again in the market-shocking April fool of 2008) on the basis that the writedown was fully discounted and the dilutive capital injections had been achieved!

On the following day in London Marcel Ospel, chairman of UBS, admitted the Swiss bank's Risk and Finance Unit had failed to understand the subprime mortgage positions that led to its $10bn (€7bn) writedown, even though it was aware of the massive figures involved. Mr Ospel described the risk management process at UBS in regard to structured instruments: The loss making positions "were established by a small number of people operating in one team", Mr Ospel said, adding they were "created in the interest of clients but were held in pursuit of proprietary trading." He added: "The people concerned and their supervisors failed to recognise properly the size and changing nature of the positions that were being established. Risk control and finance had the numbers but failed to realise in time what they truly meant." UBS additionally added that it had revised key input parameters of the models that are used to estimate lifetime default and resulting losses for sub-prime mortgage pools and that this delta had resulted in the 10 billion number.

Two days later Bank of America's Chief Executive warned that fourth quarter results would be "disappointing" and said the bank would set aside $3.3bn to cover losses and writedowns.

SERIOUS STERLING LIBOR PROBLEMS WINTER 2007

Three-month sterling Libor moved to 48 basis points above the expected level of UK base rates in three months' time,  its highest level since the day after the Federal Reserve cut its target Fed funds rate 50 basis points in the previous September (i.e. the interbank markets were destroying policy objectives). Overnight dollar Libor rose 18bp to 4.955% from 4.774%, while three-month swaps comparing Libor and expected Fed funds remained sharply elevated.

A comment article in the FT explained LIBOR in layman's terms:

"Libor is the banking industry's blood pressure reading. The prospect of this bout of hypertension sparking a stroke or a heart attack for the broader economy is now a real fear among senior Fed policymakers. The two-year US interest rate swap spread, another barometer of stress, hit its widest level since June 2000. On November 26th responding to severe pressure on the cost of short-term lending, the New York Fed said it planned to conduct a series of term repurchase agreements extending into the new year, beginning with an $8bn injection in that last week of November. On the 4th of December, the one-month sterling Libor rate was set at 6.715 per cent up more than 62 basis points in less than a week and the highest level for nine years, reflecting year-end demand for cash and mirroring sharp spikes in the euro and dollar one-month rates in the previous week. The FT quoted Joachim Fels, chief global fixed-income economist at Morgan Stanley, warning that there might be more behind the funding pressures in interbank markets than mere seasonal factors. "The fundamental issue is that banks' balance sheets are under severe stress, due to writedowns on subprime assets and due to the 'repatriation' of off-balance-sheet assets with dubious value." The manic depression between the Bank equity market and the interbank market is manifest by the contrast in the characterizations of markets after the UBS writedown. "This not only makes banks scramble for liquidity and unwilling to lend to counterparties, but also it makes them less willing and able to extend fresh credit to households and companies,".

Wall Street stocks suffered heavy falls on 11 December 2007 after a quarter-point rate cut from the Federal Reserve failed to satisfy anxious traders. Shares had traded modestly higher early in the session but plummeted after the Federal Open Market Committee cut the funds rate and discount rate by just 25 basis points. Many analysts had expected a 50bp cut, particularly on the discount rate, to help alleviate severe liquidity problems in the banking sector and offset the worst effects of the credit squeeze. "Financials are disappointed that the discount window penalty remains intact" Stuart Schweitzer, global market strategist at JPMorgan Asset Management, said.

THE CONCERTED CENTRAL BANK ACTION of 12 DECEMBER

On the 12 December the Bank of England announced (in concert with Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank) measures designed to address elevated pressures in short-term funding markets. The Bank of England announced that the total amount of reserves offered at the 3-month maturity would be expanded and the range of collateral accepted for funds advanced at this maturity would be widened. The total sizes of reserves offered, in the operations on 18 December and on 15 January, were raised from £2.85 billion to £11.35 billion, of which £10bn would be offered at the 3-month maturity.

In parallel the ECB announced an extremely innovative swap arrangement with the US Federal Reserve, which will be teased out by future students of Monetary Economics. Under the arrangement the ECB would manage two US dollar liquidity-providing operations, in connection with the Fed's US dollar Term Auction Facility, against ECB-eligible collateral for a maturity of 28 and 35 days. The US dollars will be provided by the Federal Reserve to the ECB, up to $20 billion, by means of a temporary reciprocal currency arrangement (swap line).

FURTHER WRITEDOWNS DECEMBER 2007

Lehman Brothers reported its 4th quarter on 13 December. Lehman's "Hedging Skills" and "disciplined approach" to risk management techniques were credited by the FT with being behind a hit, after hedging, of just $1.5bn, the implication being that without the hedging strategy Lehman may have written down a lot more.

On the same day HBOS brushed off concerns about the credit squeeze as it wrote down £180m on its investments because of the market turmoil. HBOS announced that its exposure to US subprime investments fell to £430m from £550m in August and that full-year profits would be hit by £180m because of writedowns on floating rate notes and asset-backed securities that are not related to US subprime. It also expected to make a fair value adjustment of about £340m on other investments that did not have exposure to US subprime.

Similarly Goldman Sachs did not report any writedowns but did warn that intensification of crisis conditions during November and December entailed it was unlikely to be able to produce continuing remarkable performance.

However, on 18 December Morgan Stanley announced further, higher-than-expected, write-downs in its 4th quarter reporting period - $9.4bn (£4.7bn), due largely to subprime related losses. The losses were largely related to one proprietary trading bet against subprime which went disastrously wrong. According to Colm Kelleher, Chief Financial Officer, there was a definable chain of command and people had been held accountable. "This was an isolated event", he said. "The losses were largely related to one proprietary trading bet against subprime which went disastrously wrong". The FT reported the inside track on what had happened: "A dozen or so traders laid on a position to offset the cost of shorting subprime. Had things worked out, the short could have netted the bank at most about $2bn. Instead, it cost the bank more than $7bn, as the traders' correct hunch was overwhelmed by a deteriorating long position in top-rated collateralised debt obligation securities." The FT reported that this represented a failing of risk management, specifically in stress testing: "Taking historical losses, even record ones, and magnifying them does not capture the once-in-a-lifetime crisis. Of course, Morgan Stanley was in good company. The reason it took such a big long position (about $14bn) to defray the costs of shorting was precisely the market's view that such securities were so low-risk.

On 19 December Bear Stearns reported a quarterly loss, the first in its 84 years as a public company - that was nearly four times analysts' forecasts. Bear surprised investors with a $1.9bn writedown on its holdings of mortgage assets in its fourth-quarter results, a far larger decline than it forecast only a month ago. More, as we know, was to come! Two days later, Crédit Agricole reported a writedown of €2.5bn ($3.6bn), pre-tax, as a result of deteriorating market conditions.

CAPITAL RAISING; CITI, UBS, MORGAN STANLEY.

On 26 November 2007, Citigroup announced that it had sourced a significant capital injection in an attempt to shore up its overstretched balance sheet -  $7.5bn in new capital at an 11 per cent coupon from the Abu Dhabi Investment. Citi stated that the high cost of the new funds highlighted Citi's determination to meet its commitment to strengthen its balance sheet without cutting its dividend. As if to confirm it was still there, bankers looked at the Citi tower in Canary Wharf with raised eyebrows and fallen jaws!

On 9 December "a matter of working days" later, UBS introduced measures to substantially strengthen its capital position, adding CHF 19.4 billion of BIS Tier 1 capital. This included an issue of CHF 13 billion of new capital which has been placed with two strategic investors: CHF 11 billion with Government of Singapore Investment Corporation (GIC), and CHF 2 billion with an undisclosed strategic investor in the Middle East.

These measures attracted serious attention from the commentatori as the Private Equity industry had become the media bete noir before the credit crunch and the Hedge Funds had been singled out as the potential locus of the CC before the events of the second half of 2007. The media now turned on the Sovereign Wealth Funds (of which investors in Citi, UBS and Morgan Stanley were examples) as potentially geopolitically destabilizing by investing in the major investment banks.

Morgan Stanley became the third top investment bank in a month to raise capital from a sovereign wealth fund after announcing higher-than-expected writedowns of $9.4bn (£4.7bn), due largely to subprime related losses. John Mack, Chairman and Chief Executive, said that the $5bn capital injection from China Investment Corporation would bolster its already strong balance sheet and strengthen its deep ties in China. Morgan Stanley said it did not foresee any political or regulatory concerns about the investment. The deal underlines the growing importance of sovereign wealth funds in the Middle East and Asia, and their increasingly bold moves to take advantage of the need for capital among western financial institutions.

HELMETMERRIL LYNCH: THE CHRISTMAS EVE RESCUE BY TEMASEK

On Christmas Eve 2007, Merrill Lynch closed out this extraordinary year with an announcement that it had enhanced its capital position by reaching agreements to raise up to $6.2 billion of newly issued common stock in a private placement with Temasek Holdings and Davis Selected Advisors. This was to meet the CEO John Thain's priority objective of strengthening the firm's balance sheet and "bolstering" the firm's capital position.

The press release goes on to describe the deal as entailing that Temasek Holdings would invest $4.4 billion in Merrill Lynch common stock and had the option to purchase an additional $600 million of Merrill Lynch common stock by March 28, 2008 whereas Davis Selected Advisors (DSA) will be making a long-term investment of $1.2 billion in common equity.

A later article in the FT indicated that DSA was actually representing the KIA (Kuwait Investment Authority), arguably the original Sovereign Wealth Fund which first came to attention in the 1970s with its well timed investments in British Petroleum plc.

Temasek Holdings is described by Merrill Lynch as an Asian investment firm headquartered in Singapore. Its portfolio spans various industries including telecommunications and media; financial services; real estate; transportation and logistics; energy and resources; infrastructure; engineering and technology; as well as bioscience and healthcare. As at end March 2007, the net value of its portfolio is more than U.S. $100 billion, concentrated principally in Singapore, Asia and the OECD economies.

WHAT BEAR STEARNS DID NOT DO - RAISE CAPITAL!

Timing is everything in markets, get that wrong and it doesn't really matter how sound your analysis and evaluation of an investment proposal is. Buy at the bottom, sell at the top. The question is when. It is knowing when to buy or sell, issue equity or not which is key to risk management post the credit crunch.

A holistic view by the board of the bank of the trend positions in BOTH capital and liquidity as shall be argued later in this paper, is the key to competent governance and sound management of a financial institution. An important article in the FT reviewing the Senate Banking Committee (SBC) testimony at the hearing into Bear Stearns on 3 April 2008 points out that when Citi, UBS, Morgan Stanley and Merrill Lynch were raising capital, Bear Stearns' big mistake was not to do so. At the SBC, the CEO of Bear Stearns (BSC) testified that when looked at individually the capital position and the liquidity position of Bear were within regulatory limits and appeared strong. Alan Schwartz (who he?!) testified that the firm was adequately capitalized and had a substantial liquidity position.

However according to William Cohan writing in the FT the crucial mistake made by Bear Stearns is that the Bear missed the opportunity to raise capital as its peers had done in the midwinter of 2007 / 2008

 

"Bear Stearns should have raised more equity capital when it had the chance. This could have happened at any number of moments in the past nine months: if not after its two hedge funds failed last summer, then following the firm's announcement of the first quarterly loss in its history after taking a $1.9bn writedown to reflect the deteriorating value of its inventory of mortgage securities in the three months to November 2007. Given the firm's $12bn equity base, a writedown of that size was certainly material.

Not only was nearly every other firm on Wall Street with mortgage troubles raising billions of dollars of capital then - among them Citigroup, Merrill Lynch, Morgan Stanley and UBS - but the mere perception of trouble at Bear Stearns (and many customers were extremely concerned) should have been reason enough for the firm to shore up its equity base. But Bear did not, despite having had many offers of capital from hedge funds, private equity firms and sovereign wealth funds."

 


 

Europe's shares hit by BNP Paribas shock, By Neil Dennis, FT.com site.

Financial Tines, August 9th 2007

ECB injects €95bn to help markets, By Gillian Tett in London, Richard Milne in Frankfurt and Krishna Guha in Washington; Published: August 9 2007 12:59

Funding squeeze likely after refinance failure, By Gillian Tett, Published: August 21 2007 03:00

Let's rebuild confidence by ripping apart the confusion, By Gillian Tett, Published: August 24 2007

Out of the shadows: How banking's secret system broke down, By Gillian Tett and Paul J Davies, FT.com site, Published: Dec 16, 2007.

House of Commons, Treasury Committee, Financial Stability and Transparency, Sixth Report of Session 2007-08 Report, together with formal minutes (UKTSC).

http://blogs.ft.com/wolfforum/2007/09/beware-the-mora.html/

Bank of England, Financial Stability Report, October 2007 Issue No. 22

UBS becomes biggest victim of credit turmoil, By Peter Thal Larsen in London and David Wighton in New York, FT.com site, Published: Sep 30, 2007

Citigroup counts cost of subprime performance, By David Wighton in New York, FT.com site, Published: Oct 01, 2007

Citigroup slides amid credit squeeze, By Daniel Pimlott in New York, FT.com site: Oct 15, 2007

Merrill falls to loss on $7.9bn writedown, By Daniel Pimlott, FT.com site, Oct 24, 2007.

MARKETS & INVESTING: Mortgage bond index declines 30%, By Michael Mackenzie in New York,  Financial Times, Published: Oct 26, 2007

Subprime anxiety hits top index, By Ben White and Michael Mackenzie in New York, FT.com site

Published: Oct 25, 2007

CREDIT MARKET TURMOIL: CDS traders warn of 'blood on streets', By Stacy-Marie Ishmael in New York, Financial Times, Published: Nov 02, 2007

Citigroup write-down, FT.com site, Published: Nov 05, 2007 

Morgan Stanley loses $3.7bn,  David Wighton in New York, Financial Times, Published: Nov 08, 07

http://www.ecb.int/press/html/index.en.html

ISTC bemoans credit squeeze, By John Murray Brown, Financial Times, Published: Nov 13, 2007

UBS chairman Ospel should fire himself, By Paul Betts, FT.com site, Published: Dec 10, 2007

Ospel admits to errors at UBS, By Chris Hughes in London and Haig Simonian in Zurich, FT.com site, Published: Dec 11, 2007

Wall St plummets after Fed rate cut By Anora Mahmudova and Chris Bryant in New York, FT.com site, Published: Dec 11, 2007

http://www.bankofengland.co.uk/publications/news/2007/158.htm

http://www.ecb.int/press/pr/date/2007/html/pr071212.en.html

Lehman Brothers kicks off earnings, FT.com site, Published: Dec 13, 2007

Morgan Stanley's shocker, FT.com site, Published: Dec 19, 2007

Citigroup raises $7.5bn in Abu Dhabi, By David Wighton, Financial Times: Nov 27, 2007

UBS strengthens capital base and adjusts valuations, Zurich / Basel, December 10, 2007, 07:00 AM,

http://www.ubs.com/1/e/media_overview/media_switzerland/releases?newsId=133686

House of Commons, Treasury Committee, Private equity, Report, together with formal minutes, Ordered by The House of Commons, 24 July 2007

http://www.publications.parliament.uk/pa/cm200607/cmselect/cmtreasy/567/567.pdf

Sovereign wealth funds: Yesterday's bad guys ride to the rescue, By John Willman, UK Business Editor, FT.com site, Published: Jan 21, 2008

Morgan Stanley taps China for $5bn By David Wighton, FT.com site, Published: Dec 19, 2007

Merrill Lynch Enhances Its Capital Position by Raising Up to $6.2 Billion From Investors, Temasek Holdings and Davis Selected Advisors, NEW YORK, December 24, 2007

http://www.ml.com/index.asp?id=7695_7696_8149_74412_86378_87784

Fresh talks on Merrill-TPG ties By Henny Sender in New York Published: April 25 2008 03:00 | Last updated: April 25 2008 03:00

http://www.ft.com/cms/s/0/b838195e-1260-11dd-9b49-0000779fd2ac.html

Turmoil in U.S. Credit Markets: Examining the Recent Actions of Federal Financial Regulators 

Date: 4/3/08, Time: 10:00 AM, US Senate Banking Committee

http://banking.senate.gov/public/index.cfm?Fuseaction=Hearings.Detail&HearingID=ec013d8f-fe1e-4fb6-a514-ab93be32ad38

The capital blunders that led to Bear's demise, By William Cohan, The Financial Times, Published: Apr 08, 2008; http://us.ft.com/ftgateway/superpage.ft?news_id=fto040820081312307761

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