Apres Moi le Deluge?

Who will stand behind these various securities?

Originally published in the April 2008 issue

Over a 36 hour period starting at six o'clock on the morning of Friday 14th March I was invited twice to appear on television, and asked to write no less than five articles for different publications. As readers will be well aware, this had nothing to do with me having suddenly developed a winning nature and film star good looks (I had these already, of course) but with the fate of Bear Stearns following rapidly upon the sudden demise of Carlyle Capital Corporation. One quote of mine which Matt Sansom of BBC World seized upon was "this could be the beginning of a deluge". What did I mean by that, and what prompted the remark?

Many newspapers have made much of the fact that CCC had a highly leveraged portfolio; a net asset value in excess of $20 billion was supported by equity of less than $1 billion, but this should not have mattered. The nature of the assets in which CCC had invested was radically different from those which had hitherto caused trouble in the hedge fund space, namely sub-prime mortgage debt securities. Yes, CCC held mortgage debt, but with AAA rating and much of it backed by an implicit US government guarantee. Until a few days before the 14th these had been accepted as very safe, low risk assets; there was certainly no thought that banks might refuse to accept them as security, nor that either they or the markets would begin to believe that they could be worth significantly less than their face value.

What happened in practice as the story unfolded over the Thursday and Friday was that the banks appeared to be saying precisely this. Why else would they demand cash calls from Carlyle against these assets? Why else would they apparently be unable to reassure Carlyle that further substantial cash calls would not be required? Most worrying of all was a suggestion in the press emanating from Carlyle that their lending bankers were unable even to agree amongst themselves on what the proper value of these assets actually was.

All of which has some very serious implications for the global financial system generally. If banks are unable any longer to accept AAA mortgage bonds as safe assets at their face value, even given the ultimate backing of the US government, then the system which the Federal Reserve painstakingly rebuilt after the savings and loans crisis at a cost of $150 billion (possibly as much as $400 billion at today's values) through their use of the Resolution Trustco and their continued backing of the GSE's (Government Sponsored Enterprises) such as Fannie Mae and Freddie Mac, lies in tatters. It was widely believed until the banks foreclosed on CCC that the implicit government guarantee which stands behind the likes of Fannie Mae and Freddie Mac would ensure the absolute acceptability of their bonds by the financial community. If this is no longer the case, then one of the major pillars which underpin the world's financial system has been kicked away.

If it is no longer the case, then logically banks must start to write down not just their holdings of sub-prime debt, but also their institutional grade counterparts. If it is no longer the case, then this must imply that bankers doubt that the US government would actually stand behind these various securities if push came to shove.

If it is no longer the case, then what about the securities issued by Sallie Mae (the student loan provider)? Sallie Mae was allowed to give up its state sponsorship in 1995 and become fully private. If Fannie Mae bonds are no longer acceptable then inevitably Sallie Mae bonds must be even less so.

An investor group led by J.C. Flowers tried to take control of Sallie Mae in a private equity transaction early in 2007, finally walking away from the deal as the first hints of the credit crunch started to surface. In December, after an analysts' conference, Sallie Mae's stock price fell over 20% in one day. The following month Sallie Mae needed funding support of over $30 billion from a consortium of banks. How much more funding might they require if the world's institutions start downgrading their bonds? Yet the markets do not seem to be factoring the possibility of Sallie Mae going the way of Bear Stearns into their analysis. Why not?

Of course the Fed is not going to stand idly by and watch the US banking system implode. The day before the collapse of CCC they announced a liquidity injection of $200 billion. On the day that Bear Stearns ran up the white flag they backed a lifeboat from J.P. Morgan and then organised the takeover of the bank over the weekend in time for the opening of the Tokyo markets. Nobody could accuse them of inaction. However, it is arguable that their intervention, though well-meaning, might actually have made a bad situation worse.

The idea behind the $200 billion liquidity injection was that banks would be able to exchange high grade mortgage debt for federal securities: presumably T Bills. Thus CCC's lending banks were faced with two choices. Either they could show faith in the world's financial systems and the implicit government guarantee that stood behind GSE securities and ride out the situation, or they could foreclose and make sure they would be first in the queue for T Bills. Given what we now know of Bear Stearn's desperate financial position on that day, it is hardly surprising that they chose the latter.

What of the future? What of those hedge funds around the world who must be sitting on Sallie Mae securities? If Carlyle's bankers were not prepared to accept GSE bonds as good security then they would have been even less prepared to accept Sallie Mae paper. So, hedge funds would be faced with the choice of trying to sell them now, presumably at a loss into a nervousmarket, or take the risk of having to throw them into the market anyway at an even greater loss when their prime broker phones up with a cash call. This does not even begin to consider the possibility of hedge funds all over the world throwing Sallie Mae paper into the market at the same time. Nor have we considered the scenario of Sallie Mae having to go back to the banks some time during the next few weeks for a further, say $30 billion. In the wake of the collapse of Bear Stearns, how likely is it they would receive a sympathetic hearing?

These comments should be viewed as idle musings, not predictions, but it does show just what alarming possible conclusions can be reached from the present starting point. The real problem seems to me to be not just that the banks have stopped lending to their customers, though this is bad enough (witness CCC), but that they have stopped lending to each other. This was a direct cause of the collapse of Northern Rock and seems to have played a similar role in the demise of Bear Stearns. If central banks around the world really want to alleviate the current situation (and it must be an open question whether the ECB, which still seems more concerned with inflation than recession, really does) then they need to find some way of kick-starting the inter-bank lending market.

Unless and until they do this, then liquidity injections can only slow the momentum of what is happening, not reverse it. Right now this has the feeling of watching a car crash in slow motion

Guy Fraser-Sampson is the author of Multi Asset Class Investment Strategy, which argues for greatly increased allocations to hedge funds by European institutional investors.