Sunday, September 21, 2008
HOW THE MIGHTY HAVE FALLEN
By: Gabriel Mendez
September 19, 2008
The Empire State Building, Trump Towers and Wall Street all symbols of the great American Dream. The difference being that the once mighty Wall Street has turned into the Boulevard of Broken Dreams. From the Lehman Brothers (now in bankruptcy) to Merrill Lynch (buyout of the company by Bank of America) and American International Group (AIG), the consequences of years of bad decision making have been quick and brutal. As investment firms stumble, markets spin, and investors shake, the questions are: Where and when will the pain end?
Over the past five days, AIG, the world’s largest insurance company, after exhausting every other option edged on the brink of bankruptcy.
At the center of it all, sits the U.S. housing market. Home prices continue to fall, reducing the values of mortgage-backed securities, (The reader will recall that many homes in the U.S. were over valued and home owners were able to borrow more money using their homes as collateral during the explosion in the housing market. This became known at the “sub-prime fiasco”).
As the housing crisis continues to spread throughout the U.S. economy, new problems for financial firms are appearing on the horizon.
In a move, not seen before, the Federal Reserve's incredible $85 billion loan, some might say bailout, of AIG prevented a full-out world panic that likely would have unfolded with the collapse of the world’s largest insurer. But AIG's sudden bounce towards bankruptcy shows how dangerously the U.S. financial system has become mixed together.
For years the mixing together of financial firm’s business covered up the large underlying risks, but now it's magnifying them. As each new thread from the crazy web has unwound during this 13-month credit crisis, a fresh problem has come front and centre. How bad things will get from here depends on how cleanly the losing firms and bad investments can be untwisted from the good ones. With each passing day the task seems to grow more difficult. By the end of the credit bust, the total losses, now $500 billion, could reach $2 trillion, according to hedge fund Bridgewater Associates.
Merrill Lynch's ties to AIG show just how difficult it might be to untangle these inter-mixed relationships inside of the U.S. financial system. During the mortgage explosion, Merrill loaned out billions of dollars worth of mortgage backed loans. To cut down its own risk, Merrill bought insurance contracts from AIG called credit default swaps, which pay off if the mortgages, blow up. Merrill holds $5 billion worth of guarantees from AIG alone.
When AIG hit the skids, it couldn't be counted on to make good on those contracts. If the insurer had remained in trouble, Merrill and others would have faced another round of losses. Given that possibility, people in the know are saying it's no wonder the Federal Reserve stepped in.
The hugh credit-default-swap market became so complicated that in some cases firms lost track of their investments. AIG, for example, begged for more money from several private money lending firms over the September 13-14 weekend. After looking over AIG's financials however, the lending firms refused any deals, concluding that even AIG management didn't know where all the “skeletons” were buried, according to a person familiar with the situation. AIG disclosed in February that auditors had found "weakness" in its systems for placing a value on its credit default swaps. In its quarterly report on August 7, the company said it was still trying to put in place a reliable system of valuing properties.
The unwinding of Lehman, one of the world's biggest bond players, won't be easy. When the firm filed for bankruptcy on Sept. 15, pain quickly spread across the financial system.
As the credit crunch plays out, one thing is certain: Wall Street will never be the same. Its new catch phrase is "de-risking," or cutting back on lending or socking away large amounts of cash.
The landscape is changing as the balance of power shifts away from Wall Street's famous avenues to other parts of the country and the world.
Non traditional firms will horn in on businesses once dominated by the Lehmans of the world. Private lending firms, hedge funds, and even sovereign (government) wealth funds from the Middle east will expand further into traditional investment banking functions such as lending to early-stage businesses.
For years Wall Street has sat at everyone’s table enjoying a free lunch. The lesson of this tale is that the tables can be turned.