Financial Turmoil

The recent turmoil in American financial markets shows that our year-old financial crisis is not yet close to ending. Government bailouts, bank failures, and volatile market movement are all emblematic of the financial sector’s continued struggles. In this article I will discuss the Federal government’s unprecedented bailouts of Fannie Mae, Freddie Mac and AIG. I will also cover Lehman Brothers’ bankruptcy, Washington Mutual’s precarious position, and where future problems may emerge.

Fannie Mae and Freddie Mac

To understand the importance of the Fannie/Freddie bailout, one has to understand the design and importance of these institutions to both the domestic housing market and the international financial community. Both companies are mortgage lenders, but neither company makes loans directly. Instead, Fannie and Freddie take loans created by banks and mortgage companies and bundle them together. They then sell these mortgage-backed securities to investors. In theory, these securities should be relatively safe since they are backed by collateral (the mortgage property itself.) Because of this safety, Fannie and Freddie have traditionally kept small amounts of capital on hand relative to the size of their portfolios.

The decline in home values since 2006 has rendered this level of capitalization too small. As foreclosures increase and home prices decrease, the collateral behind the securities has become less valuable and more risky. This increase in risk relative to the capital reserves of the company forced stock prices lower and, more importantly, attracted fewer buyers for the companies’ packaged mortgages. In July, Treasury Secretary Henry Paulson received Congressional approval to spend as much money as necessary to prevent the companies from failing. Eventually, the Treasury agreed to backstop the companies for $100 billion each in exchange for an ownership stake in each entity.

Why are Fannie Mae and Freddie Mac so important? There are two main reasons. First, had both companies failed, the housing market would have completely dissolved, likely inviting large-scale financial collapse. Since both companies are instrumental in the sale of mortgage-backed securities, the supply of money available for lending depends directly on their ability to provide liquidity. With the new backstop in place, investors are more willing to buy these securities from Fannie and Freddie. Willing buyers mean that Fannie and Freddie can continue to purchase mortgages and help stabilize the market. Without this liquidity, interest rates would have continued to rise and the crisis would have been exacerbated further.

The second reason for the importance of the Fannie/Freddie bailout involves the huge sums of bonds and mortgage-backed securities the firms have sold. Fannie and Freddie have sold over $5.3 trillion in securities to investors and governments around the world. If Fannie and Freddie were to fail, the loss of value suffered by these securities could cause drastic increases in interest rates for all U.S. debt. The reason for this chain-reaction stems from the growth of Fannie Mae and Freddie Mac as hybrid public companies, accountable to shareholders but implicitly guaranteed by the U.S. government. The importance of this unofficial guarantee cannot be overstated. Because of their status, Fannie and Freddie were able to sell their mortgage-backed securities to foreign governments with the assumption that the debt was backed by the full faith and credit of the U.S. government.

Foreign governments which have large surpluses of trade with the U.S. will try to purchase interest-earning securities denominated in dollars. The most common products are Treasuries, which are fully backed by the US government. However, mortgage-backed securities offered by Fannie and Freddie presented higher interest rates with the same implicit backing. This explains their popularity along with their importance. Given the preponderance of U.S. debt held by foreign nations, the Federal government cannot afford to let Fannie and Freddie default on their obligations. Such a failure would threaten the perception of the security of Treasuries and other important debt obligations. This helps to explain the Treasury Department’s willingness to use taxpayer money in a bailout of public companies: The stability of the Treasury market and the overall perception of U.S. debt were at stake.

Bailout of AIG

The Federal Reserve used a similar “public good” argument in its explanation for the $85 billion bailout of insurance giant AIG. Beleaguered by exposure to credit-default swaps, AIG hoped to find funding from a major investment bank to shore-up its capital reserve levels. When AIG couldn’t raise the money and its stock price crumbled, the Federal Reserve stepped in with access to $85 billion in capital in return for an 11.4% interest rate and a 79.9% ownership stake in the company.

The goal of this bailout is different from that of Fannie Mae and Freddie Mac. The Federal Reserve hopes to give AIG time to sell its assets in an organized manner for fair value to maintain market stability. In a statement, the Federal Reserve said:

A disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy.

Unlike Fannie and Freddie, AIG has several healthy business units that might be attractive to other companies. The core property and casualty insurance business is stable, as are other sectors like a successful airline leasing operation. If AIG were allowed to fail without intervention, it would be forced to sell these assets quickly, likely at below market value. By giving the company more time to sell its assets in an orderly manner, the Federal Reserve hopes to avoid disorder and alleviate concern among AIG’s insurance customers.

Bankruptcy of Lehman Brothers; Acquisition of Merrill Lynch

Lehman Brothers is an example of what happens when a company does not have adequate time to sell its assets. Lehman declared the largest corporate bankruptcy in American history on Monday. Although several banks expressed interest in acquiring Lehman, all were discouraged by derivative exposure and other toxic assets that would be a part of any complete purchase. After the bankruptcy, Lehman was forced to sell its North American operations to Barclays for only $1.7 billion.

The demise of Lehman Brothers represents another in a string of investment banks to fail in the wake of the credit crisis. Like other banks, Lehman’s obligations gradually decreased the number of parties willing to enter into counter-party transactions with the firm. Plagued by a lack of capital to support $60 billion of bad real-estate holdings, Lehman hoped to secure a similar Federal Reserve package offered to Bear Stearns this March. Many viewed the Bear Stearns transaction as a step toward moral hazard for the Federal Reserve. However, the absence of a bailout for Lehman shows that the Federal Reserve is not afraid to let large institutions fail. This sends a strong message to both large and small banks that the government will not blindly back institutions caught with risky portfolios and poor internal controls.

Another banking casualty this week was Merrill Lynch, which was acquired by Bank of America in a $50 billion stock transaction. The acquisition gives Charlotte-based Bank of America the Wall-Street presence it has wanted for years. Although Merrill was plagued by a lack of liquidity brought on by bad mortgage-related debt, its brokerage and wealth-management businesses remain strong. These divisions give Bank of America major assets it needs to better compete with Citigroup, another large universal bank. Merrill will sustain huge job losses as a result of the transaction.

Washington Mutual and Other Problems

To cap off a week highlighted by bankruptcies, bailouts, and sell-offs, other threats remain on the minds of investors. After losing $6.3 billion in the last three quarters (and 90% of its stock price in the past year), Washington Mutual threatens to be the next major bank to fail. Rising credit costs and capital requirements have forced the bank to look for potential buyers and new sources of capital. Washington Mutual would become the twelfth bank insured by the FDIC to fail this year. Because of Washington Mutual’s debt downgrades and falling share price, it has become nearly impossible for the bank to raise capital through stock issuance or debt offerings.

Washington Mutual’s continued struggles are emblematic of the ongoing problems caused by the collapse of the housing market. Both commercial and investment banks are beleaguered by the bad debt associated with mortgage-backed securities. As these products lose value, institutions are unable to maintain their capital positions and find counter-parties for trading activities. When access to counter-parties dries up, banks lack liquidity and the cycle of losing value perpetuates itself.

As banks suffer, these problems spread to other areas in the financial market. Today, the Dow Jones fell to its lowest point since November 2005. Companies as diverse as Boeing, General Motors, GE and Home Depot all posted dramatic losses. Market pessimism stems from ongoing liquidity issues and fear on the part of investors. Wachovia, Citigroup, Goldman Sachs, Morgan Stanley, and JP Morgan all lost over 10% in today’s trading. Many investors are putting money into cash or commodities like oil or gold until the bank panic subsides. Oil prices rose sharply, as did gold, which posted a gain of $70 per ounce. The unprecedented events of the past ten days are clear evidence that the credit, housing and liquidity crises are far from over.

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