Bankrupt Banks In The USAPosted on: 19 September 2008 by Gareth Hargreaves
Expert Graham Kerner analyses news from the American financial sector.
Hank Weds Frannie
Stock markets around the world soared last Monday as investors crossed their fingers that the US Government's rescue of Fannie Mae and Freddie Mac would finally mark the bottom of the financial crisis.
US Treasury Secretary Hank Paulson made a bold move last week to effectively nationalise the two giant mortgage-finance companies in an attempt to fix the credit crisis and in doing so, hoped to draw a line under speculation about the health of the two lenders.
The federal government's move to seize control of the troubled companies - which together back about half America's $12 trillion of residential mortgages - prompted relief that the embattled US housing market might finally start to stabilise after more than a year of turmoil.
It was a question of third time lucky for Paulson, having earlier in the year promised both new loans and a government injection of capital if either was pushed to the brink of disaster. Mr. Paulson had hoped to avoid the latest move, but said that the drastic measure was necessary to maintain confidence, not just in the US but in the global financial system too.
As The Independent explained, under the US plan, the agencies' regulators will take over Fannie and Freddie under a 'conservatorship', replacing their chief executives and wiping out the companies' dividends. In return, the US Treasury will receive $1 billion of preferred stock, but as a consequence its equity stake could reach $100 billion in each.
So, unsurprisingly, the news was well received and was the signal for a relief rally and time for hedge funds to close any short positions.
Unfortunately, the brighter mood had evaporated by Tuesday with investors' attention once more focused on the financial sector - specifically the health of one of Wall Street's oldest banks, Lehman Brothers. Founded in 1850 the bank has had a chequered history over the years, but its recent problems stem from the sub-prime crisis and credit crunch.
The bank, as The Financial Times explained, hoped to survive the crisis by selling its prized asset management unit and spinning off $30 billion worth of troubled property assets after failing to secure capital from outside investors. In an effort to halt the slide in its share price the bank rushed out third-quarter results, which showed a loss together with its plan to shrink the business.
The bank's CEO, Dick Fuld, said it would survive. "We have been through adversity before and we always come out a lot stronger."
Uncle Sam To The Rescue?
Well, unfortunately for Mr. Fuld, not this time round. The parlous state in which Lehman ended the week put huge pressure on the federal government to provide backing similar to the support it has just given to Fannie Mae and Freddie Mac.
As The Financial Times observed, Hank Paulson must have felt as if he carried the fate of American capitalism in his hands - starting the week with a multi-billion rescue only to end it by digging-in against calls for a second bail-out to save Lehman Brothers.
Paulson was anxious to facilitate a rescue as The Sunday Telegraph noted, making a plea to the major banks, including Barclays, to assemble a cut-price rescue, bid to save the bank. Many insiders doubted it was achievable without a sweetener from the US Treasury, similar to that given when Bear Sterns was sold to JP Morgan.
However the message from Washington was unequivocal: regulators were prepared to be pragmatic to help facilitate a deal, but there would be no repeat of the Bear Sterns model. The US Secretary said the circumstances surrounding Fannie Mae and Freddie Mac were different - the two businesses were more important to the financial system as much of their debt was held by foreign central banks.
Following help for Bear Sterns, Mr. Paulson has apparently taken the view that the markets have had six months to prepare for such an event thus countenancing the risk that Lehman Brothers might fail.
Which is exactly what happened this morning, with the Wall Street bank announcing that it intends filing for Chapter 11 - or bankruptcy in our parlance. As the week unfolds more details will no doubt emerge, but whilst its share price may have been devastated the bank has many valuable assets - totalling in excess of $600 billion, according to The Times. At the end of May, court filings showed that the bank's total assets were $639 billion with debts of $613 billion.
Hank Paulson's reluctance to commit more taxpayers' money was really no surprise, according to The Sunday Telegraph, which pointed out that the Fred and Fannie deal single-handedly vaults the US from a public debt ratio in the sound-money range - public sector debt was 43.8 per cent of GDP - into the company of long-term economic invalids such as Japan. Post deal, US public sector debt is now equivalent to 82.9 per cent of GDP.
Banks Rally Round
Lehman's final demise may have been swift, but so too has the US Federal Reserve in taking action to support the financial markets and maintain good order. The Fed has eased the terms under which it lends to primary dealers who will now be able to pledge a wide range of assets, including equities, as collateral. Similarly the Fed has broadened the range of assets that can be used in exchange for loans of government bonds and at the same time eased deposit financing rules.
There was also news that Bank of America has agreed to buy its rival bank Merrill Lynch in an all-share deal for $50 billion - equivalent to $29 per share and a premium to the closing price of $17.05 on Friday.
The Financial Times highlighted at the week-end that insurance giant AIG was looking to dispose of some of its assets but potential buyers are concerned that the business may seek Fed funding. Either way the company is putting together a restructuring plan to raise new capital of anything up to $20 billion to strengthen its position.
Not only has the Fed moved to calm nerves, but a consortium of ten of the world's largest banks have announced plans to create a collaterised borrowing facility of $70 billion to help ease liquidity. The likes of Barclays, Deutsche Bank, UBS and JP Morgan have each contributed $7 billion to the funding programme which should ease funding pressures.
The public and private sector initiatives are specifically aimed at countering a possible disruption in the triparty repo market, where investment banks secure short-term funding, much of it from money-market mutual funds.
Hank Paulson said the co-ordinated moves would "be critical to facilitating liquid, smooth functioning markets" and praised the financial sector for joining forces with the US authorities to contain market risks.
Whilst most investors had their eyes firmly focused on the banking sector, there were other events that occupied the markets too.
As oil prices continued their fall from their high of £147 per barrel to around $100 per barrel the producers' cartel Opec announced measures to cut supplies in an effort to maintain a price floor under the commodity. News of the decision was criticised by Washington and The Financial Times reported that the decision is likely to keep the cost of crude at or above $100, according to the International Energy Authority.
Yet the recent oil price fall has come too late for another airline, following news that the holiday carrier XL Leisure had collapsed, leaving some 85,000 people stranded. The company blamed the collapse on the surge in fuel prices and the credit squeeze.
However, the recent falls in commodity prices meant some good news on the inflation front, according to The Independent. While retail inflation is likely to peak at around 5 per cent in the next few months, hopes that inflation is likely to plummet thereafter were given some credence as the Office for National Statistics said factory gate prices fell at their sharpest rate for 22 years in August. With raw material costs falling more sharply there is evidence that producer price inflation, which eventually feeds through to shops, has now peaked.
Prepare To Buy
In its Money section, The Financial Times said that consensus is growing among wealth managers that the UK stock market is approaching the bottom, heralding strong investment opportunities for the long term. Having fallen some 20 per cent from their peak last year, most stock markets now offer huge value in the eyes of some professional investors, but market volatility understandably is making private investors wary.
So what's the view from the City? Nick Purves of Schroders manages UK equities from the heart of London, including funds for St. James's Place.
"What we are seeing in the market is a 'tug-of-war' between valuations, which are at low levels and news-flow, which is very poor. On every measure there are shares out there that are extremely good value, but on the other hand the economic and financial news continues to be bad."
"Sometimes the market will focus on valuations, which it did during July and August and prices rallied - in the last couple of weeks attention has swung back to the poor economic outlook and uncertainty in the banking sector. I think we are likely to see the volatility continue for a while, but in the meantime I am concentrating on the opportunities that the market is creating."
"If the market could believe that we would have a recession, that things would be difficult for a year, but that a recovery would follow then stocks would rally. But currently the market worries about systemic risk as the likes of investment bank Lehman Brothers fail and it can't think about recovery. But events over the week-end and the announcements today have not changed my outlook or investment strategy."
"One thing is certain; when we are through the current problems a powerful rally will ensue. In choosing stocks I try to price companies on the basis of normal and sustainable earnings. In other words, a company will usually trade on a price multiple of 12-13 times earnings. Currently, I have identified a number of companies whose shares trade on half that multiple. In other words these shares potentially have a 100 per cent upside."
"So my firm belief is that in three years time many share prices will be substantially higher than where they are now - this is not blind optimism or dogmatic contrarianism, but is based on educated research. In recent weeks it's been possible to see a change in trend whereby some of the value stocks I own have enjoyed a re-rating."
"Having avoided banks and cyclical consumer stocks [retailers, house builders] I have in recent weeks bought these and so far so good."
"As a fund manager I remind everyone that crisis creates opportunity because when the market is ruled by fear, investors' decisions are driven by emotion, not fundamentals and this enables me to pick up good assets at low prices. It happened in 1998 and 2002 as the market bottomed and then rallied strongly for a number of years - I believe we have the same opportunity today."
15th September 2008
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