Close Encounters with a
Panic of the Third Kind
I first
began studying the history of financial panics nearly four decades ago,
when I was an undergraduate at New York University.
I
learned about the panics of 1833, 1837 and 1857, which were the result
of speculative land booms stimulated by the westward advance of the
nation's first railroads.
I studied the panic of 1901, the outcome of a battle to corner the stock market and take over the Northern Pacific Railroad.
I delved
into the "rich man's panic" of 1907, which followed a boom in corporate
mergers ... the 1920-21 panic precipitated by the liquidation of excess
business inventories ... plus the 1929 panic that came with the
unraveling of a huge stock market pyramid built by brokers, banks,
industrial tycoons and speculators.
And from my graduate student dorm at Columbia University, I even published a book dedicated to this subject.
I found that history has brought us two kinds of panics:
1. Panics brought on by a collapse of assets with liquid markets — such as stocks, bonds and certain commodities.
2. Panics caused mostly by the collapse of assets without liquid markets — such as business inventories, land or locomotives.
Today,
there's no evidence that these 19th or 20th century-type panics will be
repeated. Too much — especially the active intervention of central
banks — has changed since then. But there is abundant evidence that we are now experiencing close encounters with a money panic of a third kind.
Indeed, according to banking regulators, there are three kinds of assets in the world:
Level One assets are actively traded. You can know exactly how much they're worth based simply on their price in the open market.
Level Two assets are not actively traded. But they're similar enough to actively traded assets to give you a reasonable estimate of their value.
Level Three assets are
the most slippery. In addition to having no active market, they're so
unique, there's no reliable way to estimate their true value. Instead,
all that banks and regulators can do is guess. And the only tools they have to support their guesswork are unproven mathematical formulas.
Here's the key:
The money panic brewing today is driven largely by this third kind
of asset — derivatives of questionable value that were artificially
created by Wall Street brokers, officially sanctioned by Washington
regulators, and falsely rated by Wall Street rating agencies.
These
are the sinking assets that are hitting the big Wall Street firms ...
panicking investors in Florida and Montana ... even threatening some
money market funds.
The irony:
Everyone finally recognizes that these assets are collapsing. But since there's no way of measuring their value until after they're dumped on the market, no one can possibly know how bad that collapse really is until it's too late.
Think of
it this way: You own General Motors. You check its share price daily.
And you see it's sinking in value. You may decide to tolerate the loss
and continue to monitor the situation closely. Or you may decide to cut
your loss and get out. Either way, at least you know how much damage it's doing to your portfolio.
That's the situation investors are facing with level three assets right now:
Thousands
of local governments, banks and individuals have no idea of exactly
when, where or how much they're losing. And it is this unusual level of
uncertainty that's creating the conditions for a money panic.
What
about the Treasury's efforts to freeze that rate of interest on these
investments in order to help millions of homeowners avoid foreclosure?
That just adds still more uncertainty, throwing not only the value but also the yield on these securities into question.
Look.
I've been screaming "Bloody murder!" about these assets since they were
first created. My father did the same before me. But no one would
listen. And now, I'm concerned that it could be too late.
Some of Wall Street's Largest Firms Have More
Level Three Assets Than They Have Capital
Specifically, according to data compiled by the Financial Times:
Merrill Lynch has
$27.2 billion in level three assets, the equivalent of 70% of its
stockholders' equity. In other words, for each $1 of its capital,
Merrill has 70 cents in assets of questionable and uncertain value.
Goldman Sachs has $51 billion in level three assets, or 130% of its equity.
Bear Sterns has sunk its balance sheet even deeper into the level-three-asset hole, with $20.2 billion, 155% of its equity.
Lehman Brothers is in a similar situation — $34.7 billion, or 160% of its equity. And ...
Morgan Stanley tops them all with $88.2 billion in level three assets, or 250% of its capital. That's an unwieldy $2.50 cents in level three assets for each dollar of capital. It
implies that, in the absence of new capital infusions, all it would
take is a 40% loss — and Morgan Stanley's capital could be 100% wiped
out.
Bottom
line: The huge Wall Street write-downs you've heard about to date —
among the largest in history — could be just the tip of the iceberg.
Major U.S. Banks Are Also
Overloaded With Derivatives
Derivatives
are bets — sometimes good bets, sometimes bad ones. And the
mortgage-backed securities that are ground zero of this crisis are also
derivatives. But they're not the only derivatives that could be
vulnerable.
My forecast: There are two kinds of derivatives that I believe could be directly impacted by a money panic:
- Interest-rate derivatives.
If you think interest rates are going down, you could use these to take
one side of the bet. If you think rates are going up, you could use
them to take the other side.
- Credit-swap derivatives. If
you think a particular borrower is relatively secure, you'd use these
to take one side of the bet. Or if you think the borrower is likely to
default, you'd take the other side.
The worrisome reality, according to the U.S. Office of the Comptroller of the Currency (OCC):
The rate of growth in these derivatives has been explosive.
At the
end of 1994, the total "notional" value of interest-rate and credit
derivatives held by U.S. banks was $9.9 trillion. And at the time, I
thought that was a lot.
But as of the latest reckoning (June 30, 2007), it was $135.1 trillion, or 13.6 times more!
That's a growth of 1,260% in a huge-but-esoteric investment area that I think could be at the core of a money panic.
And it gets worse:
All
told, there are 968 U.S. commercial banks that invest in derivatives.
But among them, 963 banks hold a meager 1.5% of all the interest-rate
and credit derivatives in America.
In contrast, just five banks hold an amazingly large 98.5% of all the interest-rate and credit derivatives.
From all my studies of history, I find that to be the worst concentration of risk of all time.
The five
banks: JPMorgan Chase, Bank of America, Citibank, Wachovia and HSBC.
How much risk are they taking? No one knows for sure. But therein lies
one of the primary problems.
Yes, we know that not all derivatives are risky.
And yes, we know that the huge "notional" values of the derivatives can overstate their size.
But we
also know that the formulas and models used to evaluate their risk
levels may not hold up under panicky market conditions.
So although most derivatives can be accurately priced right now, they may be impossible to price in a money panic, much like level three assets.
Huge Exposures
To Credit Risk
Helping to cut through some of the uncertainty, the OCC evaluates the credit exposure of each U.S. bank holding derivatives. In other words, it asks the question:
Regardless of whether the bet is a win or a loss, what happens if the investor on the other side of the bet doesn't pay up?
In
normal times, such payment defaults are rare. So this is largely a
theoretical question. But in a money panic, when markets can go haywire
and available cash financing can suddenly dry up, a chain reaction of
defaults could make this a very urgent and practical question.
Here are the answers, according to OCC data:
Overall, including all types of derivatives ...
Wachovia
has credit exposure that's equivalent to 89% of its capital. In other
words, if all of its counterparties defaulted on their bets with
Wachovia, nearly nine-tenths of its capital would be wiped out.
Bank of America
is exposed to the tune of 99% of its capital. Assuming no capital
infusions, it could be virtually wiped out in an extreme money panic
scenario.
And at three banks, the panic would not have to be quite that extreme:
- Citibank has 292% of its capital exposed to this kind of credit risk.
- JPMorgan Chase has 387% of its capital exposed.
- HSBC
beats them all with an exposure of 388% of its capital. That means that
even if its counterparties defaulted on just 26% of their bets, its
capital could be wiped out.
Now, remember what I told you about level three assets — that they don't have a regular place to trade.
Well, we
could say something similar about the overwhelming majority of
derivatives: They are not traded on regulated exchanges. Rather, they
are traded over the counter, based on individually negotiated contracts.
In other
words, if there's a default, the parties have to work through it
directly, one on one. Exchange authorities are not going to step in to
help manage the crisis for them.
And
currently, four of the five U.S. banks I named earlier trade over 90%
of their derivatives in this way — outside of regulated exchanges.
At
JPMorgan Chase, Bank of America, Citibank and HSBC, the derivatives
they trade outside of exchanges represent 94%, 93%, 97% and 97% of
their total, respectively. Only Wachovia has a somewhat lesser amount
in this category — 77%.
End result: Still more uncertainty, still more vulnerability to a money panic.
Coming Tuesday, December 11:
The Fed's Next Belated Response
Fed
Chairman Bernanke and his colleagues don't talk about a panic in plain
daylight. They dare not even utter the word. But I have little doubt
that, behind closed doors, they're talking — and thinking — about it
long past the bedtime of most investors.
They know all about last week's panic withdrawals from the Florida and Montana funds.
They know about the surprisingly large losses at some money funds.
They are
aware of the collapsing and uncertain value of level three assets ...
the big exposure to these assets at major Wall Street firms ... and the
grave uncertainty revolving around trillions of dollars in derivatives.
They're
not going to let the financial markets slide into a money panic without
a fight. Quite the contrary, next Tuesday, December 11, the Fed is
going to:
- Slash the discount rate by a quarter or even a half point ...
- Cut their target rate for short-term interbank borrowings (Fed funds), also by a quarter or a half point ...
- Restate, even more firmly, their readiness to do whatever it takes to avert a money panic, and ...
- Even
come up with some new, creative ways to pump desperately needed cash
into institutions likely to suffer the brunt of a money panic.
For the U.S. economy, already sinking into recession, I think it will be too little, too late.
But for
the U.S. dollar, it will be too much, too soon. Its value will plunge
anew. Foreign currencies — especially crisis currencies like the
Japanese yen — will surge still further.
Three Ways to Escape
A Money Panic
There is
no investment that is absolutely safe from all dangers. But in this
flammable environment, there are three you should consider very
seriously:
Money Panic Escape Vehicle #1. Treasury-only money funds such as:
These
funds have never owned — and never will own — level three or even level
two assets. They invest exclusively in the highest level, most secure
assets in the world — short-term U.S. Treasury securities or equivalent.
When my
father, J. Irving Weiss, founded the precursor to today's money funds
in the early 1960s, this is precisely the kind of money fund he had in
mind. And today, I'm pleased to see there are quite a few still
following that model.
The only risk, as I see it: The sinking value of the dollar itself. But you can offset that risk with ...
Money Panic Escape Vehicle #2. As Jack and I explain in our free 50-minute video online right now,
the world's paramount "crisis currency" is the Japanese yen. And now,
you can conveniently buy Japanese yen through ETFs or even options,
aiming for returns of as much as 28 to 1.
Money Panic Escape Vehicle #3. Gold.
The daily market price is bound to fluctuate sharply. But with the
threat of a money panic ... and with central banks rushing to counter
that threat by printing more paper money ... the yellow metal is likely
to make the $800-per-ounce level a floor and head for much higher
levels.
Good luck and God bless!
Martin
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Thanks Reggie for your blog. Always good information presented well.
Posted by: John | December 07, 2007 at 03:06 PM