What I Learned Today

“The last wrench in the toolbox”

If you haven’t heard, the “mother of all bailouts” may soon take place in the US. The Federal Reserve plans to spend $700 billion to buy up mortgage related debt from our ailing banks so the banks will be able to lend again. Credit is, after all, what America runs on. As Bernanke put it, it’s “the last wrench in the toolbox” to fix our financial crisis. But how did we get here? Here’s where the blame game leads us…

Greenspan
He had interest rates too low for too long, which resulted in the housing bubble. But what is too low too long? You can’t blame the guy for thinking “innovation and structural change in the financial services industry have been critical in providing expanded access to credit for the vast majority of consumers, including those of limited means.”

Consolidated Supervised Entities Program
In 2004 the SEC changed the rules under which banks with at least $5-billion of capital calculate their gross leverage ratios. It basically raised the leverage ratio to 30, from about half that. A gross leverage ratio measures the amount of debt a company has compared to its net capital. There are different ways to calculate a leverage ratio - this law governed the comparison of debt to net capital (which is basically your total capital minus anything that can’t be easily converted into cash (like debt)). A leverage ratio of 30 basically means there was 30 times as much debt (bad stuff) as there is equity (good stuff). Under the law, the banks could take on more debt, which was good when times were good because it allowed them to make more transactions. However, high levels of debt means it takes only a small decline in the value of the firm for the bank to go bankrupt.

Five investment banks fell under the program: Goldman, Merrill, Lehman, Bear, and Morgan Stanley. It is noted that at the time of decline, Merrill had a leverage ratio of about 40, Lehman of 36.

Goodbye Uptick Rule
In 2007, the SEC eliminated the “uptick rule”, which prohibited sellers from shorting a share when the stock was selling for lower than the previous trade. This rule was instituted after the Crash of 1929, as shorting was alleged to be the culprit of the crash. After research and assessment of the rule, the SEC suggested the uptick didn’t matter and lifted the ban. Now, shorting has been blamed for today’s crisis and has been put on a temporary ban.

Hedge Funds
Hedge funds aren’t as highly levered as ibanks, but do they do a lot of shorting. Perhaps their ubiquity spurred the financial decline. They’ll pay whether or not that is the case. About 90% of hedge funds are currently losing money and that’s sure to increase with the advent of the short selling ban.

Ratings Agencies
It’s not the Fed’s job to allocate or assess risk, so we can’t truly blame Greenspan. But the job is someone’s responsibility. Whose? The ratings agencies, these government sanction oligopolies like Moody’s, S&P, and Fitch. See, the ratings agencies slapped high ratings on all of the Mortgage Backed Securities. An MBS is a bundle of a bunch of loans, some dodgy, some not, that are all rolled into one tradable security, like a stock. The Ratings Agencies rate all securities based on their level of risk. Again, the ratings are a lot like school grades, A  good, B okay/bad, C junk. The Ratings Agencies aren’t regulated by the SEC, and so were not really watched throughout this whole game. So they were able to slap high ratings on risky MBS’ last year, and then downgrade AIG last week, putting the onus of bailing them out on you and me.

The SEC
The SEC was created in 1933 to protect small investors against securities fraud. It doesn’t have robust oversight over all financial entities, ratings agencies included, and is not really equipped for our financial world.

The Deregulatory Financial Modernization Act of 1999
In 1933, Congress established a set of banking regulations under the Glass Steagall Act. Thinking commercial banks (ones that take deposits from everyday citizens) caused the Crash of 1929, the act separated the commercial banks and the investment banks. This way investment banks would take on risky investments, and commercial banks could protect its members by not. Before 1933, there were few investment banks and the Glass Steagall Act spurred Wall Street as we know (ahem, I mean knew) it.

The Glass Steagall Act was repealed, however, in 1999 under the Deregulatory Financial Modernization (Gramm-Leach-Bliley Act) Act. This allowed the commercial banks to take on the same risky bets that ibanks did. A commercial bank (one that sells to you and me, like Citigroup or WaMU) could trade Mortgage Backed Securities, Collateralized Debt Obligations, and other SIVs, Structured Investment Vehicles. So basically, it allowed the guys that are usually safe and who hold my life savings to take on risky investments and get all mixed up in the mess too.

The Glass Steagall Act of 1933
Or you could blame the Glass Steagall Act of 1933 (mentioned above) itself, for really creating the stand alone investment bank in the US.

what’s a bank holding company?

In the largest restructuring deal since the Depression, on Sunday the Fed approved the applications of Goldman Sachs and Morgan Stanley to become “bank holding companies.”

A bank holding company is, by definition, a company that owns and controls one or more US bank. Basically, this now means the Morgan Stanley and Goldman Sachs are more like retail or commercial banks. You know - the ones that take and hold deposits from you and me (think BofA). They’ll be supervised by the government. Before any major activity, like a merger or acquisition, the Federal Reserve must approve.

The benefits of becoming a bank holding company are that Goldman and MS can now take on debt tax free. They are also viewed are more stable by investors, who last week thought they were not solid enough to survive. This will provide the bank access to “permanent liquidity and funding,” and will, thus, be given more flexibility to carry on during the tumultuous marketplace.

This marks the end of the investment banking industry as we knew it. In a personal note, a professor of mine noted “If you came to school to go into investment banking for the money, don’t bother.” Now these former ibanks will no longer be able to pay lavish bonuses on top of already high salaries. They’ll have higher capital requirements (= less debt) and more oversight (= less risky endeavors). This change may mean more jobs, however, as they’ll have to bulk up in order to take and hold deposits from more people.

On an interesting note - did you know that prior to this week, the US and Japan were the only countries in the world with standalone investment banks? Now it’s just Japan.

How to Sell Short

Perhaps you’ve seen headlines or references in articles about the ban on short selling. Many believe it is one of the main causes of the current financial crisis and the fall of such banks as Bear, Lehman, and AIG. But what exactly is “short selling?” How and when can you do it? And why is it so frowned upon?

When to Sell Short: You sell short when you think that a certain stock price is going to fall, and you’d like to profit off of that premonition.

How to sell short: Say you know something about a certain stock that nobody else does. Let’s use Apple. You were a tester for the new iPhone which you found malfunctioned. You know that upon release of the phone tomorrow, Apple’s stock price will fall. You want to profit off of this, but you don’t own any AAPL shares. Or you do, but not as many as you’d like.

So you borrow AAPL stock from someone else’s account. Let’s call him Joe. Your broker can help you do this – take 100 AAPL shares out of his client, Joe’s, account (without Joe knowing about it) and give them to you. You sell those 100 shares at $140.90 each, today’s share price. The next day the new iPhone comes out, it bombs, and as you thought, shares fall to $100. (Dramatic, yes, but go with it). The next week, you think Apple’s share price will rise, so you buy back those 100 shares at $100 and give them back to Joe’s account. You’ve just made a sweet $4,090 in profit. To sum it up: you borrow shares of stock from someone else’s account. Sell them.  Then buy them back at a (hopefully) lower price and return them to the account from which you borrowed.

Why sell short. One reason, as described above, is to speculate. If you think a stock or the market as a whole is overpriced, you can make money off of it. A second reason is to hedge – to protect yourself from unexpected losses. That is, if you’re long AAPL but want to take a little less risk, you might want to short another security in the computer industry, which inclues risk inherent to Apple. (ask billda for more)

Don’t sell short. Now I’m not recommending you actually do this, unless you are well versed in the markets. It’s pretty risky. If Joe decides he wants to do something with these shares, he can call you on it. At that moment you’ll have to cover, which means you’ll have to buy back the shares you borrowed from him and put them back into his account. So – say AAPL price actually rose and you were called when it was $160.90. Then you would have lost $2,000.

Can’t sell short. I also don’t recommend you do this, because right now you can’t. The SEC just put a ban on short-selling. After allegations that short sellers have led to the failures of Lehman, Bear, and the like, the SEC stepped in on Thursday and issued a temporary ban on short selling for 799 financial stocks. It’s alleged that short sellers often use false information and conspire to drive down the price of the stock.

This isn’t the first time we’ve placed a ban on short sellers. Short sellers were blamed for the Wall Street crash of 1929. Congress reacted by enacting a law, referred to as the “uptick rule,” which banned sellers from shorting during a downturn. Sellers could not short a share when the stock was selling for lower than the previous trade. This kept short sellers from adding downward momentum of a stock when it was already declining. After almost 80 years, the ban was lifted in 2007, when the SEC determined the markets were orderly enough that they didn’t need the restriction (this is despite the fact that just two years prior in 2005, the SEC sought to restrict short-selling outright).

The history of short-selling takes us back earlier than the Great Depression, however. In 1609, Isaac Le Maire, a Dutch trader, made the first short. He was concerned about threats of attack by English ships and shorted shares of the Dutch East India Company, the first multinational corporation and the first company to issue stock. The Dutch stock exchange did not approve of Le Maire’s actions and temporarily banned short-selling.

Later, during the Dutch depression of the 1630s, speculators saw short-selling as a means to profit off of the economic downturn. The English reacted by banning short-selling completely at the time.