what i learned today

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.

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.

First of all – what is AIG?
AIG is American International Group, the largest insurance company in the world. It’s not just an insurance company, however; its business is divided into four divisions: general insurance, life insurance and retirement services, financial services and asset management. It was started in 1919.

How did it (almost) collapse?
Like many other banks, AIG lost a lot on its mortgages, including $18.5 billion in the past three quarters – all part of the subprime collapse. Its share price has dropped 79% this year. But bad became worse this Monday when AIG received a downgrading of its credit rating. What’s a credit rating? All securities are given a rating that tells you how much risk is associated with your investment into that security. Depending on the rating, the company must have a certain percentage of money on hand.  The ratings, given by agencies like S&P and Moody’s, are a lot like school grades – A’s are good (need less money on hand), B’s are okay/bad (need more money on hand), and C’s are junk (need even more money on hand). So S&P & Moody’s downgraded AIG, which meant it needed to post $14.5 billion in collateral to support its trading contracts. AIG couldn’t sell its assets off quickly enough to get that money. Seeing its impending doom, AIG tried to rally the rest of the banks (JPMorgan & Goldman) to lend them the money. That didn’t work, so the Fed had to step in order to keep it from total collapse. The Fed has promised to lend up to $85 billion to AIG.

Wait, what is the Fed again?
It’s the Federal Reserve System, the central banking system in the US. Currently, Ben Bernanke is the Chairman of the Board of Governors of the Fed. The Fed has a dual mandate: to promote stable inflation and maximum employment. More from a previous post.

But I thought the Fed wasn’t going to bail anyone out anymore.
Well, yes, that’s what they said. And they definitely stuck to their word when they let Lehman slide to its demise this weekend. However, AIG is more than just an investment firm. It’s such a huge insurer (the largest in the world in terms of assets), and was such a huge player in the Credit Default Swaps (CDS) market, selling off risk to other financial players around the globe. If it collapsed, it would have shaken the global financial world.

What are Credit Default Swaps?
Okay, say I invest $10M into a bond for General Motors, but I’m now afraid that GM may see financial trouble. Instead of just selling my bond off, I can enter into a sort of insurance policy with a big bank, say AIG. I pay AIG a small premium every quarter. If GM remains fine, then AIG does nothing. If GM does see financial trouble and I lose money on my bond, AIG will pay me what I lost on my bond. Likely, this will be a lot of money, relative to the small premiums I pay. Once this happens, the contract of the “swap” terminates. So this is all fine and great, except for the fact that the CDS market isn’t regulated – thus, I could enter into a contract with a bank that doesn’t have the resources to cover the loss of my GM bond. The CDS market totals $62 trillion, in which AIG plays a central role. Since just about every bank, insurer, and institutional money manager has some sort of exposure to CDS, they all have some sort of exposure to AIG. Hence, the necessary bailout.

How does the bailout work?
Well the Fed doesn’t just hand over the money when they do these bailouts. It has promised a two-year loan for up to $85B. In return, it gets a 79.9% equity stake in the company in the form of warrants (a warrant is basically a call option issued by the corporation – allowing the Fed the option of buying common stock in AIG at a specific price) called equity participant notes. Interest on their loan is at Libor (the London Interbank Offered Rate – it’s basically the UK equivalent of the US Federal funds interest rate, and is often used as a benchmark for short-term lending.) + 8.5 percentage points. That’s about 12% (now), which is very high interest.

So AIG has to make good on the loan in the two-years either through general operations (not likely) or through sale of its various assets or branches of business. AIG has about $1.1trillion worth of assets, and the Fed plans to sell them off in an orderly manner.

Why so much money?
Though AIG only needed $14.5 billion after the credit downgrade this week, the $85B loan was designed so AIG would be left with little debt and it could take on whatever the next few quarters has in store.

Does this matter to me?
Yes - now you own part of AIG! Well, kind of. That $85 billion is comprised of your tax dollars. Yep – your tax money is now going to protect bad investments. Investments that packaged up your debt into various securities, and sold it off to another party, who sold it off to another party, who sold it off all over the world.

However, since the Fed is LENDING the $85B to the corporation (unlike the Fannie & Freddie deal) the government could make some serious money off the high interest rate. That is if, by some sort of divine intervention, the market, and thus AIG, rebounds. The Fed is making it clear that the taxpayer will only see positive effects of the bailout.

But will the taxpayer be affected?
Who knows. It may be true – the Fed and the Treasury may make some money off AIG due to the high interest rate, but will I ever see that money? It’s certainly a good way to assuage the public’s fears.

Will the bailout work?
Yes, it should. See, certain branches of AIG are doing just fine.  Its aircraft leasing business, for example, is the second largest in the world and is estimated to bring in between $7 and $10 billion if sold.

Who’s next?
WaMu? Morgan Stanley? Though that’s speculation, one thing is for sure: the Fed can’t afford to keep bailing out the banks.

And who’s to blame?
That’s for next time.

Received this email on Friday:

—-
Fulltime Associate Recruiting Presentation and Reception
When: Thursday, October 9, 2008
Where: Lehman Brothers World Headquarters, New York
Attire: Business Formal
—-

but the RSVP link seems to be broken..

Big News of a bailout for Fannie and Freddie – investors cheer, the markets rally, but what does it mean to you?

GSEs —> TSEs?
Well, the Government Sponsored Enterprises just became Taxpayer Sponsored Enterprises. The Treasury “bailed” them out, changed their leadership, and is putting Fan & Fred under the management of the Federal Housing Finance Agency. It’s the most radical regime change in global economic and financial affairs in decades, and as economist Nouriel Roubini states “the greatest nationalization in the history of humanity.” He now likens the USA to the USSRA, The United Socialist State Republic of America. Worth a read.

For you, the borrower:
This could mean (slightly) lower rates and greater availability of credit. F&F will now have the cash to buy mortgages from other banks and create more mortgage backed securities to sell off to investors. That means those other banks will have the money to create more mortgages - - that way there’s more money moving about the system. So that’s good for a borrower. If you’re a current mortgage holder, however, you’ll likely see little change.

For you, the homeowner:
Though home prices will continue to fall, the bailout is a potential sign for future stabilization of prices. That’s good for the 1 in 3 mortgage holders whose current mortgage is worth more than his home. Some economists project the market to bottom out as early as the first quarter of 2009; most project early-mid 2010.

For you, the F&F shareholder:
Hm, not sure yet. Though Paulson did make it clear that the TSE’s “will no longer be managed with a strategy to maximize common shareholder returns.” Sure, change the policy now that U.S. taxpayers are the real shareholders…

For you, the national Federal Debt:
The cost of government intervention has yet to be determined, but it will be huge. Upon takeover, we’ve already immediately injected F&F’s $6 trillion into the national debt.  Allegedly, a memo that has been recently circulating among economists at the Federal Reserve projects that Federal debt could reach $23 trillion by mid 2010. (It’s currently $9.67 trillion)

For you, the everyday taxpayer:
This is why I say uhoh. As a taxpayer, you’ll be footing the bill. The bailout basically means Fannie and Freddie will have an unlimited taxpayer-funded credit line. This doesn’t mean our taxes will be increased to bail them out - at least not yet. But it does mean that now our government is further in debt – now indebted to hedge funds, domestic and international banks, foreign central banks, etc. The government already put in $1 billion to F&F, and may put in up to $200B more.

And what if the bailout doesn’t work?
If the bailout does not succeed - that is, it doesn’t help the housing or credit markets - well then we’re in big trouble. If the government can’t inject liquidity into the market, then who can?