Chapter 1 or 3
THE END OF THE STAND-ALONE INVESTMENT BANKING INDUSTRY
Until 1999, the Glass-Steagall Act had prohibited U.S. banks from both accepting deposits and underwriting securities. In other words, it forced a separation of the commercial and investment banking industries. But when Glass-Steagall was repealed, many large commercial banks began to transform themselves into “universal banks” that could offer a full range of commercial and investment banking services. In some cases, commercial banks started their own investment banking divisions from scratch, but more commonly they expanded through merger. For example, Chase Manhattan acquired J.P. Morgan in 2000 to form JPMorgan-Chase. Similarly, Citigroup merged in 1998 with the Travelers Group, which in turn was the parent company of Salomon Smith Barney. The merger allowed Citigroup to offer wealth management, brokerage, investment banking, and asset management services to its clients. (A decade later, in 2009, following large losses, and under pressure to raise funds, Citigroup decided to spin off its Smith Barney brokerage to a joint venture controlled by Morgan Stanley.)
Most of Europe had never forced the separation of commercial and investment banking, so their giant banks such as Credit Suisse, Deutsche Bank, HSBC, and UBS had long been universal banks. Until 2008, however, the stand-alone investment banking sector in the U.S. remained large and apparently vibrant, including such storied names as Goldman Sachs, Morgan-Stanley, Merrill Lynch, and Lehman Brothers.
But the industry was shaken to its core in 2008, when several investment banks were beset by enormous losses on their holdings of mortgage-backed securities. In March, on the verge of insolvency, Bear Stearns was merged into JPMorgan Chase. On September 14, Merrill Lynch, also suffering steep mortgage-related losses, negotiated an agreement to be acquired by Bank of America. The next day, Lehman Brothers entered into the largest bankruptcy in U.S. history, having failed to find an acquirer who was able and willing to rescue it from its steep losses. The next week, the only two remaining major independent investment banks, Goldman Sachs and Morgan Stanley, decided to convert from investment banks to traditional bank holding companies. In doing so, they became subject to the supervision of national bank regulators such as the Federal Reserve and the far tighter rules for
1capital adequacy that govern commercial banks. The firms decided that the greater stability
they would enjoy as commercial banks, particularly the ability to fund their operations through bank deposits and access to emergency borrowing from the Fed, justified the conversion. These mergers and conversions marked the effective end of the independent investment banking industry—but not of investment banking. Those services now will be supplied by the large universal banks.
1 For example, a typical leverage ratio (total assets divided by bank capital) at commercial banks in 2008 was about 10 to 1. In contrast, leverage at investment banks reached 30 to 1. Such leverage increased profits when times were good, but provided an inadequate buffer against losses and left the banks exposed to failure when their investment portfolios were shaken by large losses
Money Market Funds and the Credit Crisis of 2008
Money market funds are mutual funds that invest in the short-term debt instruments that comprise the money market. In 2008, these funds had investments totaling about $3.4 trillion. They are required to hold only short-maturity debt of the highest quality: the average maturity of their holdings must be maintained at less than 3 months. Their biggest investments tend to be in commercial paper, but they also hold sizable fractions of their portfolios in certificates of deposit, repurchase agreements, and Treasury securities. Because of this very conservative investment profile money market funds typically experience extremely low price risk. Investors for their part usually acquire check-writing privileges with their funds and often use them as a close substitute for a bank account. This is feasible because the funds almost always maintain share value at $1.00 and pass along all investment earnings to their investors as interest.
Until 2008, only one fund had “broken the buck,” that is, suffered losses large enough to force value per share below $1. But when Lehman Brothers filed for bankruptcy protection on September 15, 2008, several funds that had invested heavily in its commercial paper suffered large losses. The next day, Reserve Primary Fund, the oldest money market fund, broke the buck when its value per share fell to only $.97.
The realization that money market funds were at risk in the credit crisis led to a wave of investor redemptions similar to a run on a bank. Only 3 days after the Lehman bankruptcy, Putman’s Prime Money Market Fund announced that it was liquidating due to
heavy redemptions. Fearing further outflows, the U.S. Treasury announced that it would make federal insurance available to money market funds willing to pay an insurance fee.
This program would thus be similar to FDIC bank insurance. With the federal insurance in place, the outflows were quelled.
However, the turmoil in Wall Street’s money market funds had already spilled over into “Main Street.” Fearing further investor redemptions, money market funds had become afraid to commit funds even over short periods, and their demand for commercial paper had effectively dried up. Firms that had been able to borrow at 2% interest rates in previous weeks now had to pay up to 8%, and the commercial paper market was on the edge of freezing up altogether. Firms throughout the economy had come to depend on those markets as a major source of short-term finance to fund expenditures ranging from salaries to inventories. Further break-down in the money markets would have had an immediate crippling effect on the broad economy. Within days, the Federal government put forth its first plan to spend $700 billion to stabilize the credit markets.
SHORT SELLING COMES UNDER FIRE—AGAIN
Short selling has long been viewed with suspicion, if not outright hostility. England banned short sales for a good part of the 18th century. Napoleon called short sellers enemies of the state. In the U.S., short selling was widely viewed as contributing to the market crash of 1929, and in 2008, short sellers were blamed for the collapse of the investment banks Bear Stearns and Lehman Brothers. With share prices of other financial firms collapsing in September 2008, the SEC instituted a temporary ban on short selling about 800 of those firms. Similarly, the Financial Services Authority, the financial regulator in the U.K., prohibited short sales on about 30 financial companies, and Australia banned shorting altogether.
The motivation for these bans is that short sales put downward pressure on share prices that in some cases may be unwarranted: rumors abound of investors who first put on a short sale and then spread negative rumors about the firm to drive down its price. More often, however, shorting is an innocent bet that a share price is too high and is due to fall. Nevertheless, during the market stresses of late 2008, the widespread feeling was that even if short positions were legitimate, regulators should do what they could to prop up the affected institutions.
Hostility to short selling may well stem from confusion between bad news and the bearer of that news. Short selling allows investors whose analysis indicates a firm is overpriced to take action on that belief—and to profit if they are correct. Rather than
causing the stock price to fall, shorts may simply be anticipating a decline in the stock price.
Their sales simply force the market to reflect the deteriorating prospects of troubled firms sooner than it might have otherwise. In other words, short selling is part of the process by
which the full range of information and opinion—pessimistic as well as optimistic—is
brought to bear on stock prices.
For example, short sellers took large (negative) positions in firms such as WorldCom, Enron, and Tyco even before these firms were exposed by regulators. In fact, one might argue that these emerging short positions helped regulators identify the previously undetected scandals. And in the end, Lehman and Bear Stearns were brought down by their very real losses on their mortgage-related investments—not by unfounded rumors.
Academic research supports the conjecture that short sales contribute to efficient “price discovery.” For example, the greater the demand for shorting a stock, the lower its future returns tend to be; moreover, firms that attack short sellers with threats of legal action
2or bad publicity tend to have especially poor future returns. Short sale bans may in the end
be nothing more than an understandable, but nevertheless misguided, impulse to “shoot the messenger.”
2 See for example, C. Jones and O.A. Lamont, “Short Sale Constraints and Stock Returns,” Journal of
Financial Economics, (November 2002), pp. 207-39 or O.A. Lamont, “Go Down Fighting: Short Sellers vs.
Firms,” Yale ICF Working Paper No. 04-20, July 2004.
Credit Default Swaps
A credit default swap (CDS) is in effect an insurance policy on the default risk of a corporate bond or loan. To illustrate, the annual premium in November 2008 on a 5-year Citigroup CDS was about 2%, meaning that the CDS buyer would pay the seller an annual premium of $2 for each $100 of bond principal. The seller collects these annual payments for the term of the contract, but must compensate the buyer for loss of bond value in the
3event of a default. That compensation can take two forms: the CDS buyer may deliver a defaulted bond to the seller in return for the bond’s par value. This is called physical
settlement. Instead, the seller may pay the buyer the difference between the par value of the bond and its market price (even in a default, the bond will still sell at a positive price since there is some recovery of value to creditors in a bankruptcy). This is called cash settlement.
As originally envisioned, credit default swaps were designed to allow lenders to buy protection against losses on sizeable loans. The natural buyers of CDSs would then be large bondholders or banks that had made large loans who wished to enhance the creditworthiness of those loans. Even if the borrowing firm had shaky credit standing, the “insured” debt would be as safe as the issuer of the CDS. An investor holing a bond with a BB rating could in principle raise the effective quality of the debt to AAA by buying a CDS on the issuer.
3 Actually, credit default swaps may pay off even short of an actual default. The contract specifies which particular “credit events” will trigger a payment. For example, restructuring (rewriting the terms of a firm’s outstanding debt as an alternative to formal bankruptcy proceedings) may be defined as a triggering credit event.
This insight suggests how CDS contracts should be priced. If a BB-rated bond bundled with insurance via a CDS is effectively equivalent to a AAA-rated bond, then the fair price of the swap ought to approximate the yield spread between AAA-rated and BB-
4rated bonds. The risk structure of interest rates and CDS prices ought to be tightly aligned.
The following figure shows the sharp run-up in the prices of 5-year CDSs on several financial firms in the months running up to the Lehman Brothers bankruptcy in September 2008. As perceived credit risk increased, so did the price of insuring their debt.
Basis points per year0
Jan-08While CDSs were conceived as a form of bond insurance, it wasn’t long before
investors realized that they could be used to speculate on the financial health of particular
companies. As the figure makes clear, someone in August 2008 wishing to bet against the
financial sector might have purchased CDS contracts on those firms, and would have
4 We say approximately because there are some differences between highly-rated bonds and bonds Jun-08
synthetically enhanced with credit default swaps. For example, the term of the swap may not match the
Jul-08maturity of the bond. Tax treatment of coupon payments versus swap payments may differ, as may the .liquidity of the bonds. Finally, some CDSs may entail one-time up-front payments as well as annual Aug-08
profited as CDS prices spiked in September. In fact, hedge fund manager John Paulson famously did just this. His bearish bets in 2007-2008 on commercial banks and Wall Street firms as well as on some riskier mortgage-backed securities made his funds more than $15 billion, bringing him a personal payoff of more than $3.7 billion.
In principle, with traders establishing CDS contracts purely to speculate on other firms, there can be more contracts outstanding than there are physical bonds to insure! As Lehman Brothers entered bankruptcy, about $400 billion of Lehman CDS contracts were outstanding, despite the fact that its total debt was only around $155 billion. However, while this apparent imbalance was widely noted at the time, it greatly overstated the true mismatch. That is because many traders had offset CDS positions established at one date with opposite positions established at a later date. The widely-cited $400 billion figure was the gross value of outstanding contracts, and did not net out these offsetting positions. In the end, it seems that only about $7 billion needed to change hands to settle the CDS contracts.
Nevertheless, this episode highlighted the utter lack of transparency about firms’ CDS obligations. Such uncertainty about firms’ exposures to the credit risk of others gave rise to doubts about their own financial stability. The nearby box notes that this lack of transparency was a contributing factor in the credit meltdown of 2008.
Credit Default Swaps, Systemic Risk, and the Credit Crisis of 2008
The credit crisis of 2008, when lending among banks and other financial institutions effectively seized up, was in large measure a crisis of transparency. The biggest problem was a widespread lack of confidence in the financial standing of counterparties to a trade. If one institution could not be confident that another would remain solvent, it would understandably be reluctant to offer it a loan. When doubt about the credit exposure of customers and trading partners spiked to levels not seen since the Great Depression, the market for loans dried up.
Credit default swaps were particularly cited for fostering doubts about counterparty reliability. By August 2008, $63 trillion of such swaps were reportedly outstanding. (By comparison, U.S. gross domestic product in 2008 was about $14 trillion.) As the subprime mortgage market collapsed and the economy seemed sure to enter a recession, the potential obligations on these contracts ballooned to levels previously considered unimaginable and the ability of CDS sellers to honor their commitments appeared in doubt. For example, the huge insurance firm AIG alone had sold more than $400 billion of CDS contracts on subprime mortgages and other loans and was days from insolvency. But AIG’s insolvency would have triggered the insolvency of other firms that had relied on its promise of protection against loan defaults. These in turn might have triggered further defaults. In the end, the government felt compelled to rescue AIG to prevent a chain reaction of insolvencies.
Counterparty risk and lax reporting requirements made it effectively impossible to tease out firms’ exposures to credit risk. One problem was that CDS positions do not have to be accounted for on balance sheets. And the possibility of one default setting off a