Thread: Banks brace for deepening financial crisis

Banks brace for deepening financial crisis

The rapid demise of Bear Stearns threatens to sap dwindling confidence in the banking system, which has lost liquidity after the collapse of the subprime mortgage market.

By The Wall Street Journal
Many bankers are steeling themselves for the global financial crisis to both last longer and grow deeper, a shift in mood that could magnify the potential for upheaval in markets and economies worldwide.

Just a month ago, financiers in the United States and Europe held out hope that the turmoil might end this year. Now, a new view is emerging: As the malaise spreads beyond risky mortgage securities and into the high-octane world of derivative investments, the pain is likely to extend well into 2009.

Sunday's deal to sell Bear Stearns (BSC, news, msgs) to JPMorgan Chase (JPM, news, msgs) -- along with the Federal Reserve's surprise Sunday-evening cut in its emergency lending rate -- signals that regulators and the banking industry alike are prepared to take unusual steps to reassure financial markets. The Fed also made the rare move of saying it will lend directly to securities dealers, the first time it has done so since the 1930s.

However, the fact that the Bear Stearns deal puts a paltry $2-a-share value on the storied investment bank, which as recently as a week ago was trading around $70, is unlikely to assuage fears that the worst is yet to come.

The next four weeks will be critical in determining whether bankers' gloomy mood is justified. On Tuesday, the world's biggest banks and brokers will start reporting precisely how much money they lost in the first quarter on bad investments, on top of previous losses. These reports will also hold vital clues to what they feel the future holds.

As last week's meltdown at Bear Stearns shows, bankers' mood swings can sometimes bring about the very scenarios they fear. The 85-year-old firm suffered a de facto run on the bank when nervous lenders and clients stopped doing business with it, sparking others to follow suit.

The global economy relies heavily on banks' willingness to lend money not only to companies and individuals, but also to one another -- providing "liquidity," or an ample flow of cash coursing through the world's economies. The current period of turmoil has its roots in a stark disappearance of this liquidity. Lending that would otherwise fund everything from basic corporate operations, to sophisticated investment strategies used by hedge funds, has dried up.

The darkening outlook among bankers can help to explain why previous efforts by the Fed and other central banks haven't yet had the desired effect of reviving the flow of money.

"Why do I have to provide liquidity to one of my competitors, when I don't know if the liquidity in the market will continue to be there or not?" asks Alessandro Profumo, the chief executive of one of Europe's largest banks, UniCredit Group. "I have to take care of my company."

Signs of malaise are abundant. Last week, banks' own cost of borrowing reached the highest level in two months. Meantime, the highly specialized markets that let banks securitize, or package and sell loans, remain all but frozen.

A week ago broker-dealer Lehman Bros. (LEH, news, msgs) announced a fresh round of layoffs totaling 5% of its work force. That followed reductions by Bear Stearns, Morgan Stanley (MS, news, msgs) and Merrill Lynch (MER, news, msgs). At Société Générale in London, traders who sell bank debt have given up on finding customers some days. "The market is not open every day," says Demetrio Salorio, deputy head of debt capital markets for Société Générale there.

As banks try to reduce their own holdings of unwanted investments, their selling further pushes down values. Swiss banking giant UBS AG (UBS, news, msgs), among the hardest hit by the financial crisis, is reducing its balance sheet -- the amount of loans, securities and other assets it holds -- by about $520 billion from its level at the end of last year. That amounts to a 20% reduction.

People familiar with the situation say UBS has weighed moves such as selling billions of dollars in mortgage securities and a U.S. brokerage unit. A spokesman for UBS declined to comment on the mortgage securities and said the brokerage unit isn't for sale.

So far, banks and insurers have written down more than $150 billion in securities tied to subprime-mortgage loans. Those markdowns include both residential mortgage securities and debt pools known as collateralized debt obligations that are underpinned by mortgage securities. Losses like these could total some $285 billion, Standard & Poor's estimated last week.

As problems extend beyond mortgage securities, though, some economists forecast that total losses to the financial sector could exceed $1 trillion, or about 7% of U.S. annual economic output. That would be more than double the level of losses suffered by savings-and-loan associations and commercial banks between 1986 and 1995, and about equivalent to the scale of Japanese-bank losses in the wake of the bursting of that country's stock and real-estate bubbles roughly two decades ago.

Several times over the past year, investors' hopes for light at the end of the tunnel have proved premature. In June, the credit crisis began unfolding as two Bear Stearns hedge funds imploded. Bankers believed the markets would stabilize by the fall. Earlier this year, banks' fourth-quarter reports were seen as a next line in the sand, as auditors forced them to come clean on their exposures to subprime-mortgage securities. Both times, however, trouble reared its head again.

Now, as banks and brokers report their first-quarter results in coming weeks, the question will be how far their problems have extended beyond subprime.

The first glimpse will come Tuesday, when Lehman and Goldman Sachs (GS, news, msgs) are expected to report write-downs on everything from loans used for corporate acquisitions, to securities backed by so-called "Alt-A" mortgage loans, which are considered to be of higher quality than the riskiest "subprime" category of mortgages.

Then in April, big consumer lenders such as JPMorgan Chase, Bank of America (BAC, news, msgs) and Wachovia (WB, news, msgs) will provide their outlook on the health of the U.S. economy.

In April and May, UBS and other European banks report their results. Analysts expect UBS, which already has reported $18 billion in write-downs, to report as much as $15 billion in new losses, including $7.9 billion in markdowns tied to Alt-A securities.

"The first quarter is looking bad," said Scott Bugie, a managing director at Standard & Poor's in Paris. "Losses are increasing in the Alt-A's. They are increasing in the home-equity lines. . . . It's just all performing poorly." Analysts estimate losses on corporate-buyout loans alone could be as much as $15 billion in the first quarter.

Banks and investors also face a significant unknown: What will happen to trillions of dollars in complex securities tied to the cost of insurance against corporate debt defaults. These arcane securities -- known by terms such as synthetic collateralized debt obligations, or CDOs, and constant-proportion debt obligations, or CPDOs -- provide income to investors by selling insurance against a default to other buyers. However, because of the way these contracts are structured, they can suffer losses when insurance costs rise.

Right now, that's what is happening. Last week, jittery investors pushed up the prices of insurance contracts, known as credit-default swaps, to record levels amid concerns that Bear Stearns' problems could spread to other financial institutions. As of March 14, the average annual cost of $10 million of five-year insurance on 125 U.S. and Canadian high-quality companies was $191,000, up from $80,969 at the beginning of the year, according to the Markit CDX index.

Getting out of a credit-default swap contract isn't like selling a stock. If a bank or other investor sells such insurance, the way it typically gets out of the deal is by going out and buying the same amount of insurance for itself. But if the price of that insurance has risen in the meantime, the bank has to pay more than what it is receiving under the terms of the older contract. That leads to losses.

Fat pitches coming
If there is a rush to buy additional insurance, that can push prices higher, exacerbating the problem. Another concern is that the sellers of these insurance contracts might not pay up if companies do, in fact, default on their debt payments.

This market is immense. In all, such contracts have been written on the equivalent of some $43 trillion in various kinds of bonds, according to the Bank for International Settlements.

Among the most vulnerable are the CPDOs, which have sold insurance on the equivalent of some $30 billion in bonds. They contain triggers that force their holders to call off their bets if losses reach a certain level, a feature that could force them to rush into the market to buy insurance. Analysts estimate those triggers will start to go off when the average cost of default insurance in the U.S. and Europe reaches about $180,000 or $190,000 per $10 million in debt, a level it approached last week.

That could cause further repercussions in the larger market for synthetic CDOs, and for banks, which have been big players in the market. "The question is, how far does this ripple out," says Scott MacDonald, who directs research at Aladdin Capital Management.

As in previous crises, the turmoil won't end until bargain-hunting investors decide that the time is ripe to start buying -- putting a floor under falling prices. So far, though, these kinds of investors, typically banks and hedge funds, have suffered as prices even for top-rated securities keep falling. In London, hedge fund Peloton Partners loaded up on triple-A-rated securities tied to mortgages, only to find itself forced to shut down last month as the price of those securities plummeted.

Thus many potential buyers are sitting on the sidelines. "We don't need to swing at every pitch, because I think we're going to see some fat pitches over the next couple of months," says Max Bublitz, chief strategist at SCM Advisors, a San Francisco money manager with $9.8 billion in fixed-income assets under management.

http://articles.moneycentral.msn.com/In ... risis.aspx

This article says nothing about the derivitives that are floating out there just waiting to explode.

UBS the Swiss clearing house for these derivitives has said that there is 575 trillion dollars worth of these according to their estimates.

I am not that astute as others may be when it comes to the realistic implications of the derivitives market, but with what little that I have been able to grasp, they are akin, according to Warren Buffet weapons of mass financial destruction.

Furthermore it seems that when the market place is healthy and booming they can be defended by some (perhaps the greedier amongst us?) as good instuments. No one seems willing to step forward now to defend them. Or at least I have yet to read of any.

Perhaps someone would take a stab at linking the banking debacle with illegal immigration? Grasping at straws? Perhaps. Perhaps not. If our economy is like a spider web, and illegal immigration has contributed so much to our economy then perhaps there is something there? JMO I know this is financial news but it does tie in.(?)

Remember America, this was not a secret, it was not hidden from you unless you live under a rock. (in which case you would be excused. )
Yes, America Ron Paul has been talking about this. Close your eyes and ears if you wish, but be warned, You are bound to run into a brick wall!

Constitutionalist excluded,....ofcourse.