How Banks Work 6: Liquidity Crises and Bank Runs
March 16, 2008
This week we continue our discussion of How Banks Work:
March 9, 2008: How Banks Work 5: Selling Loans
February 24, 2008: How Banks Work 4: Banks and the Economy
February 17, 2008: How Banks Work 3: More Elephant Poop
February 10, 2008: How Banks Work 2: Shitting Like an Elephant
February 3, 2008: How Banks Work
What has the Fed been doing recently? A little hard to understand, right? The technicalities tend to get brushed into generalizations. It was a “bailout.” They’re “printing money.” And so forth.
The problem faced by a number of financial entities recently — banks, brokers, SIVs, Carlyle Capital, etc. — has been the equivalent of a “bank run.” These entities borrow lots and lots of money. Remember our look at Wells Fargo’s balance sheet.
February 3, 2008: How Banks Work
A lot of that money has a short maturity. Lenders can ask for it back on short notice. Zero notice in the case of demand deposits, and typically under a year for a lot of other sorts of lending. Let’s say you’re a bank. Your lender says, “gimme my money back.” You have to give the money back, or you are in default and on your way to bankruptcy. The thing is, you don’t actually have any money. Remember Wells Fargo’s teeny weeny reserve? All you have is a huge pile of assets, primarily loans. What do you do? Usually this is no big problem. A bank like Wells Fargo is considered to be a good credit. Wells Fargo just borrows the money from someone else. They borrow from Lender B and pay back Lender A. The total amount of borrowing on the balance sheet doesn’t change. This happens constantly in the day-to-day activities of banks.
This is why a modern bank apparently doesn’t need “reserves.” They can borrow on a moment’s notice.
However, let’s say word gets around that a certain bank is maybe not such a good credit. Lender B starts to think “hey, if I loan Bank A some money, then Lender A is getting all their money back. But, I might not get all my money back. In fact, if Bank A declares bankruptcy, I might have to spend the next two years at the county courthouse to get my money back. That might be unpleasant.”
Lender B starts to think that maybe they would end up a bagholder.
So, maybe Lender B says “OK Bank A, I’ll tell you what. You have to pay me an extra 100 bps per annum for the money.” And, since Lender B is not the only lender with concerns, Bank A pays the 100 bps.
Now what do we have? The net interest margin contracts. Remember that the pretax return on assets was only about 2.5%. So, if you give Lender B an extra 100 bps (1%), and all of your funding costs also rise by 100 bps, then your return on assets falls to about 1.5%, which is a pretty big haircut (40%). At the same time, you may be facing credit losses (which is why Lender B is asking for the extra 100 bps in the first place), so profitability looks even worse. This is one way a bank can get into trouble, simply by paying a little more for funding due to perceived credit risk. In this case, a bank may decline over a period of years.
Maybe Bank A is in a little more trouble. Lender A wants its money back, but Lender B (or other potential lenders) say: “Hmmm, sorry. We’re not doing that anymore. If something goes wrong, I could lose my job.” Pretty much all the decision-makers in a bank are functionaries climbing the corporate ladder. It’s not their money. They do whatever they perceive to be the highest-probability route to the next rung on the corporate ladder. One month, that might be making 30-year NINJA mortgages with no money down. In fact, if they didn’t make these mortgages, they would have been kicked off the corporate ladder. “Our loan production isn’t keeping pace with Bank B! Shareholders are getting antsy. Who is responsible?” The next month, they won’t make a collateralized short-term loan to an international blue-chip financial institution with public accounting. “If you end up a bagholder one more time, outta here!” Considering the NINJA loans owned by Bank A, this might be a good idea, come to think of it.
Now Bank A has a real problem. Lender A wants their money back, but there is no Lender B. This is somewhat like a “bank run” of yore, but it is taking place mostly at the institutional level. ABCP issued by an SIV is maturing, but nobody wants any new ABCP issued by this SIV. What to do?
One thing Bank A can do is sell assets. In normal times, usually this is easy to do. Markets are “liquid,” meaning that a bank can easily find a buyer for a reasonable price for its assets. When there is only one Bank A with problems, and lots of other banks that are fine, everything is OK. The problem today is that there are lots of Bank As, and SIVs, and collapsing hedge funds, and so forth. Plus, a lot of this stuff is complicated. As in, really really complicated. What’s in this packaged mortgage stuff? People used to rely on the rating agencies, who had big staffs with special training to understand all the complications of structured finance, on top of all the complications of mortgage lending. Unfortunately, now everybody has figured out that the rating agencies’ ratings are totally fictitious.
Everybody wants to sell. Nobody wants to buy — unless the price is good enough that you can say: “OK, can’t lose on this one.” Let’s say you’re buying some best-quality mortgages for $0.90. We saw last week that it takes a neutron bomb going off in Palos Verdes (a super-wealthy neighborhood in Los Angeles) to make a 5% loss on best-quality mortgages. Maybe their economic value is $0.99. If you buy at $0.90, you’re getting paid perhaps a 7.2% yield (6.5%/0.90). You’re borrowing at 3.50% from your prime broker. (Fed funds plus 50 bps is a common borrowing rate for investment funds. The Fed funds rate is literally the rate that banks borrow at for the short term, so the bank is making a 0.50% spread by lending to you.) At a modest 5:1 leverage (like 20% down for a house, and since mortgages are collateralized by houses, it’s sort of like buying a house in a sense), that’s a yield of 7.2%+ 4*(7.2%-3.5%)=22%. Nice! And then, when the market normalizes and you can sell the mortages for $0.99, that’s a 10% capital gain as well, or a 50% capital gain at 5x leverage. If that takes 12 months, you’re looking at 50% capgain plus 22% yield for a total return of 72%. Honey!
Time to trade up that yacht!
And they would deserve it. A good fund manager is one who can take some abstract information like “Thornburg Mortgage Series 27 MBS $0.90 asked on $757 million face” (I think that’s about right — I’m not a fixed-income guy) and see: “72% return in 12 months with low risk.” It’s a rare skill, one that takes great training and discipline.
The problem is, some entities that thought they couldn’t lose, at the price they were buying and the modest leverage they had, lost big. Like Peloton Partners. Even though paying $0.90 for an asset that probably has an economic value of $0.99 looks good on paper, a lot of potential buyers are wedded to the mark-to-market convention. If they get a great deal at $0.90, but someone gets an even better deal at $0.85, then they have a 5.5% capital loss ($0.85/$0.90 -1) on a mark-to-market basis. At 5x leverage that is a 28% capital loss. In a single month (February). If you report that to your investors, a 28% down month, they all tell you that they are giving 30 days notice for redemption on March 31. Plus, the fund’s prime broker is getting nervous. These guys lost 28% in a month! And now, instead of having $5 of mortgages and $1 of capital (5:1 leverage), they now have $4.72 of mortgages and $0.72 of capital, or leverage of 6.6x. So the prime broker says: “5:1 leverage didn’t work so well. You’re going to have to take your leverage down to 4:1.” In effect, a margin call. The fund managers see 30% of their capital leaving (redemptions), and demands for leverage at 4:1. 30% of $0.72 is $0.22, so they have $0.50 of capital left. 4x $0.50 is $2.00. They own $4.72 of mortgages. Now they have to sell $2.72/$4.72 or 58% of their entire holdings. Remember, everyone else is trying to sell too. The last transaction was at $0.85. Where are the bids for 58% of your entire holdings, for a quick sale? At $0.80. Instant fund annihilation. (Not to mention that the guy who bought at $0.85 is going to have some ‘splainin to do.) Leverage is super-nasty when you get on the wrong side of it, especially in a mark-to-market situation.
Other funds look at this, and think about it, and decide that the thing to do is to take no leverage whatsoever. So they buy the stuff at $0.80. They’re getting paid about a 8.125% yield (6.5%/0.80), and could have a capital gain of 25% as the value goes back to $1.00. Over a 12 month period, that’s a total return of 33.125%. Which isn’t 72%, but you have to admit, that doesn’t suck a bit. Very super safe. No margin calls. The problem is, they can only buy a little bit, because they aren’t using leverage.
You can see why buyers are a bit nervous here. But back to Bank A. They’re trying to sell. Normally, they’d be able to sell at $0.99, the economic value, even in a recession (in which the economic value is impaired). If there wasn’t a recession, they’d get $1.00 or maybe $1.02. (The mortage broker business — like Countrywide Financial — was built on lending $1.00 and selling the loan for $1.02. This is a lot of fun on big volume.) The bid is at $0.85, or $0.80. Don’t want to sell there. They would have to revalue the entire loan book at $0.80, if they are subject to mark-to-market accounting themselves. Or maybe there isn’t a bid at all, and you’d have to hire someone to make phone calls to find a buyer. So, they do nothing. The market is “frozen.”
Nevertheless, Lender A wants their dough, so it’s off to the Lender of Last Resort, the central bank. And, since I would really like to get at least a little exercise this week, that will be the topic for our next installment in this series.
