Former Federal Reserve Board Chairman Paul Volcker congratulated CME Group on its timing as he spoke at the inaugural CME Group Global Financial Leadership conference on Monday, Sept. 15. That day the credit markets went from critical to code blue. The previous Friday, the Federal Reserve made it known that Lehman Brothers needed to find a buyer. When the bidders were informed that the Fed was not going to take on the bad assets ala Bear Stearns, Lehman was toast and Merrill Lynch was sold.
“What we have been seeing is a wrenching reversal. The market today tends to focus on the weakest link in the chain, which can lead to an insidious chain reaction,” Volcker told the audience. He would be proven correct later in the week, as that chain reaction hit Freddie Mac, Fannie Mae and American International Group Inc. (AIG). The Treasury and Fed realized that they could not take the same hard-line approach they did with Lehman if they hoped the failures of those institutions would not lead to a wider contagion.
The Dow Jones Industrial Average reversed a 1,000-point loss late in the week when word came out Thursday that Treasury Secretary Henry Paulson was arranging a $700 billion bailout. But in typical “buy the rumor sell the fact” fashion, the market tanked once the bailout was passed and additional measures are being contemplated.
David Matteson, partner with Drinker Biddle, put it this way, “It is not just Wall Street’s fault. It’s Congress, it’s Fannie and Freddie and even Main Street. It is any homebuyer who borrowed more money than they can afford, any mortgage broker who didn’t ask any credit information, any bank that sent unsolicited pre-approved credit cards and all the investors and bankers who closed their eyes to the eventual reality of an oversold, over borrowed economy. Now we have a very long and painful hangover to endure.”
And the solution, like a radical chemotherapy session, could be damaging to the patient. “The solution is to inject enough capital that our mainstream economy doesn’t vaporize,” Matteson says.
“Will it fix it?” asks Bud Conrad, president of Casey Research. “Not really. It is tragically flawed. It doesn’t fix the fundamental issue: foreigners have lost confidence in us. The source of the problem, huge trade deficits, is based on huge government deficits. Have you seen the government say ‘we are going to cut back on our profligate ways of spending’? No. They are adding to the fire by increasing to the government debt and sending more Treasuries to the world. They expect the world to reinvest $2 billion a day in the U.S.,” he says.
Conrad expects this to lead to huge inflation and a devaluation of the dollar, not in relation to other currencies that are also in trouble, but in purchasing power of commodities like petroleum and gold.
“Where do you go when you don’t trust the banks? Where do you go when you see the stock markets [plummeting] everywhere in the world? People are going to buy gold,” Conrad says. “People are going to say, ‘if you want me to loan you money in dollar- denominated terms, you better cover the expected inflation. I don’t want 2%; I want 10% on my money.’ That is why we are having these ridiculous credit spreads.”
But as Volcker said, “We have a failed financial structure. It has been held together by extraordinary official acts. Actions that are unprecedented and [go] to the edge of [the Federal Reserve and Treasury Department’s] legal responsibility.”
Those who have only followed the crisis since the recent September flashpoint may not realize that the Federal Reserve has been attempting to bailout the investment banks for more than a year by opening up the discount window and offering hundreds of billions of dollars in short-term loans (see “Silent bailout”).
A former Lehman wealth manager explains the five major investment banks were allowed by the Securities and Exchange Commission (SEC) in 2004 to take up their leverage from about 12- to-1 to as high as 40-1.
“If you are at 40-to-1 leverage, you need a 2.5% gross move in all of your assets to wipe out your entire capital. You are tacking on massive amounts of illiquid assets, i.e. CDOs and commercial mortgage backed securities; plus you have your liquid risk, your futures desk, your equity desk, your high-yield desk, which is not liquid because high yields have been trading by imputation. That can be a pretty dicey situation,” says the former Lehman manager, adding, “When your regulator says it’s OK, you have to do it to stay competitive.”
The OTC model allowed investment banks to hold securities on the books as they lost value. “In futures it doesn’t work that way,” Matteson says. “You lose money, you pay that day.”
The entire episode appears to validate the futures industry model of central counterparty clearing and the rules regarding customer segregation. Nearly everyone we spoke with suggested that credit default swaps, which added so much to the current struggle, will evolve into a cleared product, a solution backed by the recent joint venture announcement by CME Group and Citadel Investment Group LLC.
Buck Haworth, CEO of Born Capital, says, “The U.S. model of customer segregated funds is more appreciated now than it ever has been. I am seeing major customers move funds into U.S. accounts to afford themselves the protection of customer segregation.”
London based LCH.Clearnet, the central counterparty to a significant proportion of Lehman trades, initially encountered difficulties when Lehman’s administrator, PriceWaterhouse Coopers, froze customer assets, precipitating legal action by hedge fund RAB Capital, which is trying to recover £22 billion ($37.9 billion).
“They became very afraid when they learned their funds were not segregated; were in fact commingled in any of their European/London brokerage accounts,” Haworth says. “It rather surprised me but this will be a rising tide for all the U.S. commodity exchanges.”
IMPACT ON FUTURES
John Barun, CEO of Capital Markets Consulting, says retail trading has been negatively affected but professional trading in key sectors has been experiencing explosive growth. “For retail brokers, there’s a pretty dramatic impact. A large part of investing has to do with people’s confidence in the system and in the value that can be provided by the institutions they are working with. Based on that, there is probably a significant percent of the retail trading community that is restricting their activity and sitting on the sidelines,” Barun says. “The brokers benefit from frequent activity and so I would be shocked if anybody said that retail was going crazy. Their volumes are going down. On the other side, for proprietary trading groups that trade on volatility, they are just going gangbusters. These are premier markets for them to be trading in and they are making a lot of money.”
Overall credit tightness affects everyone. The day after Lehman declared bankruptcy, the Reserve Fund, a money market mutual fund company, put out this chilling statement: “The value of the debt securities issued by Lehman Brothers Holdings, Inc. (face value of $785 million) and held by the Primary Fund has been valued at zero effective as of 4 p.m. today. As a result the NAV of the Primary Fund, effective as of 4 p.m., is $0.97 per share. All redemption requests prior to 3 p.m. today will be redeemed at a net asset value of $1.00 per share. Effective today and until further notice, the proceeds of redemptions of the Primary Fund will not be transmitted to the redeeming investor for a period of up to seven calendar days after the redemption.”
The following day, investors were allowed to redeem their investments at the current value, which was below $1, according to a Reserve announcement. This was shocking as money market mutual funds are thought of as cash instruments. They back debit cards and can be used as collateral for the CME clearinghouse. The contagion of the crisis to these instruments is one of the factors believed to have pushed Treasury to recommend the bailout.
While the credit crunch has the potential to benefit futures in terms of greater volume in markets with central counterparty clearing, there is an aspect of the credit crunch that has hurt futures business. Future commission merchants make money not only from commissions but on the interest they make from the deposits of customers. This money, the float, flows to introducing brokers and has always been a significant part of the business.
“The problem is the float is down dramatically, which means the income stream is down dramatically,” says Ira Epstein, founder of futures broker Ira Epstein and Company. “It forces firms to look at other ways to make income.” And the most likely source for that income is through futures commissions.
“You are looking at the beginning of higher commissions,” Epstein says. He points out that interest on seven-day bills recently went as low as 1/20th of 1%.“That doesn’t even cover the cost of buying the short-term instruments. If all the income stream from the float goes away, commissions could triple,” Epstein says.
Another problem for retail brokers is the added volatility, not just in equities but in all sectors. Epstein says that volatility is so high that even though the prices of some commodities like silver and corn have come down dramatically, the margin requirements from the clearinghouse have gone up.
Larry Levin, president of Secrets of Traders, says that volatility “has probably knocked out 20% to 30% of the accounts that existed three weeks ago, from million dollar accounts to $5,000 accounts and everywhere in between.”
Levin says that in a normal cycle 10% of accounts would bust each month. And the added volatility and skittish market has increased errors at a time brokers cannot afford them. “I have heard of $300,000 errors taking place, and I know of a $1.2 million error.”
Russell Wasendorf Jr., president of PFGBest.com, says, “Some larger accounts have taken big hits but those were also the same customers that were making large amounts of money coming into the move. Net/net, I don’t see a lot of devastating losses to customers.” He adds that their customer seg funds are down $15 million to $20 million, which is not out of the ordinary in stressful markets.
While volatility in general is good for trading, huge increases in volatility dampen volume particularly for the discount broker. “The volatility has become nightmarish. If volatility came out of the market, more people would trade. It is the worst I have ever seen it. We don’t want to see 500 point swings in the Dow,” Epstein says.
One long-time futures brokerage executive says, “Any time markets move, there are bigger flows of money but it’s more business as [usual], the futures system is working very well. These are not normal times and these are not normal markets but I haven’t seen any undue stress on the system.”
Often portrayed as the wild west of trading, the futures industry model with its central counterparty clearing, mark-to-market accounting and customer-fund segregation rules has proven to be much more structurally sound than the investment bank and OTC model (see “Clearing the air”).
There has been speculation following the recent events that Treasury Secretary Paulson’s Blueprint for a Modernized Financial Regulatory Structure, which was released in March, is more likely to be implemented. Part of that plan involved merging the CFTC and SEC. Given what has occurred since July of 2007, it would be appropriate for the Treasury, Federal Reserve and the next administration to take a look at how the various market models and regulatory structures have performed during this crisis.