In the first article of this series, I described the first public indications of the subprime meltdown and my reaction to them:
The stock market was too high and it was May (sell in May and go away). So I made the hard decision to sell based on overall market timing rather than company specifics. Companies that I had owned for a long time were hard to part with. Mostly, I pared positions instead; these are good companies, I thought. “Raising cash—weeding” my notes say from May 11 to May 16, as I sold or significantly trimmed eleven positions.
If I had continued doing what I did those six days, I would have looked like a genius. Unfortunately, I was not sufficiently disciplined, as I will explain in the next article of this series.
This is the next article, and it is a bit embarrassing. But first some historical description to put you back into the picture of June to August 2007.
The Bear Stearns Hedge Funds
In June, two hedge funds managed by Bear Stearns got into serious trouble and failed. The two funds had leveraged up by borrowing through short-term repos of their complex CDO securities. When the CDO securities fell in value, the lending banks, including Merrill Lynch, demanded more collateral. The hedge funds had over $11 billion of repo debt. After a short period of time, they could no longer meet the margin calls. Merrill Lynch tried to sell out the collateral but couldn’t even get bids on much of it. It was at that point that everyone who was watching knew the subprime-backed CDO market was in serious trouble. They may not have understood all the implications (I certainly did not). But anyone who cared to look knew you could no longer sell real-estate-based CDOs for anything like their original values.
The leverage involved in the Bear Stearns hedge funds situation was awesome. Here were these hedge funds that had bought CDO-squareds that by their nature were already at least doubly leveraged, and they were leveraging them another almost-100%. And who was lending to them? Banks that themselves were leveraged 30-to-one! At the base of the pyramid there was like one dollar of capital for every $300 of assets. And many of those assets were subprime loans! That’s why the Great Unwind eventually broke so much china. There was just no cushion for losses in the system as a whole. But most of us did not know that in June of 2007.
The failure of the hedge funds it had sponsored did not kill Bear Stearns. It died nine months later of related causes.
I was not the only one who did not understand the implications of what I was reading about. Even many CEOs of financial companies did not. I am sure you have read Citi’s now-former Chairman Chuck Prince’s infamous remark: "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing." Prince told the Financial Times on July 10. The bull dies hard.
The Guns of August
Like World War I, the coming crisis was heralded by the guns of August, a series of economic shocks that tore away—or should have torn away—the comfortable façade that all would be well. Signs of how sick the American mortgage market was appeared in Europe. This should have suggested that the problem might be global in scope. But as we will see, the stock markets paid it little heed and continued to go up until mid-October.
The Strange Case of the Landesbanks
In August 2007, when the first liquidity crunch of the crisis erupted, almost nobody knew there was any connection between German banks and the U.S. real estate market. Those taken by surprise apparently included some of the most knowledgeable and sophisticated financial columnists in the world. As Gillian Tett of the FT asked at the beginning of her column on August 2, “How do you say ‘yikes’ in German?” (My friend Siegfried Elsing, a leading German lawyer, tells me the best translation probably is “Huch!”)
Quite incredibly, hundreds of billions of dollars of SIVs (Structured Investment Vehicles in the then-current euphemistic Wall Street jargon) and other conduits had simply flown under the radar of the financial press. Even the term “SIV” is not to be found in the archives of the FT until August 2007—and even then, only after two weeks of reporting on the Landesbank/SIV story!
Globalization and the international impact of derivatives on bank failures are nothing new. As far back as 1974, at a time well before “globalization,” “financial derivative” and “deregulation” were common words, Herstatt-Bank of Germany failed because it had misjudged the foreign exchange market and incurred severe losses. Franklin National Bank in New York failed as part of the domino effect at that time, also in part because of foreign exchange losses.
Before August 2007, most Americans had never heard of Landesbanks. Having followed banking over the years, I had heard of it, but I did not know what it was. So it came as a surprise to me to learn that it was a form of state-owned bank that had been established after World War II to lend to savings banks (the Germans have hundreds of small savings banks—called Sparkassen) and small businesses. SachsenLB was set up in East Germany after reunification in 1992. It was the weakest of the Landesbanks.
Unfortunately, the original Landesbank business plan did not work in the world of the European Union and modern finance. The savings banks and small businesses developed other, cheaper sources of credit. They did not really need the Landesbanks any longer. And the easy funding that the Landesbanks had enjoyed due to guarantees by the state governments was withdrawn in 2005 after the EU had ruled that the guarantees constituted unfair competition. Thus in 2004 and 2005, the Landesbanks were looking for new sources of income. For some of them, the only alternative to finding new business was to go out of business, and even state-owned enterprises do not like to admit that they have no purpose, nor do people like to give up jobs that pay quite well. Some of the Landesbanks already had tried international lending operations and had lost money on that.
As happens so often when a business plan has failed, someone comes along and offers to provide a “Hail Mary.” In this case, Barclay’s, Citi and other major banks were willing to show the smaller German banks how to set up offshore conduits that buy high-rated asset-backed securities (often sold to them by affiliates of the aforementioned large banks) and fund those securities with the sale of subordinated bonds and asset-backed commercial paper (also underwritten by the aforementioned large banks). The conduit would not appear on any bank’s balance sheet, but the sponsoring bank (the Landesbank in these cases) would earn fees for managing the conduit and for giving it a line of credit. Some people called it an arbitrage. You and I would call it borrowing short to lend long. You and I would call it issuing a line of credit that would be called on only when to provide the funding would result in an almost certain loss.
Two of the largest of these SIVs were IKB’s “Rhineland Funding” and SachsenLB’s “Ormond Quay,” with assets of $23 billion and $7 billion, respectively, both of which had been domiciled in Ireland for tax reasons. (These names usually are chosen by a bunch of guys sitting around late at night after having had too many cigarettes and not enough beer.) Initially, the conduits showed profits for their sponsors. But in August 2007, when the world at large realized that the assets of these entities might not be worth enough to pay off the ABCP (asset-backed commercial paper), the banks were forced, under the terms of their lines of credit, to lend to the SIVs so they could repay the ABCP. Neither IKB nor SachsenLB was able to fund its SIV’s line of credit on its own, and both failed as a consequence. In both cases, the ABCP holders were bailed out with the help of the German states (Lander), whose taxpayers footed the bill, but the banks were forced to merge with stronger German banks. In Saxony, the impact was so large that the chief executive of the state was forced to resign.
Asked about the risks they had taken, the managers of both IKB and SachsenLB pointed to the high ratings on the securities in the SIVs and the low risk that they would ever have to fund the lines of credit that they had issued to the SIVs.
The German banks were not the only ones in Europe to set up SIV-style conduits. Estimates are that over $500 billion of conduits like these were functioning in Europe at the height of the market in 2006-2007.
Securitization was supposed to disperse risk around the world to those who could hedge it or afford it. The German SIV experience showed that it also got dispersed to those who could neither understand it nor afford it. In some cases, we can see the explanation for that: A failed business plan enticed some institutions into trying to make what looked like easy money.
LIBOR out of Whack
Still in August, something called the TED Spread went crazy.
Outside a few bankers and economists, most of us had never heard of the TED spread? The TED Spread is the spread (or difference) between the rate on short-term U.S. Treasury debt and the rate on 3-month LIBOR. That spread is important because it shows how risky the banks think each other are. From August 8 to August 20, the spread increased from a fairly normal 44 basis points to a totally abnormal 240 basis points, indicating that banks were afraid to lend to each other. See Gjerstad & Smith, “From Bubble to Depression?” Wall Street Journal, April 6, 2009.
The Fed and the Bank of England rushed to provide liquidity to the banks. But the spread stayed stubbornly wide. Money market rates all over Europe reacted similarly despite European Central Bank interventions.
Nevertheless, most investors reacted dismissively. Minor German banks and subprime loans? That couldn’t have a significant impact on the world economy, could it? And that thing about the TED Spread in London was just a technical liquidity problem. Surely the Fed and the Bank of England could deal with that in a modern financial age. Couldn’t they? Well, I must have thought something like that, if the lack of alarm in my notes is a fair indication.
With all this going on, I was a net buyer of stocks in June, July and August. The market dipped and I bought. Maybe I had been lulled by Chairman Bernanke’s remarks on May 17. After all, my selling spree was on May 11 to 16. My notes say nothing about Bernanke’s remarks, but they were front page news, and my notes are about specific buy and sell orders, not my macro take of the day, except indirectly. Or maybe I was just insufficiently self-disciplined.
What did I buy?
The Blackstone (BX) IPO was in June, and I believed that smart people would continue to make money and that, even though the deal was rich and investors had no control, this would be a good long-term investment. I analogized BX as the management company for Berkshire Hathaway (BRK.A) —that is, the management company for a bundle of companies selected by smart people—in this case, using other people’s money. BX is now half the price that I paid, and the nice dividends have not nearly made up for that. I have bought some more at these lower prices, since I am still a believer long-term, but the price was too high, especially in light of the coming economic storm. Private equity does well in bad times by buying at low prices, but it takes the return of good times before the profits are realized. Such companies’ earnings are “lumpy.” I was a chump for buying at too high a price. I hope I am not a chump to continue believe it will be a good long-term investment.
I bought some Tata Motors (TTM), the Indian car company. The demographics looked good, and Tata seemed to have a leg up in its home market. I did not hold Tata long. I sold it about flat because, following the company more carefully after owning it, I decided that its foreign acquisitions suggested a management that either was scattershot or that did not really believe in its own market. I also became skeptical concerning the very small Nano or “People’s Car”.
I bought more Valero (VLO), Ryland Homes (RYL) and AES (AES). I had sold much of my Valero and Ryland at higher prices but I liked the companies and their management, so I was buying back on the dip. Wrong, wrong, wrong. Fine companies, but not in the coming macroeconomic climate. I still own VLO and have bought at lower prices more recently and have done decently buying and selling within the trading range. AES is a company that I like because it has good management and a good plan for continued growth. I continue to add to my holding when the price declines, though I have yet to make much money on it. I sold RYL a few months later, at a loss, but not as much of a loss as I would have if I were still holding it today.
I bought some other, more minor things, including a small company that reads X-Rays remotely so that it can utilize excess radiology capacity anywhere in the world. It seemed like such a good idea, until a few months later I recognized that management was not up to the task, and I sold at a slight loss.
But I should not have been in the market to buy at all. I was in thrall to Dr. Pangloss and refused to believe that this excellent global economy could come crashing down on us.