Federal Reserve & Interest Rates

The last two remaining independent investment banks, Morgan Stanley and Goldman Sachs have seen the writing on the wall and have applied to the Federal Reserve in order to convert into commercial banking institutions.

The Wall Street that shaped the financial world for two decades ended last night, when Goldman Sachs Group Inc. and Morgan Stanley concluded there is no future in remaining investment banks now that investors have determined the model is broken.

The Federal Reserve’s approval of their bid to become banks ends the ascendancy of the securities firms, 75 years after Congress separated them from deposit-taking lenders, and caps weeks of chaos that sent Lehman Brothers Holdings Inc. into bankruptcy and led to the rushed sale of Merrill Lynch & Co. to Bank of America Corp.

The big issue is the ability to raise capital by the cheapest means possible and right now that is by taking on deposits.  Investment banks normal method of raising capital, selling bonds has become very expensive, the bond market has been chaotic ever since bond insurers had their credit rating downgraded which sent interest rates upwards across the board.

Another method of raising capital is to sell equity but that is never popular with shareholders since it reduces the value of their existing stakes.  Morgan Stanley had agreed to sell a 20% stake to Mitsubishi UFJ Financial Group Inc. for about $8.4 billion when it was unable to find a U.S. bank to merge with.

A big change for the two companies is that it will now be regulated by the Federal Reserve instead of the Securities and Exchange Commission.  Another big change will be that they will now fall under U.S. deposit laws which will most likely lead to less risk taking by both companies.

Although the change will provide the two companies with much more long term security it may also mean lower profits.  Despite the upheaval of financial markets over the past year, both companies were still able to report positive net earnings although greatly reduced from previous years.

The positive to take out of all of this is that both companies are well placed to become powerful commercial banking institutions.

The financial system has been choked off by a lack of liquidity in the form of mortgage assets that no one wants to buy.  Treasury Secretary Henry Paulson has brought forth a plan for the government to become a buyer of last resort.

These illiquid assets are clogging up our financial system, and undermining the strength of our otherwise sound financial institutions. As a result, Americans’ personal savings are threatened, and the ability of consumers and businesses to borrow and finance spending, investment, and job creation has been disrupted.

The federal government must implement a program to remove these illiquid assets that are weighing down our financial institutions and threatening our economy. This troubled asset relief program must be properly designed and sufficiently large to have maximum impact, while including features that protect the taxpayer to the maximum extent possible.

The plan would be an unprecedented bailout of the financial system that is estimated at a whopping $800 billion.  I think the government finally realizes that monetary policy can only do so much on it’s own and that a fiscal plan was also needed to head off financial disaster.

The problems of the financial services industry is slowly getting worse, this week saw three financial giants brought low.  The Fed had to issue an emergency $85 billion loan to AIG to keep it from a disorderly collapse, while in investment banking, Lehman Brothers declared bankruptcy while Merrill Lynch sold itself to Bank of America at a fraction of it’s former value.

The banking system is clearly in big trouble and I’m not sure if the Federal Deposit Insurance Corporation has enough reserves to insure the deposits of Americans from the growing number of banks that are in danger of failing.  Credit is being choked off at the source as banks are stuck with assets that they are unable to sell.

Financial institutions raised hundreds of billions of capital to deal with writedowns from the subprime collapse but they are loathe to loan that money out.  The big problem is that the financial sector is so intertwined these day that even relatively strong financial institutions are worried about counter party risk so they are hoarding capital to protect themselves for when their weaker brethren start to fail.

This plan definitely puts taxpayer dollars at risk but the alternative could very well be a financial Armageddon that could plunge the world into another Great Depression.

In exchange for a 80% equity stake in American International Group, the Federal Reserve has agreed to lend up to $85 billion so that it can avoid a disorderly collapse that could adversely effect global financial markets.

The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.  

The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy. 

The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility.

This is far from a government handout, with the current Libor rate, AIG is on the hook for over 11% interest rate for the 2 year loan.  The loan is in place for the sole reason so that there can be an orderly sale of the company’s assets.

While AIG was in talks with Morgan Stanley and J.P. Morgan Chase in order to secure a $75 billion lifeline, apparently those talks broke down leaving the company no choice but to accept the government’s offer.  The world’s largest insurer has been brought low by losses stemming from credit derivatives it sold on Collateralized Debt Obligations most notably Mortgage Backed Securities.

These credit default swaps are basically insurance policies that investors purchase to protect themselves from losses.  In case of default, the seller of the swaps makes payment to the purchaser for the principal or face value in exchange for the underlying security.

When the housing market was booming this was pretty much free money as they never had to make any payments.  Now, with defaults and foreclosures at record levels, the payments have flowed out like a torrent which has pulled AIG under.

AIG’s former CEO, Hank Greenberg, who is also one of it’s largest shareholders has come out in criticism of the plan stating the company merely needed a temporary loan not a government takeover and breakup.  There is a good chance that stockholders could be wiped out after the dust settles, though frankly management has done a good job of that themselves as the stock has lost over 90% of it’s value over the past year.