The Mother of all Margin Calls: Leverage Bites
There was a great article in Thursday's Wall Street Journal about the fragile state of the markets called "Magnifying the Credit Fallout." It explains for the non-Wall Street audience how the $400 billion or so in mortgage losses could be causing such large reverberations, despite the fact that similar sums of money are often lost in equity markets on a daily basis, with no ill effects. The notable difference, the author highlights, is that these losses are taking place at banks and banks are levered about 10:1 - a leverage ratio that is much higher even than hedge funds. I have commented here before about banks' roles in money creation and destruction in a piece called Making Money out of Thin Air. The Wall Street Journal article points out that the losses at banks are resulting in a $4 trillion contraction in their lending capacity due to this high leverage - an impactful number to be sure. Importantly, this contraction is cascading down to other levered borrowers like mortgage REITs (At 12/07 Thornburg had assets of 18x their equity, while Carlyle was levered 36:1), hedge funds (many are down below 2:1 leverage, but some go as high as 7x and higher and several have begun to implode in the last couple of days), leasing companies (Financial Federal who reported earnings the other day has assets of 5x equity, but they fund themselves with long-term debt - obviously smart guys), etc, etc. But perhaps most importantly, the consumer is heavily levered in their real estate holdings. If you put just 10% down on your house, you're 10:1 levered on that investment. While people oftentimes have abundant additional assets too, my bet is this is a pretty good approximation of many such borrowers' overall "household leverage." FYI, the average homeowner has a historically low equity of 47.9% in their homes, which is nonetheless a much less levered position than that of many homebuyers of recent years.
Lately we have been hearing more and more about margin calls - Thornburg Mortgage REIT and a few hedge funds have felt the pain of dealing with a margin call when you are highly levered. For newbies, when an institution or an individual pledges a marketable security as collateral for a loan to buy another marketable security, the bank monitors the value of this collateral constantly. If the value of the collateral declines, the bank may ask for more collateral to be posted by the borrower....the infamous margin call. This will often cause the institution who borrowed money to have to raise new equity capital or sell positions to pay back the bank or boost collateral by some other means. This often happens at inopportune times and the institution often exacerbates its own situation by being forced to sell securities into a declining market.
A version of this scenario is currently happening to banks and I think it's instructive to think of the current situation in financial markets as the "Mother of all Margin Calls." Due to the transition in banking from making whole loans that a bank owns to maturity, to an environment where banks instead assemble packages of loans and sell off the pieces as securities, banking for most large banks has transitioned to an investment banking and trading business. As a result, they are falling increasingly under the purview of "fair-value accounting," which applies to marketable securities. See The Economist's article Mark it and weep for a primer on this subject. The result of the marking to market of mortgage backed securities, and recently muni bonds, collateralized loan obligations and CMBSs has resulted in banks' capital bases being hit hard by write-downs. It has exposed the problem that these most highly levered of all institutions' capital bases are actually much more exposed to market volatility than is comfortable for the financial system. So why the margin call analogy? In this case the margin lender to the banks is the Federal Reserve. The collateral level that the Federal Reserve requires the bank to maintain is called the regulatory capital requirement. So you can think of the stock offerings and sovereign fund investments the banks have been indulging in lately to boost their capital levels as reactions to the potential threat of getting a margin call from Uncle Ben Bernanke.
It is no wonder that banks are nervous about lending. They need to harbor their scarce and volatile capital, in case of future losses or just securities price declines. It's no wonder they are nervous about lending to each other - read about this phenomenon in the Economist' s When the rivers run dry.
So when will banks feel better about their positions and the security of their capital bases? They keep saying they have enough capital, but then they raise more. (I don't need to tell you they would never admit to being worried about their capital levels as that would be like yelling fire in a crowded theatre.) We all now know that their models for defaults on various securities have stunk so far. Since we are sliding into a recession, with tons of consumers levered 10:1, they are probably useless altogether. But eventually we will get through this and banks will feel better because:
1) They raise so much capital that the margin call issue becomes moot.
2) Real estate and other riskier debt securities have a huge rally.
3) The delinquency trend starts to visibly improve.
Let's think about each of these scenarios. The huge capital raise is a possibility, but let's face it, they have raised a lot and at least one sovereign fund is sounding like they aren't ready to pony up more money to save Citibank. I think a lot of the investors who bought the recent offerings by Citibank and Merrill actually bought into the "margin call" scenario and figured they could make a quick killing by helping relieve an acute but short-term liquidity squeeze situation. They probably aren't betting on a quick fix of this nature anymore. With regard to scenario #2, higher-risk debt securities could have a big rally if investors believed that they were very cheap even in a historically high default level scenario. Indeed, both Pimco and Wilbur Ross appear to feel this way about municipal bonds and their buying has helped support the market recently. However, my guess is that most of the buyers of this ilk are long-term investors, who can and need to be able to absorb short-term pain and by definition, use little or no leverage. This means they have to use much more capital to offset any selling by any entity receiving a "margin call." They can cushion the fall, but they probably can't stop it, or they already would have. With regard to the last scenario. The end to the delinquency trend seems nowhere in sight. Freddie Mac had this to say about the housing market and defaults on its recent earnings conference call:
The large decline in house prices in the fourth quarter has led us to increase the expected decline in our median house prices pass to approximately 15% peak to trough causing us to increase our expectations for expected default cost. While the relationship between house prices and defaults is clear, the forecast for expected defaults is not precise. This is particularly true in this environment as the rate of decline nationally is without recent precedent and the lack of correlation between unemployment and declining house prices is also unusual.Of the total 15% decline in home price nationwide that Freddie expects, they have only seen 5 percentage points of it so far. That said, they feel that they have written down their portfolio enough, so that they will actually see a large amount of reversals of write-downs as the market improves. Let's hope they are right as Fannie and Freddie are the most levered of all financial institutions at 40:1....Woof!
Not much to be positive about regarding this liquidity crunch, it will take time and absorption of the many losses to come before conditions are likely to improve. The wheels of de-leveraging are in motion and they will likely have to travel many miles through this great unwinding before we see a return of normal liquidity to the markets and the economy. You can be sure regulators are thinking about these things and will be doing their part to move the unwinding along, by clamping down on the use of leverage anywhere they can. Same as it ever was.
From the Blogosphere
Carlyle Capital receives default notice after failing to meet payment demands.
Citigroup to shrink mortgage portfolio
Hedge funds stem exits as credit lines tighten
Long-Term Capital's Meriwether hedge fund loses 9% this year
KKR and Carlyle Funds in Deep trouble
Peloton lays blame on Wall Street lending crackdown for hedge fund liquidation