Gain an insight into what happened the week Wall Street went into meltdown. In this one-off first rate article Peter Lee relays his first hand experience of one of the most significant weeks in Wall Street's history.
This exclusive article delivers a comprehensive day by day account of a truly eventful week in Wall Street's recent years. Containing top data and analysis and compelling editorial this report is a must read for anyone involved in the global financial markets.
Special focus: Sub-prime and leveraged loans
Prelude – Fin de siècle
It all felt a little like the end of an empire – while Bear Stearns nearly went up in flames, Spector and his CEO Jimmy Cayne had fiddled with cards at a pre-arranged week-long bridge tournament. It was soon to become clear that much more than one of Wall Street's most prestigious institutions was in danger of going up in flames.
That the credit bull market had ended in a flurry of bad lending came as a stunning revelation to precisely none of the participants in the wholesale capital markets. They all understood it because they had all played their part in it. Commercial banks had, like investment banks long before them, moved decisively into the business of distributing securities to investors and away from making considered credit appraisals on debt assets they intended to hold for any length of time. They were now paid, and paid handsomely, to gather junk into piles and then shovel it out the door. And even as they shovelled as hard and as fast as they possibly could, they knew for sure just what total junk some of it was.
If prime corporates wouldn’t take on more debt and emerging market sovereigns were swimming in wealth, then the system would turn round and lend to anyone it could. The two fastest-growing segments of the financial markets had been sub-prime mortgages – including many extended at high loan-to-value ratios to borrowers with no job, no income, no assets – and Alt-A mortgages to the self-employed who simply filled out forms declaring their earnings, which were then not checked – and loans to companies that private equity funds had bought at unsustainable leverage multiples.
It had been abundantly obvious since February, when HSBC took a $10.6 billion provision against bad debts in its US mortgage unit, mainly against so-called second-lien or piggy-back loans, that the hits would soon be felt across the financial system. As long ago as December 2006, Euromoney had reported on the coming crisis in sub-prime and on the debacle of a leveraged loan market that was now pumping out loans that could not be, were never meant to be, repaid, but rather refinanced by the greater fool (Have Wall Street banks gone sub-prime at the wrong time?).
These, Euromoney pointed out, were not loans that had become distressed because of unforeseen setbacks to the borrower’s business: they were distressed loans from the minute they were written.
Now, in the midst of the summer slowdown, just as Wall Street had sought to take a breather before returning in September to distribute a record pipeline – $330 billion or more by some estimates – of these toxic leveraged loan deals, the blows were suddenly landing thick and fast.
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The failure of two credit hedge funds spooked the credit rating agencies and investors, leading Bear Stearns to remove its president, Warren Spector |
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The previous week, beginning August 6, had been dominated by the decision of Bear Stearns to dispense with its co-president, Warren Spector, in the aftermath of the failure of two credit hedge funds making leveraged investments in CDOs. The firm had been put on ratings watch over the possible hit to future earnings from associated reputational damage.
It all felt a little like the end of an empire – while Bear Stearns was getting burnt, Spector and his CEO, Jimmy Cayne, had fiddled with cards at a pre-arranged week-long bridge tournament. It was soon to become clear that much more than one of Wall Street’s most prestigious institutions was in danger of going up in flames.
Bear Stearns had responded with a call to reassure investors that it had the financial means to withstand short-term uncertainty – unused, committed secured bank lines for $11.4 billion, another $11.4 billion of cash and a further $18 billion in unencumbered collateral; it had cut commercial paper outstandings to $11.2 billion at the start of August from $23 billion in January and had $68 billion of equity and other debt capital of greater than one-year maturity.
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"I’ve been at this for 22 years. It’s about as bad as I have seen it in the fixed-income market during that period of time"
Sam Molinaro, Bear Stearns |
The market didn’t listen to these details. It simply heard a large broker-dealer gauging the strength of its defences against an impending financial emergency. The headline quote came from Sam Molinaro, chief financial officer. How bad were market conditions? "I’ve been at this for 22 years. It’s about as bad as I have seen it in the fixed-income market during that period of time."
In the same week, German regulators had to orchestrate a taxpayer-funded bailout of IKB, a bank that, in an effort to diversify exposure from its core function of lending to the German Mittelstand, had used cheap, short-term funding to acquire higher-yielding sub-prime mortgage exposure through Rhineland Funding Capital Corp.
By the end of the week, the markets were jumping at shadows, seeing threats everywhere. Curiously, attention seemed to be distracted away from the initial source of the market disruption. Little notice was paid to a 2.8% fall in the share price of Countrywide, a leading originator of American mortgages. Instead, the admission by BNP Paribas that there was no longer a functioning mortgage-backed securities markets against which to value the assets in three of its funds and that it could therefore not establish the net asset value of these funds and so was temporarily suspending investors’ redemptions, seemed to spark a new panic.