The investment banker finishes the last forkful of his fish, leans back in his chair, plants his fists on the table edge and, gazing into the middle distance, appears to reflect. “I probably shouldn’t tell you this,” he says after a short pause, “but this firm had its best day ever for sales commissions yesterday. Not its best day this year,” he hastens to add. “I mean the best day in its history.”
Ten days have passed since the destruction and mass murder at the World Trade Centre in New York and in many small ways the natural order in the financial world is starting to reassert itself. Investment bankers are competitive, ruthless and driven by the desire to make money. Rather than panicking because world stock markets have fallen sharply since the attack – the same markets that they were encouraging investors to buy into until recent months – equity traders are delighted to be earning commissions on huge volumes in share trading as those same investors scurry to get out. Whether it’s the Bass family selling Disney shares to meet margin calls or insurers forced into selling to meet policy payouts and maintain regulatory capital ratios is irrelevant: it’s all volume. If the market continues to be volatile, with rallies following sell-offs, so much the better.
For broker-dealers, it’s not falling markets that are the problem, but quiet markets when clients neither buy nor sell. That may lie ahead, if the sell-off following the attacks is followed by a funk period when nobody does anything very much – as in the months following the 1987 stock market crash. But markets have been anything but quiet in September. And somehow it’s reassuring to hear investment bankers boasting and griping in the usual way. This banker’s biggest complaint is that the firm’s temporary New York offices don’t have the normal dedicated phone lines to institutional investors that customers can open simply by touching a screen. He fears that investors will turn to other brokers rather than bother to pick up their phones and dial into his firm’s new offices.
Nemir Kirdar, president and chief executive officer of Investcorp, bridges the Arab and the Western worlds, identifying private-equity opportunites in America and Western Europe for Gulf investors. He declares simply that September 11 was “an unforgiveable day”. But he remains sanguine.
“Whenever you have a major catastrophic incident of this sort it creates shocks in the marketplace and people’s reaction has been very predictable throughout the decades,” he says. “In this situation some people want to move to liquid assets. But that is a short term reaction and the short-term move to go liquid reverses itself.”
Banks get drafted
As if the fatalities and bleak trading difficulties were not enough, international banks find themselves dragooned into the war against terrorism by Washington. Described as “draconian” by the White House, an executive order gives the US sweeping powers against international banks that have dealings, however tenuous, with international terrorists.
Firms need no prompting to take profits while they can, both to make up for lost revenues from the days when the markets seized up after September 11 and because problems abound in core investment banking. In equity new issues and M&A, volumes have already been falling for almost 18 months. And though financial markets began operating again with impressive speed after the attacks, central bankers excelled themselves, and back-office and support staff at firms and exchanges worked round the clock to get systems operational, the outlook for the financial services industry is not encouraging.
Markets have been falling since the end of March 2000 when the tech stock bubble burst. That has robbed investment banks of revenue from managing IPOs and advising on mergers and acquisitions, which always decline in bear equity markets, even though target prices come down along with, or faster than, acquirers’ share prices.
One European business head at a leading firm tries to put numbers on it. His firm figures that European clients spent something like e14 billion to e15 billion on investment-banking services in 1999 and e10 billion to e12 billion in 2000. For this year it had hoped that business would be flat, or, given luck, even up 10%. It now looks likely to be down 50%. It’s a similar picture in the US, where the hoped-for recovery in investment banking revenues in the fourth quarter of 2001 has now been delayed indefinitely.
The largest firms could bear such low levels for a few more months but unless prospects of a recovery are visible early in 2002 there will be big lay-offs. Just in case any of his teams were still inclined to mope around watching CNN, this banker quickly decided the best way to snap them back to attention was to call a client review meeting starting at eight on a Sunday morning to ask where revenues were going to come from. He gave his staff one week’s notice to prepare their presentations for delivery 12 days after the attack. “This is like Formula One racing,” says this investment banker. “While the safety car is out on the track after an accident, everyone slows down together. As soon as the wreckage is clear, the top drivers press the metal to the floor.”
For a short while after the attacks, no-one had time to worry about that sort of competition. Bankers restrained their instincts and rallied together. Firms offered each other spare office space, agreed to extend settlement times in some markets and declined to press for timely settlement when counterparties had obvious operational problems. “We had a bit of an investment bankers’ love-in,” says a source at a European firm. When ICAP, the leading interdealer broker in the swaps market, resumed limited broking operations in New York on Monday September 17, six days after its offices were destroyed, it publicly thanked 17 separate institutions – including banks, investment banks, brokers and even news organizations – for offers of assistance.
There was concerted action on how and when to reopen the markets: on Thursday 13 September the heads of the major investment and commercial banks, prompted by SEC chief Harvey Pitt and New York Stock Exchange head Richard Grasso, met at Bear Stearns’ mid-town office, and again a day later at CSFB, to discuss just that.
It even led to an apparent rapprochement between Morgan Stanley’s CEO, Philip Purcell, and John Mack, his former number two, now CEO of CSFB. “Wall Street has this amazing peculiarity,” says David Komansky, CEO of Merrill Lynch. “It’s usually viciously competitive, but we all pull together at times of crisis.” But, he says with a hint of a smile nine days after the attack, “we’re talking to each other a lot less than we were last week. We all much prefer to compete with each other.”
Central banks were quick to recognize the short-term dangers and responded in a reasonably well coordinated way. “The terrorist attack markedly disrupted payment transfers that are usually measured in terms of trillions of dollars each day,” Federal Reserve chairman Alan Greenspan told the Senate banking committee on September 20. “Many obligators temporarily lost their technical ability to pay on time, leaving those counting on receiving payments caught short.” Those pressures quickly ended up concentrated in the banks, and the Fed acted quickly to ease them with a massive infusion of funds through discount window lending and open market purchases of collateral.
Normally the Fed frowns on any bank borrowing emergency funds through its discount window. This has been rare for the last decade and such borrowing normally carries a stigma since it signals that a bank is in trouble. Under these utterly exceptional circumstances the Fed encouraged such borrowing, and suggested that banks in turn should contact corporate customers and persuade them that they could draw down on back-up bank credit lines without worrying that this would damage their credit standing. It did $81 billion in reverse repo trades on September 14, compared with a more normal $10 billion.
Indeed the unprecedented scale of this injection of liquidity took some time to sink in. US banks have to maintain a minimum level of reserves as an average of their deposits over a two-week maintenance period either in cash or in a non-interest bearing account with the Fed. If banks have an excess of these reserves – as they tend to – they trade them with each other at the Federal funds rate. By September 19, the value of excess reserves available to the US banking systems – provided by discount window lending and open market operations – was $39 billion, compared with $1.6 billion during the
second half of 1998 after the Russia and Long-Term Capital Management crises.
According to David Greenlaw, senior economist at Morgan Stanley, this suggests that severe dislocations in the banking system in the immediate aftermath of the attack, when banks could not assess their reserve positions because of problems in payments and settlements, led banks to hoard reserves unintentionally. On September 19, towards the end of the week following the attack, as banks resolved these operational difficulties, the effective average Fed funds rate fell as low as 1.2%. Greenlaw notes that it may take days or weeks for the effective rate to rise to the 3% level to which the Fed cut its official rate on September 17. “Clearly [for the economy] it is the real rate that matters,” suggest Greenlaw. “If 3% does turn out to be the ceiling, then the September 17 rate cut amounted to more than 50bp.”
Meanwhile even before the Fed first acted, the European Central Bank had injected e70 billion of overnight funds on September 12 and e40 billion the following day. “The exercise was more a confidence-building one than one deriving from objective liquidity tensions in the money market,” says a source in Frankfurt. By Monday, the ECB was following the Fed’s lead, cutting rates after the Fed had cut before the US stock market reopened. “We are in daily contact with our counterparts in other important central banks,” says the source in Frankfurt. “The ECB is coordinating its activity with the Federal Reserve System and other major central banks of the world. One could even talk of intimate contacts among the major central banks.” He adds: “In the ECB’s assessment the critical moment for operational and systemic risk has now passed.” This was on September 20.
Bankers say the sense of coordinated central bank response was crucial in the first days after the attack – even before the rate cuts that came in the week of September 17. “It was very reassuring,” says Jack Malvey, global head of fixed income strategy at Lehman Brothers. “Injections began in Asia, then Europe followed on the Wednesday morning and the US jumped in. The central banks were saying: ‘Whatever you need, we’re here. We’re not going to let a major institution go down.'” CSFB’s credit strategists, led by David Goldman, said in a report on September 17: “In effect, the authorities have ring-fenced the financial system. Financial stability has become a matter of national and global security.”
With the immediate danger of a crisis in the payments system apparently averted, it did not take long for those at less badly affected firms to separate their natural human sympathy for the lost and bereaved from an unemotional return to business. For all the talk in the first few days after the attacks of firms denying facilities to short-sellers and for all the encouragement of patriotic buying, traders were admirably hard-headed and pragmatic.
Lehman Brothers had conducted a full practice run of its disaster recovery plans during the second quarter of this year. These had first been drawn up after the bombing of the World Trade Centre in 1993 and further refined amid the fears about computer failures in the run-up to the year 2000. On September 11, this exercise, which had involved employees from the most junior to the most senior, stood the firm in good stead. Within minutes of the first attack, its short-term risk managers were on their way to back-up offices.
After checking and confirming its risk management systems and ability to clear and settle, the firm’s traders quickly turned to their own portfolios. “You might have been short quality assets and long riskier assets, so you needed to cover that short position straight away and then think about liquidating riskier assets and running a smaller balance sheet,” says Malvey. So that would have been done in the first few days? “In the first few hours,” says Malvey. “It’s one of the enduring lessons from the 1987 stock market crash: cover your bond shorts. You may not want to be long, but you certainly don’t want to be short.”
And what did the firm advise its clients to do? “First, check your portfolio, try to decide what you’re not comfortable with and then figure out if you want to sell it, because for certain smaller, less liquid assets it might be difficult to get prices for a few days,” says Malvey. “Many are going to be defensive for the next couple of months. But there are already investors, including hedge funds, hunting for value on a medium-term view. Just as 1990 was the best time to buy US junk, now might be the time to buy the best-quality high-yield debt you can find.”
Similar things were happening at banks and investment banks across the US and worldwide. Rather like rebooting a computer system, financial firms, investors, issuers, regulators and exchanges reopened markets in simpler instruments first and slowly worked through more complex, longer-dated, riskier assets. By two days after the attack, the US treasury market was functioning, though liquidity was poor. Some commercial paper was being rolled over, though primary bond markets were closed and corporate bonds traded in the secondary market on a T+3 day settlement cycle rather than T+1.
Emerging-market bonds were trading at 30% to 50% of their normal volumes, according to JPMorgan, and on T+5, rather than the normal T+3. Customers were at least able to sell and did so, while some traders covered short positions. In Europe, MTS, the electronic bond trading platform for European government bonds, found that 90% of market participants were connected and all markets were trading at volumes only slightly below the normal average and at spreads only marginally wider than normal. Equity markets in the US remained closed.
By Monday September 17 the New York Stock Exchange and Nasdaq reopened after frantic efforts by technical staff over the weekend. The operations of Bank of New York, a leading player in custody and clearing, had been particularly badly hit by the attack after 8,300 employees were evacuated from its downtown offices. It appeared that the bank’s primary and back-up systems were knocked out together, and this, combined with disruption to many of its clients’ systems, led to a bottleneck in processing and payments problems. This spread concern through financial markets. The bank struggled to cope, but quickly leased 600,000 square feet of office space in midtown Manhattan spread over 17 addresses and strove to set up auxiliary systems at remote locations. When stock markets reopened, it was able to cope with the huge volumes and by Friday September 21, chairman and chief executive Tom Renyi felt able to tell staff: “All of our processing systems are now completely recovered.”
The primary bond markets reopened that week with deals from high-quality and agency issuers, including a $5 billion 10-year Freddie Mac reference note, which had been due to price in the days after the attack and was delayed until the following week, and issues from the Inter-American Development Bank and the World Bank. Corporate deals re-emerged in the US credit market. Indeed rarely can such a feeling of relief have surrounded the successful completion of a one-year FRN for GE Capital Corporation. And those competitive instincts appeared to have lost none of their edge when several banks declined invitations to join the syndicate for a Walt Disney bond, saying it was the wrong credit at such a time. They happily left it to sole lead manager Goldman Sachs.
Though many bankers see it as their duty to resist the terrorists by proclaiming that markets are back to normal, clearly they are not. John Kim, CEO of electronic corporate bond-broking firm BondBook, says “US treasuries are trading at 20% to 25% of their normal volumes, and are likely to continue to do so for the foreseeable future. And there is virtually no activity in the US corporate bond market.” According to the Bond Market Association, daily US treasury turnover is usually in the region of $140 billion in the inter-dealer market and $150 billion for investors, but is now around just $30 billion in each; corporate bond trading has slumped to $2.5 billion a day, from an average of $15 billion.
The attacks have hit more than just the desire to trade; they also destroyed much of the infrastructure, and killed many of the brokers. Eurobrokers, ICap (formerly known as Garban Intercapital), TradeWeb and of course Cantor Fitzgerald were all based in the Twin Towers. Cantor Fitzgerald was by far the hardest hit. Based on some of the top floors of the north tower, the firm lost over 600 of its 1,000 employees, including Fred Varacchi, its president and COO of Cantor’s electronic trading platform, eSpeed.
All are back up and running in some form or other, using offices they had for back-up, or more often using premises provided by other financial institutions. TradeWeb is based in London for the time being.
It’s far too early to gauge the longer-term effects of the bombings on these firms, and on liquidity provision in the treasury markets. Cantor, for example, has long been the dominant treasury dealer, owning on average a 25% market share, and way over 50% in some of the more liquid maturities. Cantor had been moving as much of its flows as possible onto eSpeed and therefore, in theory, should be more able to withstand the loss of so many staff. But clients will be looking for a secure place for liquidity, which might involve using voice brokers more, or switching to platforms unaffected by the attacks.
That doesn’t rule Cantor out by any means: its eSpeed platform is one of the most robust in the world of electronic trading and is used in all its offices, not just New York.
Already, though, there are other liquidity providers coming into the market, whether as new or as larger players: the banks have been stepping in, as has another electronic platform, BrokerTec. It was set up as an inter-dealer platform for trading both cash and futures by several investment banks in 1999, and just two days after the attacks announced that it would be providing price data to any market participants that could get connected.
There is, at least, liquidity in the treasury market. The same cannot be said for the corporate market where high-grade and high-yield issuance and trading is at a near standstill. It could be a near-repeat of 1998, when several banks found themselves stuck with inventories of bonds which they could not sell, and which they were forced to mark to market, leading to heavy losses at firms such as Merrill Lynch and Goldman Sachs. Investors, too, are staying out, but that will change, explains BondBook’s Kim. “There is a huge difference at the moment between liquidity makers and liquidity takers in terms of price. Investors will at some point want to get back into the market again, but banks might not have either the staff or the liquidity to match.”
Liquidity is also a concern for corporates whose route to the capital markets might now have been indefinitely blocked. With interest rates falling, issuing longer-term debt does look attractive, but the markets are waiting for the larger issuers to make the first move. “What we really need is a two-year or more deal from one of the big credit card or auto companies,” says a debt investor. In the meantime, says one investment banker: “You can expect to see us and other pure investment banks using our capital to help our clients much more than before.”
What happens next is, as bond and equity analysts and senior executives at banks and investment banks all now cheerfully admit, anybody’s guess. Clearly there is a risk that victory has been declared too early on the soundness and safety of the financial system. It took weeks after the Russian default on its own domestic bonds for the stresses to emerge in the world financial system at a little-known hedge fund called Long-Term Capital Management. Counterparty credit risk analysts at the larger firms must stay on high alert. All will be poring over reports of banks’ loan exposures to stricken industry sectors such as insurance and airlines – information that credit rating agencies were scrambling to piece together as Euromoney went to press. Syndicated loan arranger rankings – which put Mizuho, ABN Amro and JPMorgan on the watchlist for exposure to airlines – are not much to go on.
Moody’s analysts, looking at what they call September 11 risk for large US banks – that is credit risk arising from exposure to directly affected industries such as airlines, insurance, lodging and tourism – have so far found nothing to lead to any ratings downgrades.
Recessionary imponderables
The real worry is bank’s exposure to a general recession, which most economists conclude must now follow in the US. Credit analysts draw comfort from the huge earnings capacity of the largest US banks, which reported core pre-provision earnings of $115 billion in 2000. Earnings could fall by 20% and credit costs double and the industry would still generate $40 billion of surplus earnings, Moody’s analysts suggest.
| September 11: the first response was to flee | ||||||
A further imponderable is the extent to which extraordinary official sector and government intervention will support, or even distort, markets and the economy in the US and worldwide. One of the Fed’s first decisions was to ease for a few days its normal capital requirements on banks. It also encouraged banks to show forbearance to borrowers – for example to waive penalty fees on late payments for loans where disruption had prevented timely payment. These are meant to be temporary measures designed to prevent short-term disruption of the financial system from damaging the real economy. The worry is that extended relaxation of lending standards will store up credit problems that banks will have to face in the future.
Within days of the attack US airlines were lobbying for up to $24 billion in government aid, loans and loan guarantees to see them through the crisis. The UK Treasury agreed to provide an indemnity for third-party war and terrorism liabilities above the $50 million most insurers were offering UK airlines just to keep them flying. The EU may be pressed to relax legal impediments to airline bail-outs.
But how far should governments support inefficient industries that were already struggling before the attacks? And what other troubled industries might now assert their strategic importance and hope to receive government help that might cover up their own past mistakes – telecom companies, for example? There may be a political imperative here – president George W Bush may choose to support industries and prevent lay-offs to protect his high approval ratings from slipping as military action begins and more lives are lost – but free markets should be allowed to operate as fully and as soon as possible.
In the UK, the Financial Services Authority (FSA) relaxed its resilience test guidelines for insurance companies in an attempt to shore up the stock markets by preventing forced selling. Meanwhile several large UK investing institutions including HBOS and Legal&General have cancelled stock-lending programmes. Their reasoning: this merely facilitates short-sellers and permits them to drive down the value of stocks these institutions hold for the long term. That same argument could have been made before September 11. Institutions certainly could defend this course of action as clearly financially self-interested. But short-selling should not be demonized: it’s a feature of efficient markets.
Negatives and positives
Much of the financial system is not ring-fenced: only those whose failure would bring down the entire system will be bailed out. Others will now have to cope with weaker earnings as the recovery in investment banking revenues looks likely to be further delayed, and expenses will increase for banks struggling to find new office space and replace damaged IT. (TowerGroup’s first estimate is that it may cost $3.2 billion to replace the technology hardware and software destroyed in the World Trade Centre.) Firms will be reluctant to announce lay-offs so soon after the funerals and memorial services for many friends and colleagues. Weak earnings may make some firms more vulnerable to takeover, possibly adding fresh impetus to the consolidation of financial services.
|
Grounded: aircraft stranded at Orlando and other airports prefigured massive erosion of airlines’ business |
||||||
What are the positives? The yield curve is now very steep. As the Fed reduces short-term interest rates and investors worried about the economy sell off longer-dated assets this may persist for some months. Such a steep yield curve, engineered by the Fed, proved to be powerful medicine for the banking industry in 1991, allowing a recovery for institutions then teetering on the brink. As recovery took hold there quickly grew up a market for distressed assets into which banks could sell problem loans to providers of new capital. The yield curve may perform a similar function this time – making it easier for struggling debtors to service their obligations and allowing for a prudent degree of short funding of longer-term assets by financial institutions, as well as securing them some windfall gains on short-term debt portfolios. The only downside for banks from low rates is a lower arbitrage on their investments of free-of-cost balances.
The steep curve may also provide some inducement for borrowers in the bond markets to push out large volumes of shorter-dated debt, though the instinct of many is to replace short-term debt with longer maturities so as to reduce exposure to roll-over risk. Short-term markets, though least risky, are often among the most nervous. You only have to look back to the end of last year when a number of investment-grade companies were downgraded to BBB or even junk status. It was a destabilizing event for the commercial paper market: banks wouldn’t supply the back-stop credit lines, investors wouldn’t invest, or both. For many commercial paper issuers, the market was all but closed for several months.
Convertible bonds provided an alternative for a few months at the start of this year, as interest rates dropped but equity markets volatility remained high – excellent conditions for convertible issuance, and conditions which appear to be repeating themselves now. “We could see a good amount of converts issuance in the next month or two,” says Robert Shafir, head of equities at Lehman Brothers. Unless the company is perceived as high risk, of course.
The response of many corporations now clearly at risk has been breathtakingly fast, especially in the US airline industry, which announced 100,000 job losses within 10 days of the attacks. Management of a heavily unionized industry with substantial overcapacity has apparently seized the opportunity to cut back perhaps even more than was needed. Mergers and acquisitions – rather than government bail-outs – may yet be the next step for airlines and the same may be true across the troubled telecom and media sector as well as for banks.
Looking for bargains
Stock markets had been drifting downwards since the spring of 2000 with no floor in sight. Many world markets are as much as 35% down from the period of dot com frenzy that fuelled highs: a greater loss than 1987 and comparable to 1973-74. Markets are discounting corporate earnings substantially below present rates. If the sell-off after the attacks hastens the markets’ drop to the bottom, bargain hunting might begin soon. Some investment bankers, showing a welcome return of the insensitivity normally typical of the breed, talk of “a winter offensive” by traders and investors to pick up bargains in oversold markets.
The V-shaped recovery won’t happen until traders and investors can assess the likely scale, length and outcome of military action. And with the equity-risk premium rising, companies will need to see a strong potential return from any new venture or operation before raising new equity capital. If consumer spending weakens and the economy with it, if geopolitical tensions raise the costs of international trade – through higher insurance premiums and more border security – it’s hard to see where those returns will come from.
In the first hours after the attacks, staff at Lehman Brothers thought they might be back in the World Financial Centre in a few weeks. Then, after reports that the Amex tower was unsteady, it dawned on them that it might be months. The firm might never be back. It has signed a lease in Jersey City for one year, extendible to two. “I don’t think we’ll be there in three to five years,” says Malvey. “I don’t know where we’ll be.” None of us do.
