Times are tough — and they are about to get a whole lot tougher, according to equity analysts who cover the financial services industry. They believe the credit crisis will continue to wreak havoc in the U.S. economy for at least two more years.
Last month, as Treasury Secretary Henry Paulson Jr. and Federal Reserve Board chairman Ben Bernanke were making their case to Congress on the need for an urgent, $700 billion bailout of the faltering U.S. financial system, Institutional Investor hosted a roundtable discussion on the future of American finance. The participants were Todd Bault of Sanford C. Bernstein & Co., the top-ranked Insurance/Nonlife analyst on II’s All-America Research Team for a fifth year running; Bruce Harting, who was with Lehman Brothers Holdings until the firm’s capital markets division was acquired by Barclays last month and is No. 1 in Consumer Finance for a fourth consecutive year; Charles (Brad) Hintz of Bernstein, on top for the first time in Brokers & Asset Managers; Andrew Kligerman of UBS, No. 1 in Insurance/Life for a third straight year; and Heather Wolf of Merrill Lynch, in first place for the first time in Banks/Midcap.
Institutional Investor: How did the financial world’s state of near collapse come about? Accounting issues? Excessive risk-taking? Poor management? Flawed business models?
Hintz: For brokers two things happened. One was four good years of trading, which essentially means chief financial officers who tell you that you are using too much capital leave, and you end up with that slow shift into weaker risk management and weaker credit concerns. This was aided and abetted, curiously, by the Securities and Exchange Commission. In 2004 the SEC rolled out a new capital-allocation system called the [consolidated supervised entities] rules — they are Basel II rules for brokerage firms. The curious thing is, brokerage firms look great under Basel II. In fact, they look remarkably better than commercial banks under Basel II.
Now, Basel II assumes you have access to a deposit base. Do brokerages have access to a deposit base? No. Basel II says you assume you have a lender of last resort. Do brokerages have an assumption of last resort? No. Basel II does not charge for any liquidity on the balance sheet. So you’ve got leverage going straight up since 2004 and the liquidity of the balance sheet going straight down. That’s the problem that says, ‘I’m going to have an illiquid balance sheet leveraged very heavily, and I’m going to believe in the confidence in the marketplace.’ What we found out with Bear, Stearns & Co. was that — like Drexel Burnham Lambert, like the Salomon Brothers run in 1991, like the Lehman run in 1998 — funding is the Achilles’ heel of a brokerage firm. When confidence leaves the marketplace, you can be dead within 24 hours.
The other problem is the issue of credit default swaps. They gave you a liquid asset for trading credit — much better than the corporate bond market. We never got to a standard model for pricing in credit default swaps. You could price them on credit or you could price them on equity, and, of course, that leads us to where suddenly this very, very useful tool began being used for hedging equities. And that leads us to Lehman and to Morgan Stanley and to Goldman, Sachs & Co. — and one could make an argument that they invented it so they’re getting their just deserts. But we should recognize that Goldman Sachs and Morgan Stanley are pretty credible organizations, with good capital structures, and they’re up against the wall right now.
Harting: On the mortgage side it was the securitization and the people originating loans not keeping skin in the game and selling on to a distribution mechanism that became global. The originators were being paid for volume rather than underwriting, and then the distributors were complicating the securities they were selling and putting them into more structures that created what appeared to be more liquidity but ultimately resulted in less liquidity.
Individual lenders thought they were making good loans, but when you looked at the whole, no one was keeping track of what was happening in communities or states or specific geographies in terms of the aggregate amount of loans. So you got what appeared to be a relatively low percentage of all originations in subprime or Alt-A or option adjustable-rate mortgages, but after a year or two of steady volume at 10 percent of total originations being subprime or Alt-A, those numbers added up. Once the game of buying and flipping homes on easy credit stopped, all that volume came right back onto the market. What was the marginal top 15 or 25 percent of demand in 2006 and 2007 quickly reversed and flipped to supply, and it has exacerbated this decline in home prices. Now we are trying to find a bottom.
In terms of Fannie Mae and Freddie Mac, for example, approximately 80 percent of their losses are coming from only seven or eight states. So, whereas the 1980’s was a rolling recession — you didn’t have one nationwide decline simultaneously — this time it really has been a nationwide decline all at once. Within that decline, though, there are seven or eight states that have played a disproportionate role, but unfortunately that disproportionate amount of mortgages has been globally distributed. With global distribution of those underlying securities, it doesn’t really matter if they’re Florida-based loans or California-based loans.
Wolf: Liquidity and credit are opposite sides of the same coin. This is a crisis that was generated out of excess liquidity, and that excess liquidity drove a credit crisis. We’re coming full circle — liquidity is drying up and, fairly shortly, the credit crisis is going to get substantially worse than anybody anticipates. Whether you look at residential real estate or commercial real estate — which will become a serious problem for this country — you had a very small subsection of the market providing the liquidity that made underwriting standards drop and credit so easily available, subprime and Alt-A on the residential side and then the commercial-mortgage-backed securities market on the commercial side. That component, that 20 percent, has driven artificial price inflation on the residential side and the commercial side, and that artificial price inflation is now starting to deflate. So, as it pertains to the banks in this country, obviously we’ve had the same problems with residential mortgages and home equity, but the biggest issue for smaller banks is residential construction. Commercial construction and commercial real estate are going to start to become big issues as well. It’s the mirror image of what has happened on the residential side. Too much liquidity makes credit too easy to get, and we just cycle all the way down.
Bault: With nonlife insurers the problem is in some sense very different. Insurers don’t deal in liquidity. The primary product is an insurance policy, which is an illiquid liability. There’s a very small securitization market for that stuff, and it’s not very efficient. You’re primarily talking about liabilities that are written and held to term, so insurers are always in the market for a broad range of assets, dominated by fixed income. Over the years more and more of those assets shifted to asset-backed securities for what were considered fairly prudent reasons, because ABS has long duration.
The basic business of most insurers is not being impacted by this credit crisis. What’s being impacted is the asset side of their balance sheets. From an accounting standpoint there are two statuses: “available for sale,” which means you can sell them at will, and “held to maturity,” which means you don’t intend to sell them until they mature. Most insurers hold their assets on an “available for sale” basis. Now, in hindsight, it probably would have been a good idea if insurers declared more of their assets held to maturity, but the problem there is that your payments on the liabilities side are unpredictable, so if you sell an asset prematurely that you had designated “hold to term,” you create other accounting problems.
The point is the assets are held as available for sale, and because of that they have to be marked to market even though companies are holding them to maturity. In ordinary times that’s not a big deal, but in this crisis the asset-backed securities have been marked relentlessly down and down and down and down.
Insurers thought they were doing something that in normal periods is prudent, with the expectation that ‘we can hold this asset to term, and our own underlying credit analysis says we’re going to have losses that are well above normal but not to the extent the marks are saying.’ If there is a big disconnect between expectations of investors who depend on liquidity and insurers with essentially illiquid vehicles, that’s a problem. The methodologies being used to mark them were not completely consistent — and they can’t be completely consistent because another problem with this crisis is that the securities themselves are nonhomogeneous. They are not comparable even by vintage or credit tranche.
Insurers thought they were doing something that in normal periods is prudent, with the expectation that ‘we can hold this asset to term, and our own underlying credit analysis says we’re going to have losses that are well above normal but not to the extent the marks are saying.’ If there is a big disconnect between expectations of investors who depend on liquidity and insurers with essentially illiquid vehicles, that’s a problem.
Kligerman: Things weren’t so nice for the life insurance sector back in the early 1990s, when there were some insolvencies based on excessive real estate and high-yield investments. Then in 2002 and 2003, what the industry saw were improperly managed equity exposures. So each step along the way, the rating agencies and the regulators have more proactively policed the life insurance industry. And in these astonishing times, we’re seeing a sector where the investment risks actually appear to be manageable. The life insurance sector’s unrealized losses right now, as a percentage of book value, are in the ballpark of 10 percent. The unfortunate part about this is having some of that exposure, the life insurers have been no exception to the pressures on their stocks. The stocks are not down as much as the brokerages, the asset managers and some of the other financials, but they’re down.
II: I’m glad you brought up the early ’90s because I had one insurance executive say to me, “We thought we had this fixed. We had our real estate debacle.”
Kligerman: Right.
Bault: And when you look at this situation, it doesn’t appear to be anywhere near as big a debacle for the insurers. Yet they have been terrible stocks relative to the market.
II: Heather, you said the credit crisis is going to get substantially worse than anyone anticipates. Could you elaborate?
Wolf: This credit cycle for the banks started with subprime mortgages and home equity. The problem is that this is persisting for much longer than any of us anticipated, and as a result, the broader economy is going to fall into a recession. Almost every other loan category is going to start to cycle, and what we’re most concerned about is that the problems are starting to spread away from the consumer side of the economy to the commercial side of the economy. While house prices continue to deteriorate and consumer-oriented credits continue to deteriorate, the commercial side is cracking. At some point in the next year to two years, you’re going to see peak losses both in consumer lending and in commercial lending. This is still only the fourth inning of this credit cycle.
II: You hear people saying, A thousand banks will fail, and some will be big names. Do you have a similar feeling?
Wolf: Yes. There is too much overcapacity in the banking system, and for this credit cycle to be corrected, some of these banks need to fail. We haven’t put a number on it, but we are of the mind-set that a lot of the smaller banks in this country will go away. The Federal Deposit Insurance Corp. is going to need to be recapitalized even if a large bank does not fail.
II: Do you think that underwriting standards on the commercial side got as bad as on the residential side?
Wolf: On plain-vanilla commercial lending not backed by real estate, the underwriting stayed relatively healthy. The only problem is that those credits are secured by some sort of assets, such as inventory and accounts receivable, and therefore, they’re very economically sensitive. Every time we go to slow down, we get a spike in commercial losses, and every time we have a recession, losses go above 2 percent.
On the commercial real estate side, I know from talking to both bank underwriters and CMBS underwriters that underwriting standards lapsed substantially — not in the bank channel but in the CMBS channel. Most of the banks maintained slightly healthier underwriting standards in commercial real estate, but then again, most of the banks maintained relatively healthy underwriting standards in residential real estate as well.
Very few banks actually entered the subprime market. A couple of the big ones did, but 99 percent of the banks in this country really had very little subprime exposure. Unfortunately, subprime and CMBS are artificially inflated asset prices, which is going to impact everybody across the board.
II: How bad do you think credit losses will be, and what will the broader consequences be?
Wolf: When you talk about peak losses, you really have to talk about them by asset class. In residential construction we would not be surprised to see cumulative losses approaching 15 percent [of total loans]. In commercial we would not be surprised to see cumulative losses approaching 5 to 6 percent. In commercial real estate it is still an open question, because we’re at the top of the first inning in that cycle. We only have the early-1990s comparisons, where cumulative losses were on the order of 7 to 10 percent, and the years since, when we’ve had zero losses — until now. So it’s a very black-and-white situation, and it’s very difficult to know at this point whether we’re going to be black or white in this credit cycle.
Harting: I remember living through the 1989–’93 meltdown in residential real estate and the creation of the Resolution Trust Corp., which is now the big debating point: Should we or shouldn’t we have another RTC-like organization? The big difference is that the initial legislation for the RTC called for $50 billion of funding, and then they had to go back every year until cumulatively there was $400 billion of funding. The RTC was to hold and resell as quickly as possible assets that were in failed savings and loans; an institution had to fail first, be taken over by the FDIC, and then it was the RTC’s job to dispose of those assets.
There was not this mark-to-market question that Congress is debating as we speak. The latest I’ve heard from Bernanke is somewhere between the mark-to-market value and the held-to-maturity value, and that’s a very, very wide gap. So, at the moment, I’m siding with the skeptics of the plan and saying we need to hear a lot more before we pass this because we don’t want taxpayer money just being thrown at this problem. I think what Capital One Financial Corp. did today was very interesting — they did a pre-emptive equity raise while the prohibition on short selling is in place.
The difference between the 1989–’93 experience and today is that, because most of the loans were in whole loan form on the books of the savings and loans that were failing, we thought in terms of actual accrued losses. Each year the S&Ls would take loan-loss provisions as needed — there wasn’t this notion of trying to forecast cumulative losses. That to me is a huge difference. We have been pushed into this new vocabulary of cumulative losses because that’s what the ABS markets are demanding. To mark to market an asset-backed security, you have to get some sense or estimate or forecast value of what the cumulative loss will be embedded in that security. That has created an impatience in the way the equities are valued, because we’re in a rush to condemn some of these companies and write down all of their loans to this cumulative loss number when, in fact, if we allowed the losses to occur over time, they would have an offset in the form of revenues.
Bault: One of the things that a lot of investors take completely for granted because they are largely working in liquid markets —
Hintz: Not anymore, they’re not.
Bault: Not anymore — and this is the key. You were talking about needing to estimate cumulative losses on these asset-backed securities. When you have a liquid market, that’s exactly what you don’t have to do. The market does that for you and produces an estimate probably better than you ever will.
The insurance industry has no such market, and all we do as actuaries is estimate the equivalent of cumulative losses. We have to take underlying cash flows and estimate where they will ultimately get to, and we understand that any given estimate is going to be wrong to some degree. The accounting mechanism allows insurers to adjust that over time. Subprime securities look exactly like reinsurance. I can map the terminology one for one, back and forth: Tranche equals layer. Subordination equals attachment point. It is the same thing, and you cannot value reinsurance in an illiquid market.
The word “impatience” is exactly right. There isn’t any other logical choice but to slow down and try to value this stuff from the ground up using credit techniques. But that’s exactly what the market is not doing, so you have these gigantic bid-ask spreads, and the truth is probably somewhere in between.
Wolf: It’s going to be incredibly interesting to see how the Troubled Asset Relief Program affects this whole issue. What Secretary Paulson wants to do is to create a liquid market that can start establishing a clearing price for some of these securities. The question then becomes, What do you do with banks that are using accrual-based accounting and are not marking to market these securities? How will the market that TARP is trying to create impact expected loss assumptions for these credits?
A good example is residential construction credits. The average bank that we cover is assuming anywhere between a 10 and 15 percent loss severity on those credits, but if you look at distressed-debt bids that are coming in, they’re coming in with severities anywhere from 40 cents to 90 cents on the dollar. I concur with what all of my colleagues are saying: We need to let the financial services companies earn through some of these credit problems. It’s going to be interesting to see if the regulators and market participants allow the financial services companies to do that, or if they look to TARP to determine some kind of ultimate clearing price or expected loss assumptions on these loans.
II: There is an old dynamic on Wall Street between the traders and the bankers. When the trading is going well, the traders end up running the firms.
Hintz: That’s exactly right.
II: The people who have been put in to solve the crisis are invariably going to be people with trading backgrounds, but are they the right people to go forward in a new world?
Hintz: That’s a loaded question. I guess what you are asking is, Do we have talented people at the top?
II: No. Do we have the right talent?
Hintz: We do have traders up at the top of these firms. We can be critical about many things on Wall Street, and one is the fact that we don’t rotate people around across accounts. Think of [Morgan Stanley chairman and chief executive officer] John Mack. He was in fixed-income sales, then became head of fixed income, then president, then CEO. Was he ever an investment banker? No. Did investment banking ever report to him? No. Did he ever run asset management? No. Did retail ever report to him? No.
We can look at the same thing in terms of [Lehman Brothers chief executive officer Richard Fuld Jr.], who was a commercial paper guy. Fuld ran fixed income, he ran the company, and that’s it.
Kligerman: The financial services industry needs great athletes as CEOs. When you look at companies the size of American International Group or Citigroup or Lehman — or Bear Stearns, for that matter — you need nimble, dynamic executives who can do many different things. They’ve got to be smart enough to see things way ahead of time.
Having covered AIG through all of these horrific issues, I question the board’s decisions in terms of management. I wonder, had they put a more dynamic team in place following [former chairman and CEO Maurice (Hank)] Greenberg, would AIG be in a tremendously better position than what we’re seeing now?
II: How would you rate what Paulson and Bernanke have done so far?
Bault: Earlier, Heather described the Troubled Asset Relief Program as the Treasury Department and the Fed trying to create a liquid market. I would say it a little bit differently: They are trying to be specialists of last resort. What I mean by that is, down in the pits the specialists are supposed to temporarily put their own capital at risk, when necessary.
There is this huge bid-ask spread, and the Fed is going to come in and say, “For this class of asset, we’re going to take this number, and until we get new information, we’re going to sit on this number.” Then as more data comes in, they’ll change that number, but they’ll change it less quickly than liquid markets will, in the hope that it would help to stabilize asset prices.
If you believe this is a liquidity crisis, which the Treasury and Fed do, then you say that could be a pretty good approach. If you don’t think this is a liquidity crisis, if you think this is a solvency crisis — you think the paper is all much, much worse — then you don’t think TARP is a good idea because it’s just propping up bad assets and delaying the day of reckoning.
Wolf: It’s going to depend on how they treat real underlying credit, how they treat loans and at what price they will be buying them from the banks. If they buy them at the same prices or same expected loss assumptions that banks are currently holding them, then you’re just transferring around bad assets. They need to force some of the overcapacity out of the system and to force recognition of bad assets. Otherwise it’s Japan all over again.
Kligerman: I give the predecessors of Paulson and Bernanke, particularly the Fed, a D for having contributed to this. Their low-interest-rate policy clearly made this mortgage crisis easier. If you look at Bernanke and Paulson today, though, you probably have to give them an incomplete because it doesn’t seem like things are getting any better. They seem to be getting worse, and it may be as late as 2010 before we can actually judge what they’re doing.
II: Does anyone have a better grade for these guys?
Hintz: In terms of Paulson, I’m glad he’s there. He knows markets. But I think this is on-the-job training because there’s no rule book for this. You have to go back to the 1930s to look at a credit event as long as this.
Wolf: I think Paulson will absolutely fix the liquidity issues. There’s no question, with his background, that he will get these markets functioning again. My concern is, does he have somebody with commercial banking experience who knows how to fix the credit problems?
II: Morgan Stanley and Goldman Sachs have become bank holding companies. How much of this is symbolic, to build confidence, and how much is real?
Hintz: The key piece of information that came out of the Monday announcement was when the Federal Reserve said it would lend to some of the Financial Services Authority–regulated broker-dealers. The Fed was already lending to the U.S. broker-dealers, which meant dollar funding was not a big issue, but counterparties were beginning to pull away around the world. The U.K. is really the euro fixed-income book and the sterling fixed-income book, and if you’re seeing counterparties pulling away and trades in your name being turned down in the marketplace, you have a funding problem — and you can’t issue a long-term bid at the holding company because your credit-default spreads are too wide.
So you’re caught in a bit of a bind. You can direct what long-term debt you currently have at the holding company down to the broker-dealer to keep it live, but you’re in a losing game. You need a trading line, a foreign exchange line for dollars to euros. That may seem like a very easy to thing to do, but it really isn’t during periods of stress because you’re trying to meet client needs too.
Why did Morgan Stanley and Goldman Sachs do it? I don’t think it was an easy decision. If you have the Fed coming in, then you have a regulated holding company, and a regulated holding company has a very significant impact on the brokerage firms. Remember, brokerage firms have operated since 1935 without a regulator at the holding company. Therefore, they would freely do whatever they wanted. If you were to look at a Goldman Sachs or a Morgan Stanley balance sheet, you would run into some really entertaining things. Morgan Stanley has an oil tanker fleet. Goldman has power plants and a massive, massive private equity business, hugely profitable. None of these are technically prohibited as a bank, but the size of them is going to change.
They knew when they chose the Fed as a regulator they were choosing a much more intrusive regulator, which is going to constrain many other businesses. They’re going to have to convert much of their private equity business into a true asset-management-type business.
II: How are they going to make money going forward if they’re reducing their leverage? So much of Goldman’s earnings are proprietary.
Hintz: Sixty percent of their revenues are from the trading side. Absolutely. You have an issue.
I found an old piece of research by Sally Krawcheck showing that the margins in the U.S. securities industry over a period of time from 1980 had been declining in every single business line, investment banking in a modest decline and fixed income at a more significant decline, as Telerate gave way to Bloomberg and Bloomberg metastasized everywhere, and everyone knew what their pricing was. As a result, the idea of making money from bid-offer spreads went away. At the same time, in the equity divisions commissions were falling, customer execution was dropping, retail margins were coming down. It’s a wonderful piece of research, and what it shows is a declining return on assets for the industry.
She focuses then on fixed income and says, ‘To replace the declining bid-offer spread, what the Street does is increase its capital views and go into a prop-trading business. Remember, what is illegal in equities is only immoral in fixed income, and so you go into proprietary trading in fixed income.
She also says, the challenge for a brokerage firm management is to balance high-return-on-equity, low-capital-intensity businesses — asset management, investment banking, those kinds of businesses — against declining-ROE but easy-to-grow businesses.” Trading. How do you grow trading? Throw some balance sheet at it. Boom. You get more revenues out of it.
To get reasonable ROE you’re going to have to have that balance, and then she goes on and makes some analogies, saying commercial banks have some problems because they’re weaker in the world of investment banking, and if you grow trading you’re going to have a lower debt.
We were there in the mid- to late ’90s. We took leverage up. You take leverage up, businesses that are terrible, businesses that did not generate return on the cost of capital — money markets and preferreds, medium-term notes — suddenly become profitable again, if you take it 30 times. And those businesses become loss leaders. You do them to keep BlackRock and Pimco happy, and you’re making your money on a handful of fixed-income businesses.
This is really what the Street was before, and of course, what does it lead to? It leads to a much better capital allocation, much better expense allocation. If management doesn’t exactly know where their profits are coming from or which generates [economic value added], you can make some pretty bad mistakes on your balance sheet.
I got an e-mail from [Robert] Scott, who was the president of Morgan Stanley, and he said, “You’re forecasting that the ROE of Morgan Stanley is going to drop 300 basis points because we’re going to be leveraged at about 20 times. We can do better than that, because we can spend time taking apart that balance sheet much finer than what we’ve done in the past.”
My analysis was to leave the ROA where it was and take the leverage down. He’s right. They’ll be able to fine-tune it, but will trading be as important? No, but let’s face it: the Street is very creative. One of the things they’ll do is take trading businesses — not flow trading, not making markets in governments and corporates — but take some prop-trading business, put it into a hedge fund structure, put the correct liabilities structure against that hedge fund, and turn that prop-trading business into an asset management business.
So I would expect you’ll see some movements in that direction as a way to get around this. On the commodities side, if I have to get rid of power plants, if I have to get rid of oil tankers, what’s going to happen is that my willingness to take energy hedges out five, six, seven years — that’s going to come in because I won’t be able to hedge this piece with the physicals anymore. That doesn’t mean I’m not going to have a good business here.
Kligerman: It’s sort of a welcome-to-the-world that Todd and I cover, because we’ve always been very heavily regulated, or at least policed by the agencies. What’s so fascinating is that after the Glass-Steagall Act fell, in 1999, many in the insurance sector thought there’d be a tremendous amount of mergers and acquisitions, with banks and other financials buying insurance companies, and they didn’t. They said, ‘We don’t want to buy this sector. The ROEs are way too low. We don’t want any part of it.’
As was just mentioned, you can balance high-ROE business with lower-ROE business and still generate very good returns for your shareholders. The insurance industry has done a decent job of that. But on the other hand, this deleveraging that’s being discussed about the other financials, the banks and the broker-dealers, I don’t think that necessarily solves the problem. Let’s look at a company that was pretty heavily regulated, AIG. Somehow, they managed to do credit-default swaps that basically brought the company to its knees.
Wolf: Deleveraging only fixes one side of the coin. You have to start addressing the overcapacity on a credit side, and you’ve got to start recognizing some of these problem assets for what they’re worth, to fix this.
II: What will be the effect on the international posture of American financial institutions? That’s been an area of great growth, but it’s more expensive and higher risk generally. Do you see any area where that might slow down or retrench?
Hintz: Fixed-income markets are domestic and euro and Japanese — Japan is a small market compared with Europe and the U.S. Europe and the U.S. have roughly the same size, in terms of market capitalization, in fixed income. The fixed-income market is growing much more rapidly in Europe for a couple of reasons. Every time a country is brought into the Eurozone, all its banks get disintermediated and all the assets turn into securities, so we have some good secular growth trends. Also, if you go to the International Monetary Fund Web site and look at the composition of foreign exchange reserves held at central banks, what you find is that it’s not in the best interest of any central bank to see the dollar collapse, but it’s in the best interest of every central bank to slowly diversify. What you’re getting is a slow — not a rapid diversification, not a panic — but a slow diversification out of dollars and into euros, which causes incremental demand for European fixed-income assets, which is causing the growth. That growth is great, and it’s great for all the major U.S. growth returns. It’s great for all the big six universal banks in Europe. It’s great for the Canadians, who have done very, very well at growing their fixed-income operations in Europe.
Asia is a different issue. We’re a long way away from Asia having fixed-income markets, and there’s no shortage of bankers who’ve been sent to Asia to build fixed-income markets and have had their careers hit the rocks. I’m not certain that’s going to change in the near future.
Equity markets are quite different. Equity markets in Asia are doing well and growing. When I talk to clients, I tell them China and India are great merchant banking opportunities for brokerage firms, a great place to originate deals and bring them to the large, developed capital markets of the world. They’re great places to have a brokerage firm.
II: Heather has us in the fourth inning of the crisis overall. Is that right?
Wolf: Of the credit crisis, not of the liquidity and credit crisis. From a liquidity perspective, we’re closer to the end of the ball game.
Hintz: We’re going into an economic turndown. Credit crises related to economic turndowns have lasted on average 4.8 months, so two quarters. But we have a credit crisis that has led to an economic turndown, and I don’t know whether it’s two quarters or three quarters or four quarters for this economic turndown. This one is different than the other ones.
II: When do we start to breathe easy again?
Hintz: We’ve got a long way to go — until 2010.
Harting: That sounds about right.
Wolf: I concur.
Bault: Could be a little earlier for insurers if asset valuations stabilize.
Hintz: Fixed income tends to be a business that’s self-correcting. If you’re a fixed-income guy and you’re terrified, like they are today, and you’re taking cash because your bonds are maturing or your interest payments are coming in, you’re putting on the short end of the curve. No one is taking the risk right now. They’ve all gone to the short end of the curve. The returns are just dropping like a stone. Portfolio managers are all worried about their relative returns, and at some point you will have that fixed-income portfolio manager saying, ‘Exxon Mobil Corp. is not going away. BP is not going away.’ You will see that first move typically on the industrial credit side because you can analyze them, you can see what their position is in the economy, and that will encourage the next wave to come in.
Unfortunately, we’re still in the midst of a great crisis of fear in the marketplace. There’s value in fixed income, but no one who wants to buy the assets, and there’s our fundamental problem — liquidity.
Harting: You’re starting to hear more cries for suspending mark to market and fair value — and I’ve been saying that for a year now and getting pushed back into the corner and into a cage and told to go back to the insane asylum — but until you address the accounting issues I don’t think TARP or anything else really gets a handle on this.
Bault: Usually, mark to market is right. It’s the right methodology 95 percent of the time. But not right now.
Harting: Right now it’s just the greater fool theory. You can’t hold any assets because by definition the longer you hold them, the more you lose. And the sooner you sell them, the less you lose. So everyone’s in a rush to sell things, and it’s not based on cash flow or economics. It’s just based on trade. As long as that’s the rule of the day, where do we go with this? So many models have crashed and burned trying to predict how far home prices will go down, but no one believes them anymore.
Wolf: I think mark-to-market accounting is a bit like the efficient-market hypothesis in that it works over the long term; but in short-term market dislocations, it doesn’t work. I don’t know if abolishing it is necessarily the right answer, but some amendments need to be made.
Bault: This is where the principles- versus rules-based accounting comes into play. It would be very nice if there were some sort of sliding scale. In other words, if you had a gauge of illiquidity, then the more illiquid the market becomes, the more you shift away from mark to market.
Hintz: The evolution of fixed income has been toward more of these illiquid assets. We have gotten away from very, very basic risk management tools.
II: What is the outlook going forward? Where will we end up?
Bault: I’ll give you two things that I think might change. First, insurers are going to end up taking less asset risk and trying to figure out more ways to declare their assets as held to maturity, which means they’ve got to think even more carefully about matching their assets to the cashable payments so they don’t get into a bind. Now that’s suboptimal in these times. That means they’re probably going to have yields that are lower than is reasonable, but that may be what they have to do. The nice thing about insurance is that its demand is relatively inelastic, so if funding goes down a little bit, insurers will raise prices.
Second — and this is more interesting — insurers may have to rethink their capital bases a bit. Most insurers use common equity as the majority of their capital, with a certain amount of debt for financial leverage, and on the nonlife side in particular, more and more insurers are going to have to think about alternative forms of capital, which are a bit stickier or perhaps a bit more opportunistic. So you may see more preferred stock. You may see more private equity shares. You may see alternative temporary facilities that are opportunistic based on what happens in the market.
Kligerman: Given the pressures from deleveraging, there may come a day when life insurance returns on equity become attractive. But there’s so much stress now in the financial sector that it’s a long way off. And the life insurance industry needs to consolidate. Believe it or not, the industry hasn’t been impaired enough to see dramatic consolidation, so, at least in the near to intermediate term, you’re not likely to see a great deal of consolidation.
Wolf: From a bank perspective, we will see a large number of insolvencies. That said, on the other side of this credit crisis, the banks are going to be in a better financial position than a lot of other financial services companies because their business model doesn’t have to change. They’ve been overregulated for quite some time.
Remember, when a bank goes insolvent, the FDIC takes it over. They keep the bad assets, and they sell the deposits and the good assets for peanuts. So the banks that are thriving and doing well will be able to buy franchises for very low prices, and on the other side of this credit cycle, they’ll be very well positioned.
Harting: My hope is that the Fed program is one that is shaped more like the 1933–’34 program, where they took real estate owned or nonperforming loans and warehoused them, so it becomes somewhat of a longer-term, buy-and-hold program. Then rent out a lot of these properties for the next three to five years and return them to the marketplace when people have built up savings and can start to buy homes.
Fifty percent of the property sales in California right now are banks just dumping their real estate as fast as they get it, and it’s exacerbating the price decline. You’re starting to see private equity money come into this marketplace, buying servicers, buying these nonperforming loans, so there is a bid. Someone believes they know how to analyze the bottom.
When these Case-Shiller and Office of Federal Housing Enterprise Oversight indexes begin to show some sensibility, more private equity will come in, hopefully assisted by this government program, which will take some of this property off the market and hold it. RTC’s mission was as soon as they got a bank or a thrift and sold the goods, assets and deposits and kept the bad assets, they’d put it right back on the market. I’m hoping they don’t do that this time around.
Hintz: The big trading houses stick to the liquid parts of the market — it’s been proved that their business model works there. The regulatory word is that they will be more constrained going forward, which means it’s going to be more difficult for them to roll out new products or enter new areas, but it doesn’t mean it’s impossible. It just means their relationship with the Fed is going to have to have a much higher priority. Management is going to have to discuss their business plans with them, which is something they’ve never done in the past.
Some large hedge funds will go public and become the new brokerage firms, and in the world of investment bankers, the boutiques become the name of the game. There’s no shortage of investment bankers who do not want to tie their compensation to the returns of a trading group anymore. They’ve learned a lesson. We’ve trained an entire generation of equity investors to be very skeptical when somebody tells you about their wonderful black-box trading strategy that generates good returns in all environments.
In terms of secular changes, mortgages are not going to be as important as they were as a business for Wall Street. My guess is that Wall Street cedes the mortgage business to the large universal banks, and underwriters’ liability costs go up markedly for asset-backed securitizations. As a result, the Street is going to be much, much more careful about what they put into an asset-backed security because the SEC has the authority right now to tighten up the representations and warranties that you put into a prospectus on an asset-backed securities deal.
Of course, when you tighten up an underwriter’s liability, that increases the quality control but drops the revenues of the business. In the world of fixed income, we lose about 20 percent of the revenues that come from the mortgage business. We lose about 5 or 6 percent of the revenues that come from structured products, and the ROE of the fundamental business goes down — doesn’t go away, just goes down. ROE becomes more of a cyclical business, doing very well at certain points in the economic cycle and less well at other points. What we’ve done in recent years was to try to fill in those low points with other types of securitization — subprimes, things like that. That’s going to go away.
