It would be hard to understate the magnitude of the meltdown taking place on Wall and Bay Streets right now. The Dow tanked 500 points in one day, the TSX is off more than 700 since January, and the surprises just keep popping out.
Lehman Brothers is bankrupt and Merrill Lynch — long the most recognizable nameplates among retail brokerages — has disappeared into Bank of America. Did I mention the lynchpin organizations of the American real estate sector, Fannie Mae and Freddie Mac, were nationalized last week?
The word unprecedented gets us there. A typical comparison is that this is something like what the Great Depression was like. Let’s hope it is the heat of the meltdown fueling the hyperbole, but this is remarkable.
The most interesting rumour to pop up is that Manulife could be in line to pick up AIG. That would be interesting. Manulife would become a monster. And Donald Guloien, newly announced as the incoming CEO, would have a heck of a new job in front of him.
But let’s get through the disaster at hand before we contemplate that. This period of de-leveraging has been awesome in its scope, and the U.S. financial sector seems set to re-emerge on the other side a radically different beast.
At the very bottom of the pyramid of value are the dreaded retail and commercial mortgage-backed securities that were sold through the recent era of low rates. These were sold with all kinds of leverage attached. There was leverage in the sale of the home to buyers who couldn’t afford the home. The mortgage-backed securities that were then packaged up from that deal (to deliver the payment from the home buyer to the investor) were built with layers of leverage. And then when this paper was sold it was bought with borrowed money. The result is that from top to bottom leverage and credit has been marbled throughout the system, and as doubts rise about how much of all this paper will eventually be paid back, we’ve seen the disasters follow.
What will bring it to an end? The biggest issue is the continuing fall in home prices. Only when bankers get a real idea of where house prices are going to be at, and how much of all this debt consumers will be able to pay back, will any of this paper underlying the banking system be properly valued. Until then, fear rules among the bankers, and anyone who has to sell assets to make up other obligations becomes a desperate player in a market flooded with other sellers.
That’s what’s scary here. You don’t know how long this vortex will continue to spin and destroy value. One PIMCO commentator defined the paradox of de-leveraging as a process where forced selling causes decreases in asset prices, which decreases the value of the firm at sale, leaving a firm just as leveraged on a relative basis as it was before the sale.
The complexity of these securities also seems to be slowing down this whole process. These asset-backed securities became so complex that bankers are having a problem getting a handle on value, even if they get a handle on the underlying mortgage. Have bankers written themselves out of a job by writing securities that were too complex? That would be the ultimate irony.
It will help if the price of oil stays where it is and what little cash the consumer has can flow to the western banking system rather than into sovereign wealth funds. So let’s hope the peakists can keep quiet for a bit and not stoke inflation concerns. But it looks like it’s still a big buyers market when it comes to the obligations of the American consumer. Come and get it. Please, come and get it.