(Mr. Partnoy is the author of one of my favorite books, F.I.A.S.C.O. If you have never read it, I urge you to do so. It will put today's events into their proper context. Here is a synopsis, it was written in 1999:
FIASCO is the shocking story of one man's education in the jungles of Wall Street. As a young derivatives salesman at Morgan Stanley, Frank Partnoy learned to buy and sell billions of dollars worth of securities that were so complex many traders themselves didn't understand them. In his behind-the-scenes look at the trading floor and the offices of one of the world's top investment firms, Partnoy recounts the macho attitudes and fiercely competitive ploys of his office mates. And he takes us to the annual drunken skeet-shooting competition, FIASCO, where he and his colleagues sharpen the killer instincts they are encouraged to use against their competitors, their clients, and each other. FIASCO is the first book to take on the derivatives trading industry the most highly charged and risky sector of the stock market. More importantly, it is a blistering indictment of the largely unregulated market in derivatives and serves as a warning to unwary investors about real fiascos, which have cost billions of dollars. - AM)
By Frank Partnoy
Published: January 18 2009
Friday’s bad news from Citigroup and Bank of America confirmed what many experts have long suspected: the subprime losses of 2007 were a bullet that fatally wounded the banks. Many lost so much money on toxic subprime mortgage-related derivatives that they have been essentially insolvent for more than a year. It has taken so long for these banks to fall only because of government support and some investors’ bottomless capacity for denial.
Consider Friday’s eye-popping figures. Bank of America recorded a $15.3bn (£10.4bn, €11.5bn) loss at Merrill Lynch, which it owns. Citigroup announced a total 2008 loss of $18.7bn, nearly half of which came from the fourth quarter. Even in the context of this crisis, these losses are epic.
At the same time, the US Treasury said it would inject $20bn into Bank of America and would backstop losses on $118bn of its assets. The government also sweetened its promise to support nearly triple that amount of assets at Citigroup by pledging loans of roughly $250bn from the Federal Reserve. These efforts are the financial equivalent of putting feeding tubes into dying patients.
A perusal of Citigroup’s most recent disclosures reveals that it could not survive without government life support. The losses are just the beginning. Revenues overall are down by one-third compared with 2007. Principal transactions, which include head-spinning “variable interest entity” and other off-balance-sheet deals, declined 84 per cent last year. Bank of America’s 2008 numbers were not as bad but, even excluding the Merrill losses, earnings were down by nearly $2bn.
Even worse, costs are increasing. Operating expenses were higher at both banks in 2008 than in 2007. Although commentators have focused on the bonuses of senior executives, compensation expenses overall at both banks were nearly as high last year as in 2007. Citigroup paid employees $32bn; Bank of America paid $18bn. When a company pays out more in compensation than its market capitalisation, as Citigroup did, the end is near.
Both banks also are plagued by lawsuits arising from the crisis and Friday’s news included a clue about how substantial their litigation expenses might be. In the din of reporting on new losses and rescues, few noticed that Merrill settled one subprime dispute for $475m. More will come.
The bottom line is that, given declining assets and increasing liabilities, many – perhaps most – big banks are essentially insolvent and have been for a long time. It is incredible that they lost so much money on derivatives but even more amazing that they stayed alive for so long afterwards.
The banks’ fate was sealed in early 2007, when the value of derivatives linked to subprime mortgages collapsed. A year ago, the crucial triple B rated mortgage instruments that were the surgical focus of the banks’ bad bets had already declined by three-quarters. At that time, some hedge fund managers concluded that the banks were insolvent and took short positions. The smart money said the banks already were dead, or at least close.
Although sophisticated investors recognised early on that this crisis was about solvency, not liquidity, and that the liquidity crunch arose from fear that banks could not repay their obligations, others came to this view more slowly. The last, as usual, were the credit rating agencies. On Friday, they finally rose to the pulpit to give Citigroup and Bank of America an overdue eulogy, cutting their ratings. Just as their last-minute downgrades of Enron nailed its coffin, these also might be the end, at least for Citigroup.
It is ironic that credit rating agencies still retain such power. They were a significant cause of the crisis. They helped fire the fatal bullet by giving unreasonably high credit ratings to “super senior” tranches of subprime mortgage-backed collateralised debt obligations. It is astonishing that their views would matter to anyone at this late date. Yet government regulations continue to rely on ratings.
Government intervention, like modern healthcare, can prolong the inevitable, but only for so long. Soon we will bury more banks. Their children will survive but they will not. The massive government intervention of recent months merely provides a financial hospice, to give us time to say goodbye.
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