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Wednesday, September 17, 2008

Credit Crunch 2.0

Sunday, September 14, 2008 (7:40PM): Unless you’ve been living under a rock recently, you have undoubtedly heard of the troubles plaguing Wall Street firms and banks. Whether it’s the government takeover (conservatorship) of Fannie Mae and Freddie Mac at the expense of common and preferred shareholders this past week or the potential bankruptcy of Lehman Brothers. I say potential as I write this at 7:40 p.m. on Sunday 9/14/08, but I’ll bet if I get up and walk over to my Bloomberg in the next few minutes it will be the actual bankruptcy of Lehman Brothers. This firm’s troubles are not the beginning nor the end of this crises; there are other firms that may have problems. Now apparently Bank of America is in negotiations to buy Merrill Lynch.

These past few weeks have been unprecedented and historic to say the least. I call this “Credit Crunch 2.0” because this is the newer bigger credit crunch. Does anyone remember New Century Finance??? Maybe, maybe not, but New Century is arguably the first domino in this disastrous situation. New Century was a mortgage company that filed for bankruptcy in April of 2007 (seems soooooo long ago), and this weekend we have a 158 year old Wall Street institution suffering the same fate. In emergency talks this weekend attended by the Who’s Who of Wall Street and the Feds, they tried to come up with a solution to save Lehman Brothers. On Friday, Secretary of the Treasury Henry Paulson said there would be no government money as with Bear Stearns. Despite the markets negative reaction to this news it appears that he has stuck to his guns, and without government backing the potential buyers of Lehman (Barclays & Bank of America) walked away leaving Lehman with almost no other choice than bankruptcy. This clearly has the potential to be a nuclear bomb for the world financial markets. The sheer magnitude of the potential ramifications has everyone scrambling to help facilitate an orderly market tomorrow morning. The International Swaps Market held a special “netting” trading session today so firms could zero or net out swap transactions that they had with Lehman. The Fed is expanding the quality of collateral it will take even including equities, banks are reportedly pooling up to $70 Billion to lend to troubled firms, and it is being reported that the Fed ‘forced’ Merrill to sell to Bank of America. Yes, that has become a done deal since it was mentioned a few sentences ago. This is an extremely fluid situation with many players, AIG is said to have turned to the Fed for help, rather than give itself over to private equity.

So what does all this mean? To say this is unprecedented is an understatement of proportion that rivals the crisis itself. The market reaction is decidedly negative right now, but that is partly due to the tremendous uncertainty that is still out there. The entire system has been shaken and tomorrow morning we will begin a new era. There will only be two independent investment banks, the government will have participated in the public market system in ways that were almost unimaginable a few years ago, and how Wall Street operates will forever be changed. I don’t know what will happen tomorrow, but my guess is that after tremendous chaos in the morning, the markets will most likely stabilize in the afternoon. By stabilize I certainly don’t mean recover, but even in severe downslides they need to be orderly in order to prevent panic. In the long run this will be good for the markets. I know it seems that is what I always say, but 2+2=4 no matter how many times you compute it.

The Morning After

Monday, September 15, 2008 (11:38 AM): The reaction to this weekends historic events has been dare I say relatively organized. It may be tough to be positive on such a gloomy day, but I’ll give it a shot. The bottom line is the financial system is NOT going to collapse, period end of story. There are going to be casualties, there always are. The investment banking industry will not be your father’s investment banking industry, but it will exist. We must remember that the core of the financial system is the deposit institution. Mr. and Mrs. Smith put their money in the bank, and the bank loans that money to Mr. Jones to buy a house start a business or whatever. The system got greedy and over extended itself and those that were the greediest are suffering the consequences. What we must remember is Mr. and Mrs. Smith still have money to put in banks and Mr. Jones still wants to borrow. Of course there is fear of bank failure and credit standards are going to get tighter, but the fundamentals of the system remain and therefore the system will survive, the markets will survive and yes, we too will all survive. You can see the evidence of this in the relative strength of deposit banks like Northern Trust, JP Morgan, Wells Fargo, etc. The institutions that stayed true to this core business model are weathering the storm. Like these institutions, we stay true to our core business (asset allocation) and we also will weather the storm.

Brad Reynolds, CFA

PS from Leon (September 15, 2008: (1:16PM): This crisis has had me look seriously at Schwab and Fidelity. I spent a pretty good amount of time on Friday talking to Schwab folk about their situation. Fortunately, Schwab isn’t in the investment banking business or involved in this sub-prime debacle. In addition, Schwab currently has a zero default rate on home mortgages (which is no surprise since you have to have a significant Schwab account to even get a Schwab mortgage). In addition, Schwab has very nice positive cash flow and lots of insurance: $21 million per account SIPC, and a $600 million dollar Lloyds policy. For now, I’m satisfied with Schwab’s safety (note I said ‘for now’). In the meantime, I’m with Brad: stick to the basics; eventually, I don’t know when, the storm will pass.