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Saturday, September 20, 2008

Financial market reforms

Three of the top five investment banks in the US have failed, and the story is not yet over. Of the three, Bear Stearns and Merrill Lynch have fallen into the arms of universal banks (which marry investment banking and deposit taking) JP Morgan Chase and Bank of America respectively, and the late Lehman Brothers could end up in the Barclays stable. With mounting apprehensions on counter party risks, commercial banks have pulled back on lending and investment banks are facing a credit squeeze. A universal banking model becomes an attractive proposition.

Although the 1933 Glass-Steagall act, which separated investment banks and commercial banks, was repealed in 1999, the universal model is still viewed with suspicion in America. The fact that the crisis has left universal banking majors like UBS and Citigroup unscathed would be used as justification for the success of the universal banking model.

The Economist posits three arguements against the independent investment bank model
1. Investment banks have higher leverage than other banks (in America at least), which worsens the impact of falling asset values. They do not have the safety-valve of banking books, where souring assets can escape the rigours of mark-to-market accounting. And they lack the stable earnings streams of commercial and retail banking.

2. As a group, the pure-play investment banks have relied heavily on short-term funding, particularly repo transactions in which counterparties take collateral as security against the cash they lend. But with such collaterals (like asset backed securities) now under scrutiny, such lending will dry up. A shift towards longer-term unsecured financing would increase the cost of raising capital.

3. As well as dearer funding and lower leverage, the investment banks face the prospect of weakened demand for their services. As and when the market for structured finance revives, it will be smaller and less rewarding than before. Demand for many services will not go away, but in a world of scarcer credit, universal banks will be tempted to use their lending capacity to win juicier investment-banking business from companies.

The sub-prime crisis is also bound to raise questions about the securitization model under which lenders off-load assets from their balance sheets, leaving them to move forward with more lending. These debts are then securitized as complex asset backed securities with multiple tranches of structured debt obligations. In the process risk gets disperesed far and wide into the market, with the attendant problems of locating and pricing risks.

In this context, secured securities like covered bonds are likely to become popular. Covered bond is a form of senior debt that is paid back from the issuer’s cash flows but is also secured against a ring-fenced pool of assets, such as mortgage loans, in the event of default. That makes it safer than unsecured debt. But covered bonds also offer more protection to investors than asset-backed securities, because the issuer retains the credit risk, rather than securitising it away, and must also keep the cover pool up to snuff by replacing non-performing loans with performing ones. For extra safety, the pool contains more collateral than the value of the bond.

For jittery investors, these are instruments that offer safer exposure to America’s mortgage market. For issuers, the costs of funding are lower than raising unsecured debt, and issuance does not depend on the revival of the securitisation markets.

Update 1
In the recent boom years, investment banks have been increasingly moving away from their traditional focus areas of M&A advisory services and securities underwriting to proprietary trading using its own capital and borrowed money to make massive bets. Goldman Sachs, which houses some of the largest hedge funds and private equity firms, was the best example of this shift. From 1996 to 1998, investment banking generated up to 40% of the money Goldman brought in the door, whereas in 2007, Goldman’s best year, that figure was less than 16%, while revenue from trading and principal investing was 68%.

With nervous investors like hedge funds pulling out their monies and share price falling, the two remaining investment banking majors, Goldman and Morgan Stanley, decided to convert themselves to deposit-taking bank holding companies. Though this eanbles them to access banking funds, it also means stricter regulatory control by the Fed and Office of the Comptroller of the Currency, rather than the loosse and periodic audit by the SEC. Further, they would not be able to deploy leverage on a massive scale as before. Whereas banks like JP Morgan and Citigroup borrowed about $10 for every $1 equity, the ratio was 33:1 when Bear collpased and in the range of 20-30:1 for investment banks.

Update 2
James Suroweicki sums up the crisis surrounding investment banks. He is spot on, "The entire edifice of Wall Street is built on confidence. Investment banks rely on short-term debt to run their businesses, and their businesses consist of activities—trading, dealmaking, money management—that depend on people’s faith in their ability to honor their obligations. As soon as the customers and creditors of a company like Lehman start to wonder whether it might collapse, they become less willing to lend or to trade, and more likely to demand their money back. The perception of weakness exacerbates the reality of weakness."

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