How subprime killed Bear Stearns
A problem with risky mortgages has led to a global financial crisis. The bigger issue: Experts don't know when it will end.
It started last summer when borrowers with weak credit started defaulting on their mortgages. Last night, it brought down an 85-year-old pillar of Wall Street.
How did we get to this point? How did rising foreclosures among subprime borrowers lead to Bear Stearns being scooped up in a fire-sale for two bucks a share?
The answer starts with investment banks: They sold complex securities backed by debt that was a lot riskier than most realized. The realization that the banks had failed to manage this risk sparked widespread concern among investors and other financial firms. Suddenly, investors found they couldn't put a value on much of what the banks were selling. As a result, the lending markets that keep Wall Street humming seized up because people feared they wouldn't get paid back.
"We got to the point where the various parties in the financial system started not to trust each other," said Lawrence White, an economics professor at New York University.
What's worse is that no one knows when it will end.
Every week, it seems, another part of the U.S. financial system falters and the federal government has to come up with a new rescue plan. The Federal Reserve Bank's actions have helped soothe the markets in past crises, but the magnitude of the current meltdown may prove unprecedented, experts said. Today's troubles ensnare not only traditional banks, but investment firms, hedge funds, insurance companies and non-bank lenders.
No place like home
The roots of the current crisis lie in the euphoria of the real estate boom. With housing prices soaring and the economy solid, financial firms dove into the lucrative mortgage market. To meet the insatiable desire for mortgage-backed securities, firms loosened their lending standards and extended credit to people with weaker financial backgrounds.
But the lenders didn't put in place the necessary controls to handle the risk of a downturn in the housing market, said Amiyatosh Purnanandam, assistant professor of finance at the University of Michigan. The financial firms weren't ready to cope with a downturn in the value of the housing market or of these securities.
The signs were there: The rates paid on risky securities, such as junk bonds, moved closer to those of super-safe Treasuries, an indication that investors didn't feel the need to pay a premium to take on more risk.
"Every time we see a big crisis, someone messed up the risk management," Purnanandam said.
A slowdown in home values last year touched off the maelstrom. Subprime homeowners found they could no longer afford their monthly payments, leading to a spike in delinquencies and defaults. Investors panicked because they could no longer value the securities backed by these mortgages.
At first, some thought the problem would be contained within the mortgage industry. But within a few months, it spread like wildfire through the debt market as people lost faith in the investment banks' ability to manage risk in general. Investors are hesitating to put money in securities backed by municipal bonds, student loans, credit cards and even mortgages backed by Freddie Mac and Fannie Mae, which have an implicit government guarantee, for fear they won't be paid back.
"What happened was we figured out the whole scheme wasn't working the right way," said George Tsetsekos, dean of the LeBow College of Business at Drexel University. "It's an issue of confidence in the marketplace over the ability of institutions to receive back the funds that were lent."
Financial firms are also shying away from extending credit to one another, afraid that the collateral backing the loans will lose value.
The banks are saying "I don't want to be involved in any relationship where you owe me money because I don't know if you will be able to honor that obligation," White explained.
Faith in the currency wanes
The dollar is compounding the problem. The dollar's fall against other currencies has made it less attractive for foreign investors to put their money in dollar-denominated U.S. securities. And that is pulling much-needed funding out of the system, Tsetsekos said.
Without liquidity, the global financial markets started breaking down, forcing the Federal Reserve to repeatedly inject cash into the system and take the hard-to-trade mortgage securities as collateral in return.
The crisis reached new heights last Thursday when Bear Stearns suffered a classic run-on-the-bank after questions about the investment bank's finances surfaced. The bank, one of largest underwriters of mortgage-backed bonds, had suffered greatly in the meltdown and didn't have the diversity of revenues that cushioned its rivals.
Clients began withdrawing funds or demanding more collateral from Bear Stearns (BSC, Fortune 500), leading it to turn to the federal government for help. On Friday, JPMorgan Chase (JPM, Fortune 500), along with the Federal Reserve Bank of New York, announced they would step in with funding while the investment bank explored its alternatives.
Two days later, JPMorgan announced that it would buy the venerable Wall Street firm, once known for its high-quality risk management, for a shockingly low $2 a share, a 93% discount from Bear Stearns' closing price on Friday.
The move, however, has not calmed everyone's nerves. Instead, some investors are looking for the next institution to fail, with their sights set on Lehman Brothers (LEH, Fortune 500), whose shares were down 32% in late-afternoon trading Monday.
"Once you see one bank subject to this kind of run, depositors starting worrying maybe the bank across the street may be equally as susceptible," White said. "Clearly that's what the Fed is worried about."
Showing posts with label Wall Street. Show all posts
Showing posts with label Wall Street. Show all posts
Tuesday, March 18, 2008
Monday, March 3, 2008
An interesting read on ENERGY RISK
The underinvestment in clean energy and clean technology is mind boggling, considering the market opportunity. Capital outlays on research and development seem not to be focused on the approaching carbon constrained world and the myriad opportunities presented.
The outlays for R&D last year were $4 billion for U.S. energy companies — that includes oil, gas and power companies. The Federal government's outlay was $7.5 billion in many politically wired projects. The energy industry is the most capital-intensive industry on the planet and requires vast reservoirs of capital. The funny thing is that the industry is awash in capital but seems content on stock repurchasing and dividend boosting. It's not a very enlightened approach to the future.
In fact, it can be argued that the major oil companies are now in a liquidation phase of their existence. Their reserves-to-production ratio is declining, and they are now beginning to peak as they now produce and monetize their depletable assets. Investment in a new energy future is not being pursued by many energy companies yet. I see the energy companies, therefore, as the buyers of the new clean energy technology, not the innovators producing them.
So, the energy companies don't seem to have the vision to create a better future in alternative energy, cleantech, gasification and energy efficiency. Why aren't large institutional investors filling this capital vacuum? The answer is that they don't like government regulated and mandated markets, as well as tax leveraged investments. Private equity (PE) funds in the $5 to $10 billion range and up are focused on subprime workouts, leverage buy outs, and replatforming companies in roll ups. Despite the three high profile funds in the alternative energy space (namely the KKR, Carlyle Group and Blackstone groups), most private equity shops are not investing in the energy sector outside traditional oil, gas, and coal production plays. There is some interest in uranium as well.
Part of the reason for this phenomenon is that Wall Street is always focused on fees. Investment banking fees, legal fees, engineering fees, and other deal fees. The research on this new emerging clean energy sector is scarce and large investment houses in New York don't focus on areas that don't feed the fee machine. That is why the preponderance of deals has been focused on ethanol, wind and PV solar. To say the sector is under researched is an understatement. Smaller boutique houses such as Jefferies, Ardour Capital Management and Piper Jaffray are carrying the bulk of research on public companies, and Cleantech Venture Network and Clean Edge are providing much of the intellectual capital for the private companies.
Many folks holler about the need for a level playing field for renewable and clean technology. Well, one is coming, and it's called carbon constraints. They are going to be economy wide, and that has not happened before. And many companies outside the energy sector don't have much if any experience in reducing their emissions footprint. You can look at greenhouse gas reductions as a business cost center or an opportunity. The opportunity is to invest in the future and make more money in streamlining business practices. But the learning curve will be steep. What's really needed is price discovery for the price of carbon on all economic inputs and outputs. That will move the needle, and that day will arrive in two years with Federal mandatory greenhouse standards.
Last year's investment in Cleantech in the United States and Europe was $5.18 billion, according to the Cleantech Group. This was up from $3.6 billion in 2006, and $3.95 billion of that investment was in North America. That investment was concentrated in energy generation, energy storage, transportation, energy efficiency, recycling and waste reduction. While investment was up for the sixth consecutive year and will most probably grow again this year. This level of investment is far short of what is needed to move not only the US economy, but the global economy, onto a cleaner and greener economic path.”
I am convinced more than ever that two things are now going to occur to accelerate this transition and economic transformation. One is the U.S. movement into the greenhouse gas reduction scheme on a national and international basis. So, carbon will be an accelerator in this economic equation and a facilitator for cleantech investment. The second factor is the scale of capital needed, and ironically the capital is there as the graph shows below. The private equity sector is going to have to get over its apprehensions of government mandates and see the economic opportunities. That means investment returns. If it looks likes project finance, which many of the technologies do, it is not going to excite Wall Street to invest full tilt. But if the investment returns can show 5, 10 and 20 times capital invested, then not only excitement but a shift to defining or game changing technologies then investment starts in earnest . It's the scale that's needed.
On the street today, Goldman Sachs has invested in 11 later stage defining technologies for their own portfolio. The other banks have not moved that far, as yet. But they will. The hundreds of private equity funds are nibbling around the edges and studying the sector. Deployment of capital is now needed in the hundreds of billions range. It's infrastructure, transport, energy efficiency and most importantly it's carbon reductions will ignite this new investment acceleration. The entrepreneurs and the dreamers are out there in the hinterlands creating the next economic cycle, and it is not a bubble. Higher sustained energy prices, more rapid technology shift and a price for carbon will materialize investment in tangible projects for today and next generation technologies for tomorrow. This is the holy grail of sustainability - building a sustainable future backed by sustainable returns.
The outlays for R&D last year were $4 billion for U.S. energy companies — that includes oil, gas and power companies. The Federal government's outlay was $7.5 billion in many politically wired projects. The energy industry is the most capital-intensive industry on the planet and requires vast reservoirs of capital. The funny thing is that the industry is awash in capital but seems content on stock repurchasing and dividend boosting. It's not a very enlightened approach to the future.
In fact, it can be argued that the major oil companies are now in a liquidation phase of their existence. Their reserves-to-production ratio is declining, and they are now beginning to peak as they now produce and monetize their depletable assets. Investment in a new energy future is not being pursued by many energy companies yet. I see the energy companies, therefore, as the buyers of the new clean energy technology, not the innovators producing them.
So, the energy companies don't seem to have the vision to create a better future in alternative energy, cleantech, gasification and energy efficiency. Why aren't large institutional investors filling this capital vacuum? The answer is that they don't like government regulated and mandated markets, as well as tax leveraged investments. Private equity (PE) funds in the $5 to $10 billion range and up are focused on subprime workouts, leverage buy outs, and replatforming companies in roll ups. Despite the three high profile funds in the alternative energy space (namely the KKR, Carlyle Group and Blackstone groups), most private equity shops are not investing in the energy sector outside traditional oil, gas, and coal production plays. There is some interest in uranium as well.
Part of the reason for this phenomenon is that Wall Street is always focused on fees. Investment banking fees, legal fees, engineering fees, and other deal fees. The research on this new emerging clean energy sector is scarce and large investment houses in New York don't focus on areas that don't feed the fee machine. That is why the preponderance of deals has been focused on ethanol, wind and PV solar. To say the sector is under researched is an understatement. Smaller boutique houses such as Jefferies, Ardour Capital Management and Piper Jaffray are carrying the bulk of research on public companies, and Cleantech Venture Network and Clean Edge are providing much of the intellectual capital for the private companies.
Many folks holler about the need for a level playing field for renewable and clean technology. Well, one is coming, and it's called carbon constraints. They are going to be economy wide, and that has not happened before. And many companies outside the energy sector don't have much if any experience in reducing their emissions footprint. You can look at greenhouse gas reductions as a business cost center or an opportunity. The opportunity is to invest in the future and make more money in streamlining business practices. But the learning curve will be steep. What's really needed is price discovery for the price of carbon on all economic inputs and outputs. That will move the needle, and that day will arrive in two years with Federal mandatory greenhouse standards.
Last year's investment in Cleantech in the United States and Europe was $5.18 billion, according to the Cleantech Group. This was up from $3.6 billion in 2006, and $3.95 billion of that investment was in North America. That investment was concentrated in energy generation, energy storage, transportation, energy efficiency, recycling and waste reduction. While investment was up for the sixth consecutive year and will most probably grow again this year. This level of investment is far short of what is needed to move not only the US economy, but the global economy, onto a cleaner and greener economic path.”
I am convinced more than ever that two things are now going to occur to accelerate this transition and economic transformation. One is the U.S. movement into the greenhouse gas reduction scheme on a national and international basis. So, carbon will be an accelerator in this economic equation and a facilitator for cleantech investment. The second factor is the scale of capital needed, and ironically the capital is there as the graph shows below. The private equity sector is going to have to get over its apprehensions of government mandates and see the economic opportunities. That means investment returns. If it looks likes project finance, which many of the technologies do, it is not going to excite Wall Street to invest full tilt. But if the investment returns can show 5, 10 and 20 times capital invested, then not only excitement but a shift to defining or game changing technologies then investment starts in earnest . It's the scale that's needed.
On the street today, Goldman Sachs has invested in 11 later stage defining technologies for their own portfolio. The other banks have not moved that far, as yet. But they will. The hundreds of private equity funds are nibbling around the edges and studying the sector. Deployment of capital is now needed in the hundreds of billions range. It's infrastructure, transport, energy efficiency and most importantly it's carbon reductions will ignite this new investment acceleration. The entrepreneurs and the dreamers are out there in the hinterlands creating the next economic cycle, and it is not a bubble. Higher sustained energy prices, more rapid technology shift and a price for carbon will materialize investment in tangible projects for today and next generation technologies for tomorrow. This is the holy grail of sustainability - building a sustainable future backed by sustainable returns.
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