The Glass Half Full: Anatomy of a Global Financial Crisis

Three watershed events in recent weeks point to this assessment.

First and foremost, moving beyond supplying term liquidity, the U.S. Federal Reserve has targeted its support to address the main weaknesses behind the crisis.

Main weaknesses

• Aversion to structured product risk, including mortgage-backed securities (MBS) and related Collateralized Debt Obligations (CDO), through the Term Securities Lending Facility (TSLF) to swap U.S. Treasuries for a wide range of non-U.S. Treasury securities for up to $200 billion.

The Fed measure complements actions by Fannie Mae, Freddie Mac, Federal Home Loan Banks and the Federal Housing Administration that have provided some liquidity and marginal bids in the U.S. mortgage and MBS markets. More direct support measures are under consideration by the U.S. Administration and Congress.

• Aversion to counterparty risk, through the rescue of Bear Sterns — which effectively extended “too big to fail” to “too interconnected to fail” protection — and the Primary Dealer Credit Facility (PDCF), which allows non-banks access to the Fed’s Discount Window.

These actions should begin to gradually change risk perception of structured products and counterparties.

Second, write-downs reported by major banks and brokers have probably passed the halfway mark in market estimates of total losses.

Since the beginning of 2007, banks and brokers have reported $241 billion of losses, consisting of $215 billion in mark-to-market losses and $26 billion in credit losses.

European banks account for $130 billion of the loss tally, U.S. banks $92 billion and others $19 billion. Losses at non-bank financial institutions such as insurance companies and monoline financial guarantors probably add another $40 billion, bringing total losses stemming from the credit market crisis to roughly $281 billion.

A loss figure of $281 billion is probably half or more of the total loss estimates — ranging from $400 to $600 billion.

A note of caution about loss estimates: More pessimistic forecasts for the U.S. economy and its housing sector would produce larger loss figures — up to $1 trillion or so — but, on the other hand, the lion’s share of reported losses is unrealized mark-to-market writedowns which could become to mark-to-market gains and writebacks if thin markets for pricing indicators such as the ABX and CMBX indexes recover.

The growing perception is that there could be further write downs, but probably less severe — for banks — than those seen thus far.

Third and quite important is market reaction to the most recent reports of write-downs (including by UBS, Deutsche Bank, West LB, Bayern LB) and efforts to raise fresh capital by UBS ($14.8 billion), Lehman Brothers ($4 billion) and WaMu.

It is an indicator of improving market sentiment that such financial firms have been able to tap public markets for capital, compared with earlier efforts focused on sovereign wealth funds. So far, banks and brokers have raised about $182 billion of fresh capital — they may need to raise more, including by reducing dividend payments.

In recent weeks, in response to those developments, credit risk spreads have narrowed somewhat and equities have stabilized — in particular, financial institutions’ share prices have recovered strongly from pre-Bear Sterns lows.

Against this encouraging backdrop, however, it is perplexing and worrisome to see continued tension in the important interbank market. Spreads between three-month interbank rates and expected overnight rates (specifically, Libor/Euribor less Overnight Index Swap rates) remain unusually high.

Compared with normal spreads of eight to ten basis points observed prior to August 2007, the current spread for USD is 73 bp, with 75 bp for the euro and 99 bp for GBP (approaching the previous crisis peaks in September and December 2007 of more than 100 bp).

As central banks have added substantial liquidity in term interbank markets, the recent spread widening probably has more to do with counterparty risk aversion, but preference for liquidity and safe, liquid assets remain strong and pervasive.

A few examples suffice to illustrate this point.

• Banks and brokers have built up substantial liquidity pools (of cash and liquid assets) — in some cases amounting to 20-25% of their balance sheets.
• Equity hedge funds currently hold record cash positions — remember these are hedge funds, NOT money market funds!
• Primary dealers have tapped the PDCF for a weekly average of $38 billion — a historically record volume of borrowing, compared with bank discount window borrowing of $6.5 billion, close to the previous crisis peak borrowings in the range of $7-8 billion.
• Non-financial corporations have drawn down committed lines of credit from their banks to reduce funding uncertainty as banks tighten lending standards and other financing options have become more expensive (such as the commercial paper market). It is estimated that if 35% of the committed lines of credit ($2.3 trillion currently outstanding) are drawn down, banks will need to add an additional $40 billion of capital to keep their Tier 1 ratios unchanged.

Such precautionary behavior worsens the credit squeeze, hurting the real economy.

For the period immediately ahead, two conclusions seem likely from the above observations.

First, the credit squeeze has caused more high-yield (HY) corporate debt to become distressed. According to S&P, 51% of US corporate borrowers are now below investment grade, compared with 28% in 1992. The outstanding volume of HY debt is now $1 trillion, compared with less than $10 billion 30 years ago.

Within the universe of HY debt, the proportion of borrowers rated CCC or lower has risen noticeably in recent years. And in recent months, the proportion of distressed debt (those trading below 75% of par value, or below 50% in the case of severely distressed bonds) has climbed significantly.

These developments will most likely lead to a sharp rise in HY debt default rates — probably well above the 5% forecast for the end of this year — resulting in another area of credit loss to financial institutions.

Second, the current quarter of 2008 will see much weaker economic data, particularly in the United States. In combination with pervasive risk aversion and deterioration in HY corporate debt market, this may undermine the recent fragile stability.

In short, we may have entered the second half of the credit market crisis, but it is unlikely to be much less painful or suspenseful than the first half.