Back online again, with the Great Financial Services Market Correction
By dkildahl on Jun 14, 2011
Its been a while, lots changed. I now head up the Global Financial Services organization for Sun, the team for which I was the CTO last year - a win for the geeks, you could say. Or "were you careful what you wished for?", is the other thing you can say.
One thing I will tell you, I have been on the road for the last quarter and have racked up more miles than I did all of last year. And I did travel quite a bit last year. Last quarter - Singapore, Paris, London (3 trips), Vienna, Toronto, Florida, California (3 trips), Washington DC and Boston. Food in Singapore was the best.
OK, but the fun bit is the Great Market Correction. This entry is likely already out of date, this is worse than going to Frys and buying a TV, to find out that Samsung has shipped a new one already! I will make another entry to update this, and then another one, and likely one more after that.
What is the crisis all about?
One cannot isolate any one sector of the Financial Markets - the Capital Markets (Bear Stearns, Merrill Lynch, Lehman Brothers, Morgan Stanley, Goldman Sachs), Banking (Washington Mutual, HBOS, Wachovia, Bank of America, Lloyds TSB, Barclays, UBS) and Insurance (AIG) sectors are all affected.
Where did all this start? Likely with the "credit crisis" caused by the "subprime loans" late 2006. Subprime loans are loans made to a high risk portion of the market, which would typically not qualify for conventional "prime" loans. Subprime loans are considered high risk, and the borrowers are typified by poor credit status, job history etc.
The fun begins when these loans are packaged together and "securitized" into "investment vehicles". Terms like Structured Investment Vehicles (SIVs) and Collateralized Debt Obligations (CDO) abound. Put simply, some really smart traders in the Fixed Income units of these banks create instruments from these loans that can be traded in the Capital Markets just like a stock or a bond. What complicates these instruments though is the fact that all sorts of mortgages, subprime and prime, are lumped together and onerous mathematical models are put into place to try and price them. Terms like tranches are used to describe the ratings of the assets used to create these instruments.
What is the size of this market? About USD7 trillion. Yup, its gigantic. Banks and other institutions across the globe traded and bought these instruments. Hedge funds in particular - and this is important for the Bear case - have been heavy traders of these securities.
Good so far, except for the fact that the defaults on the subprime loans got to unprecedented levels. Yes one always expects risk with subprime, that is the definition. The mathematical models expect a certain %age of these mortgages to default, and insurers (this is where AIG comes in) offer insurance against these defaults (using very complicated instruments called Credit Default Swaps). In this case, the defaults were much higher than expected. "Predatory lending practices" were blamed. The fall of housing prices was blamed (a lot of the subprime mortgages were made based on "ever increasing" house prices, so you could afford a USD1M home on an income of USD50K, because the house value would increase forever!).
Late 2005 - US housing bubble beings to fizzle out, with the market falling
Q1 2007 - about 30 subprime lenders declare bankruptcy
July 2007 - Bear Stearns hedge fund investing heavily in subprime, collapses
Aug 2007 - the largest mortgage lender in the US, Countrywide, comes very near to declaring bankruptcy (it is bought by Bank of America in early 2008)
Aug 2007 - large mortgage lenders, Ameriquest and American Home Mortgage, go out of business
Sept 2007 - UK's Northern Rock gets into trouble as its involvement in the US Subprime crisis becomes apparent, causing a "run on the bank", it is taken over by the state in Jan 2008
Aug, Sept, Dec, Jan - Fed cuts various borrowing rates, and injects nearly USD50B to encourage banks to borrow to keep the credit markets going
Mar 2008 - Bear Stearns tries to hammer out a deal with the Fed and JPMC to get emergency funding to improve its liquidity position
Mar 2008 - Bear gets bought by JPMC for USD2/share
Now for the month of Sept 2008
- Two mortgage lending giants, Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), are taken into conservatorship by the federal government. USD200B *each* is injected into the firms.
- Lehman Brothers, established in 1850, files for bankruptcy, the largest ever in US history. Lehman's demise is directly related to their heavy investments in the subprime markets, they lost USD2.8B in Q2 and another USD3.9B in Q3 prior to them declaring bankruptcy.
- Merrill Lynch, facing a similar crisis, decides to sell itself to Bank of America for USD50B, which translates to USD28/share. At the end of 2007, Merrill was trading at USD98/share.
- Bank of England extends its emergency scheme for inter-bank lending, to try and boost liquidity.
- UK's #1 lender HBOS looks to a rescue deal from Lloyds TSB. Cause? HBOS's heavy dependence on the inter-bank money markets, having the largest wholesale funding requirement in the industry - of GBP200B (difference between loans made and customer deposits). With the funding lines drying up (counterparty risk being at historic levels), HBOS feared a "run on the bank" and started lobbying the government.
- UK government will overlook its anti-competitive measures to effectively allow the creation of a monopoly in the UK lending market.
- Money Markets, considered to be "as safe as a bank account" since they invest in very short term debt instruments, fall below the NAV $1/share. Cause? Some of the short term paper was Lehman debt.
- Barclays buys Lehman's American investment banking and capital markets businesses to add to Barclays Capital.
- Russia halts trading on two of its exchanges to stem panic selling, and injects USD70B into the market to prevent a free fall.
- Short sellers have a field day with the stocks of the last two remaining standalone investment banks - Morgan Stanley and Goldman Sachs.
- UK and US regulators impose curbs on short selling
- Australia, Taiwan and Netherlands do the same
- AIG effectively gets taken over by the US government, which makes a USD85B loan to prevent bankruptcy. The Federal Reserve makes a two year loan at a punitive interest rate of Libor (the London inter-bank offered rate, a short term lending rate) + 8.5%, for a 80% stake in AIG. Thats is a very very high rate, and AIG is now looking to sell off assets to pay if off quickly. Cause for AIG bankruptcy? Its Capital Markets division primarily (AIG Financial Products, all of 389 people), and their links to Credit Default Swaps and Subprime. AIG invested heavily in an arcane (yet worth USD45Trillion!) market of CDS, where they issued contracts that act like insurance against defaults in a range of assets. As the defaults increased, AIG had to write down the value of the protection it sold and post collateral to the counterparties. Take a look atthis article from Feb 2008.
Why did the feds rescue AIG, and not Lehman? Because AIG is huge, gigantic, enormous, and has its fingers in all aspects of global financial markets - and it *insures* numerous financial institutions against defaults! I was at SIBOS when all this occurred, and the joke was that if AIG went belly up, we would not be able to fly back home as AIG likely owned the airplane which was leased by the airline we were flying. The bigger joke is - the larger you are, the more risk you take, the higher your chances of being bailed out. The smaller guys, they get taken care of by the markets themselves!
- US federal government puts together a bail-out plan costing the US taxpayer USD700B, to buy out the bad mortgage based assets. Will this solve the problem? Highly unlikely, a lot would depend on how they would price these assets, chances are still that the price will not be enough and some banks will still go bankrupt.
If this move had happened when it was proposed, Lehman and Merrill would still exist.
- Morgan Stanley and Goldman Sachs become banks, "scrap Wall St. model" - according to the Wall Street Journal dated Sept 22. Meaning? They need the primary source of money today - Direct Deposits. They now come under a lot more scrutiny than before - the federal reserve oversees banks, as opposed to the SEC for the securities firms. And they are likely getting ready to acquire. This move also helps their books - banks can classify assets as "held of investment", as opposed to "mark to market", which forces firms to value their assets based on current market price - not good now-a-days.
- US Treasury Secretary ("King" Henry Paulson) and Chairman of the Federal Reserve Bernanke further solidify plan for bailout - offering a "reverse auction" to price the bad assets and buy them.
- Washington Mutual tries to sell itself - suitors are JPMC, Wells Fargo and Banco Santander of Spain. Unsuccessful, after Wells and Banco Santander walk out.
And now for September 29.
- The largest bank failure in the history of US - Washington Mutual fails and is seized by the FDIC. Why did it fail? Too much exposure to the mortgage crisis, no more credit, run-on-the-bank etc. etc. Shotgun wedding with JPMC arranged for USD1.9B.
- The House of Representatives rejects the bailout plan, causing a 800 point drop in the Dow Jones Industrial average.
- Wachovia gets bought by Citigroup - which now puts Citi in the "too big to fail" bucket. Perhaps it was already there, but this definitely guarantees it.
And this news is wrong already!
- Belgium, the Netherlands and Luxembourg pledge more than E11B to Dutch-Belgian bank and insurance giant Fortis NV to keep it from insolvency.
- Dexia, the French-Belgian bank, gets essentially nationalized. The Belgian, French and Luxembourg governments inject E6.4B into it.
And October 2008
- Ireland guarantees the debt of its top 6 financial institutions - the sum of money is E400B, which is 2x the country's GDP, yikes!
- Central Bank of India promises to pump in cash to prevent a run-on-the-bank on India's second largest bank - ICICI.
- Short term lending gets hit hard - the "commercial paper" market completely jams up, with no one willing to give out loans.
- LIBOR - the London interbank lending rate - for overnight loans hits 6.88% from 2.57%. The US overnight rate hits 7%, should be around 2%. No one wants to give anyone any money, banks are hoarding cash.
- Korea worries about short term loans, and guarantees to help small and mid-size businesses.
- Hong Kong has a run-on-the-bank on Bank of East Asia Ltd.
- US, UK governments increase the guarantee limit on bank deposits, hoping to encourage savings and preventing run-on-the-banks.
- Wells Fargo says they will buy Wachovia... what will Citi do with all the placards and buntings at the Wachovia branches? tsk tsk tsk...
1. At the heart of capitalism is the ideology that "free markets always self correct". This is a correction, yet the governments everywhere are intervening - by injecting liquidity, by nationalizing firms, by putting curbs on specific aspects of the markets, by easing regulations that they should be imposing. "Why would anyone provide equity capital to listed companies if the government can ride roughshod over them and destroy shareholder value?" - was the sentiment of a trader at the forced HBOS takeover by Lloyds TSB. Are we looking at an era of market nationalization? This is a very scary path we are going down.
2. "US presidential candidates vow broad changes for Wall St.", "Obama pledges end of 'anything goes' culture". Not just the feds and regulators, but presidential candidates are jumping into the fray, and will be forced to take some action to show that they are for the "little guy".
3. The OTC Derivatives market and Hedge Funds are essentially an unregulated industry, and will likely start to come under heavy scrutiny, either directly or indirectly.
4. The relationship of the SEC and the FSA (in the US and UK respectively) with the markets will be redefined, and will likely start to get marginalized with the federal government "taking over".
5. The era of the standalone investment banks comes to an end, will the creation of exotic trading instruments that Wall St. prided itself on, also end? The large bank philosophy is more conservative, and nimbleness is not a forte. Will they look to manage risk, or avoid it? No one can make money without taking risk.
6. Regulations are king again, and with the federal governments bailing out the markets, they will impose tougher regulations.
7. Globalization is imminent - the acquisition of Merrill by BofA brings BofA into 40 new countries, where Merrill has retail presence. Barclays buying up Lehman's US businesses gives a UK based bank a very large footprint into the US capital and investment banking markets.
8. Spending across retail and wholesale banking will continue since 85% - 90% of the spending is non discretionary. This spending supports compliance, risk, core and transactional systems. So the industry's aggregate spending will remain fairly constant, but as banks consolidate, there will be large variabilities in spending between banks with strong balance sheets that will benefit from the consolidation and the losers which will likely be sold to stronger players.
9. Direct Deposits will be a primary source of capital for the banks and capital markets - look to your bank to encourage you to leave your money in your savings accounts. I just experienced this today at Wachovia.
What does this correction mean for Sun?
First and foremost, we need to consider that this a major opportunity for Sun, not just a challenge. Yes, there will be some restructuring of our account coverage in finance, and many IT projects may be cancelled. But there will also be feverish activity of on-boarding a huge amount of employees and integrating lots of systems at the merged firms.
This plays right into Sun's core competencies: VDI, IdM, SOA, and Data Center consolidation/virtualization (especially with the new xVM release) are all key enabling technologies. We know what it takes to absorb a Merrill-size company from the IT perspective, and our recent involvement with the Bear on-boarding at JPMC can attest to that.
We position Sun as a leader and trusted advisor in reducing the on-boarding and integration pains at these firms. This is not going to be business-as-usual: we'll need to frame these competencies in the new context and have conversations at the executive levels of the organization as well as the IT/technical levels. Still, these conversations will focus on areas where we have a tremendous amount of expertise. Lets not forget that Sun was able to grow our business in this industry at 3 times the rate of IT spend last year because of our focus.
Risk Management is going to play a critical role in this industry going forward, and all these areas all play a strong role in reducing operational risk:
- Data center modernization/virtualization targets it directly by increasing the manageability of the data center
- IdM tightens the security of the enterprise, ensuring proper authentication and authorizations
- VDI reduces the latency and improves the functionality of critical applications for remote workers
- SOA enables flexible integration of core IT systems while increasing their manageability as well as the visibility and agility of the business processes they support.
Market and credit risks are obviously at the hart of this crisis, and this is probably one area where IT spend is likely to increase going forward. Sun has very strong relationships with the key ISVs in this spaces and the my team is developing a strong Risk and Analytics program around them.
Besides risk, another likely spend area in many of these firms will be customer retention and satisfaction, particularly customers on the retail and commercial sides of the banks - remember Deposits are king! Banks are likely to focus on their core competencies in these areas (such as Payments), and Sun's strong focus on payments and banking in general over the last two years is likely to continue to pay off. Our strong account coverage of the big banks will enable us to have the right conversations with the right people.
Finally, the banks will shore up their efforts with the retail and wholesale sides of the business and refocus their non-discreationary spend in areas such as core banking systems and payments, where Sun has a strong presence.