Self-Inflicted Wounds and Mutual Assured Destruction

Oooh, the week has barely started and we’ve already had an overdose of adrenaline-generating news. Thornburg Mortgage and Carlyle Capital, both twisting in the wind, battered by margin calls, look unlikely to escape bankruptcy (Thornburg has already defaulted on financing agreements; Carlyle is seeking a standstill). Freddie and Fannie took a further beating thanks to a Barron’s article that took a harsh look at Fannie’s finances. Bear Stearns and Lehman were the focus of worries about solvency. WaMu is reported to be seeking cash from private equity investors and sovereign wealth funds.

Now at first this looks like a financial market meltdown, but there is some interdependence in these developments. On the one hand, the latest market downturn has been triggered by the increase of the conforming loan limits for Fannie and Freddie, which has led to a rise in their credit spreads since late January. Since then, there has been more discussion in DC about various ways to ameliorate the ever-worsening housing mess, and too many solutions involve Freddie and Fannie sopping up dubious debt for anyone’s taste, particularly in the absence of an explicit Federal guarantee of their obligations. The sudden rise in spreads is effectively a protest against this line of action.

On the other hand, we’ve been in a credit contraction since last June. Any doubts as to its seriousness should have been put to rest in August. And anyone who had access to a chart showing subprime ARM resets over time (they peak in August 2008, continue at a high level through year end 2008, and the option ARM resets kick in in 2009-2011, admittedly at a lower level) should have concluded the crisis was not going to resolve itself quickly.

With this in mind, why were Bear and Lehman so highly geared? Lehman is levered 40 to 1, Bear is geared 34:1 (by contrast, Carlyie is levered 32:1). Trading firms should know better.

In deteriorating debt markets, the last thing you want to be carrying is a big balance sheet. Perhaps the banks in question assumed that the Fed’s interest rate cuts would produce enough gains in value (due to lower prevailing rates) to make deleveraging less urgent.

But now Bear and Lehman (and no doubt their peers as well) are delevearging out of necessity, as mark-to-market losses force them to write down assets, leading to hits to equity, and then putting them at gearing levels that are untenable. So shrink they must.

But witness a Bloomberg story Monday, the big prime brokers (Morgan Stanley, Goldman, Deutsche, and Bear control over 80% of the market) have increased their margin requirements.. This is going to push firms that might have OK under the old standards into margin call territory. That will lead to forced sales. That in turn will lead to lower asset prices.

There are reasonable odds that these forces sales will in some (perhaps many) cases lead to the recognition of lower market values which will force the investment banks to write down their own inventory (leading to further damage to their capital bases) and writedowns of collateral posted by other hedge funds, potentially leading to more position liquidations.

In 1998, when LTCM was on the ropes, the investment banks injected more capital and orchestrated an orderly liquidation. But here, there are too many players exposed, not enough managerial bandwidth to determine who might be worth exempting from the new margin terms (recall too that LTCM was in such bad shape that it opened its books; hedge funds are notoriously secretive, so any investment bank is operating with only a partial view of where its exposures lie).

We have other sightings of banks shooting themselves in the foot in misguided attempts to save their hides. Yesterday, we noted that credit card issuers were getting tougher with customers who came to them to restructure their debts via credit counselors. The idea of trying to extract more blood from turnips will backfire. First, if banks get too stringent, customers will quit trying to get themselves out of their debt mess; they’ll just default (and if you have a thick enough skin, you might simply outlast your bank, since they are unlikely to go to the expenses of forcing borrowers into bankruptcy. The statute of limitations on bad debts is as little as six years in some states). Second, to the extent customers who don’t have enough money to go around will simply rob Peter (their car or house payments) to pay Paul. To the extent that these measures lead to more housing defaults, it’s a worse outcome systemically. Third is that these measures are an invitation for Congress to gut the 2005 bankruptcy bill that the industry so eagerly sought.

But don’t expect matters to improve any time soon. We’ve entered the “every man for himself” phase, and we will no doubt see unintended consequences.