WSJ: Guessing How Things Might Get Worse
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Wall Street's latest parlor game is best played with a comforting cocktail in hand: trying to guess just how the ever-fragile banking crisis could tip into doomsday territory.
The scenarios have the air of gritty science fiction -- a huge capital crunch triggered by bond-market selloff and a money-market bloodbath.
The scenarios have, by all accounts, a slim chance of occurring. But they are a reminder of how much the rapidly changing financial system, for all its innovation, is still built on confidence. "Trust is a funny concept, because our trust is increasingly built on abstractions," says Lawrence E. Mitchell, author of a history of the financial industry called "The Speculation Economy."
Here are two leading scenarios as described by Wall Street bankers, traders, and regulators.
• The bond-rating selloff
Rightfully designated as an obscure corner of the financial markets, the business of bond insurance is obscure no more. A host of these insurers have reliably guaranteed $2 trillion of bond payments and principal for years. But having waded into some sketchy mortgage-backed securities, they stand to need significant, and potentially unattainable, heaps of fresh capital.
The fear is that ratings downgrades at MBIA, Ambac Financial Group, or Blackstone Group-led Financial Guaranty Insurance might create a cascading effect of other bond downgrades. Without that extra insurance, a triple-A-rated credit tranche might, for instance, become a double-A-rated or single-A-rated piece of paper. This has deep consequences for all sorts of institutional investors, who might be contractually mandated to carry only triple-A bonds, for instance.
In the doomsday case, a bond-insurer downgrade or bankruptcy sets off this bond-market fire sale. The consequences of this could be unpredictable and severe.
Take a look at the effect of bond downgrades on capital-reserve ratios for banks and insurers. For each piece of paper, these institutions have to value-weight their holdings, keeping some capital on their balance sheet in turn. Obviously, a lower-rated A-rated bond requires more capital reserves than a triple-A-rated one. This means that a bond-ratings blowup could also create a larger bank capital clinch-up than that being experienced today.
Bond issuers can of course go find new underwriters. But what of the issuers who can't win the confidence of other capital-starved underwriting firms? In such a case, banks might force the hand of regulators to relax their long-standing demands on capital cushions. These rules demand that a bank keep at least 4% of its holdings in capital on hand, also known as Tier 1 reserves.
So far, the bond-insurance industry is hanging tough. MBIA recently received a $1 billion cash commitment from Warburg Pincus. But late yesterday, one such insurer, FGIC Corp., was told by ratings service Fitch that it needed to raise $1 billion or face its own downgrade.
• Breaking the Buck and Much More
Confidence is at the very heart of the money-market mutual fund, where the sanctity of the "buck" is one of the last American absolutes. "Breaking the buck" -- meaning to lose one's invested principal -- has proved so utterly verboten that it's only happened once.
That's only kind of true. In reality, at least seven funds have been made whole because they have been bailed out by issuing institutions keen to keep their reputations intact.
Some of these funds aren't traditional money-market funds. Rather, they are "enhanced funds" that stretch for a bit more yield -- and that stretch involved investing in, you guessed it, asset-backed securities to subprime.
The bailouts are comforting if a small money-market mutual fund falls behind. The worry is that the credit contagion might go deeper into this market, potentially affecting a far greater sweep of investments. One test case comes from money-market funds at Charles Schwab and Legg Mason, both of which have massive funds with some exposure to less-than-desirable structured-investment-vehicle paper. While the vast majority of these assets aren't impaired, it is still clear that the SIV paper is a riskier credit because of its exposure to subprime mortgages.
If the value of this SIV paper drops even further, it could touch off losses through the money fund. What would happen if a money manager had to make the choice between "breaking the buck" or paying for, say, a crippling $2 billion shortfall?
For some on Wall Street, the threat is less about the capital shortfall and more about an ensuing crisis of confidence in money funds, leading to liquidations, which in turns creates forced sell-offs and still greater losses.
At Legg Mason, Moody's Investors Service downgraded the firm's senior debt, saying that Legg Mason could lose less than $300 million for losses in its own money funds. It was a "very remote" possibility that the losses would reach $1 billion, Moody's said.
Money market analyst Peter Crane, of Crane Data, dismisses such a scenario, saying that losses would eventually be manageable, given lower interest rates and increased capital inflows into the sector. "No one is going to have to pony up $1 billion," he said. Let's hope. |
