Subprime crisis explained

In an earlier post, I mentioned that private equity firms stand to gain significantly from the Treasury Department’s plan to buy distressed securities.  In this post I briefly explain in layman’s terms how this crisis developed and why the government’s bailout is essential to resolving the travails in the credit markets.

How the crisis evolved

One of the major problems with the collateralized mortgage debt is an inability to price these assets.  The troubles stem from Alan Greenspan’s lax monetary policy, which kept interest rates absurdly low in early part of this decade, contributing to a housing bubble. In the meantime, Wall Street firms began to collateralize mortgages into individual securities.   Essentially, banks took your home mortgage and added it to 99 others and put it into one bond-type security.  The banks then began to trade these securities amongst themselves and hedge funds.  When the housing bubble began to burst, many of these firms suddenly found themselves unable to sell the “toxic” securities.  Under the mark-to-market accounting rule, which requires firms to price assets at their current levels, the firms had to make guesses at the price of the securities, based on supply and demand.  With an abundant supply and no demand, the price of the securities plummeted.  Several firms, including Citigroup, Lehman Brothers, Bear Stearns, and Merrill Lynch, were forced to take massive writedowns when they reported quarterly income, leaving their balance sheets looking depleted.

As balance sheets were stained with the blood of collaterized debt obligations (CDOs), hedge funds began to circle the weakened banks holding these securities.  Viewing the damaged balance sheets as indications of morbidity, the hedge funds began to short the shares of affected (and unaffected) banks.  The short selling of these firms caused panic, with investors and customers increasingly withdrawing their business from affected firms.  Bear Stearns was the first major investment bank to fall, with its share price collapsing from $160/share to $2/share in a period of a few months, before it was sold off to J.P. Morgan.  In September of 2008, Lehman Brothers, another affected Wall Street titan, filed for bankruptcy.

Meanwhile, one firm which suffered from exposure to CDOs employed a smart plan to protect its business from disaster. Merill Lynch’s John Thain, the newly appointed CEO, took quick action to sell off the toxic assets.  By selling the mortgage debt at 22 cents on the dollar, Thain took a one-time loss and freed Merrill’s balance sheet from speculation of bankruptcy.

It is worth noting that some firms took measures to protect against the subprime losses.  Goldman Sachs, for example, realized the danger of CDOs a few years ago and took out expensive insurance to insulate itself from losses, while Goldman’s mortgage unit actually shorted CDOs for a profit.  Similarly, J.P. Morgan avoided exposure to the subprime crisis.

Why the Treasury Department’s intervention is essential to saving the credit markets

With the collapse of Lehman Brothers and AIG, the world’s largest insurance company, the credit markets have suddenly tightened up.  Therefore, this bailout is absolutely necessary from the perspective of the workers and consumers.  

As we learned last week, Caterpillar, one of the stalwarts of American industry, was forced to borrow for the short-term (~1 month) at 325 basis points (3.25%) higher than it was borrowing at two weeks ago.  Goodyear is confronting a similar situation.  Such frighteningly higher borrowing costs indicate the credit markets have frozen up.  If this continues, it will devastate American industry.  If Caterpillar must pay twice as much to borrow, it will have less money to pay workers, leading to layoffs.  The government, by buying up the toxic securities, will shore up bank balance sheets, saving the banks from ratings downgrades from the Moody’s and S&P ratings agencies.

Why the private equity firms may benefit

As I mentioned in a previous post, private equity markets may benefit from the Treasury Department’s intervention.  A brief recap in layman’s terms:

If the Treasury buys up distressed debt, it may set a price floor.  The government, by buying at, for example, 30 cents on the dollar, immediately sets the “mark.”  Therefore, the uncertainty that plagued banks earlier disappears.  Private equity firms, who are flush with cash (KKR has $60 billion in assets), may see the government’s intervention as a lucrative opportunity, even at slightly higher prices.  With the “full faith and credit” of the U.S. Government backing up mortgages, CDOs which were once considered toxic may become investment opportunities.  Furthermore, as private equity firms are not publicly traded (Blackstone being the exception), their balance sheets are not subject to public scrutiny.  Therefore, the mark-to-market problem which affected Lehman and others is not an issue.

Why is this good?

If private equity firms buy up some of the distressed debt, there’s less up front cost for the U.S. taxpayer to shoulder.