Doc Maher provides a simple example to understand the credit crisis.
In business school I learned that the fastest way to go out of business is to become illiquid. That is to say to lose liquidity. In simple terms liquidity is having enough cash or the ability to get enough cash to cover operating expenses.
Just because your company is profitable or has more assets than liabilities on its balance sheet, doesn't necessarily mean that it's liquid. In fact many growing companies face this need for cash constantly. They invest all their profits back into the business to buy the things that make it grow. In fact many fast growing businesses are constantly borrowing money to feed the growth. By all measures these companies are profitable but they have cash problems.
A quick example might help. Let's say I open a small store. It's very successful. The first week I buy $1000 worth of product to sell. I sell that for $1200 and after expenses of $100, I net $100 profit. However I realize that due to demand I need to buy $1300 worth of product for the next week. But I only have $1100, so I borrow $200. The next week I sell out again and take in $1600. Great! After my $100 expenses I net $200, twice as much as last week! Except it's time to buy more product and this time I need $1900 worth. Ok I have $1500 so I borrow another $400. What's happening here? It seems like my profit keeps going up but I'm in debt $600 and I haven't even been paid.
Well we can see that in fact the small store is not only profitable but that profit is growing like crazy. The problem is that we don't have enough cash on hand to drive the growth, so it looks like we are just getting deeper and deeper in debt. I'm not liquid. To solve this problem I borrow cash to keep going. Of course as long as I can continue to borrow I'm a big success. However what happens if no one will let me borrow? In fact they turn around and demand that I pay all the borrowed money back. I'm out of business! This is Chapter 11 bankruptcy!
So somehow businesses need to raise the cash they need to satisfy their operating needs. If the source of that capital dries up for some reason we have a credit crunch or a lack of liquidity in the financial system.
OK so what happened to Lehman and what does that have to do with defaulting loans and how is the FED (Federal Reserve Bank) involved?
Well, Lehman like a lot of business needed money to cover operating expenses. However there was no money to be found. Why? Lehman had total debts of $613 billion and total assets of $639 billion. That doesn't sound that bad, the assets exceed the debt. But unlike my little store, Lehman said it was about to report a $3.9 billion loss in the third quarter after reporting a loss of $2.8 billion in the second quarter.
The third quarter loss was "...driven primarily by gross mark-to-market adjustments stemming from write-downs on commercial and residential mortgage and real estate assets...During the fiscal third quarter, the Firm is expected to incur negative gross mark-to-market adjustments on assets of ($7.8) billion, including gross negative mark-to-market adjustments of ($5.3) billion on residential mortgage-related positions..." This is amazing; they lost $7.8 billion in write downs and only lost $3.9 billion for the quarter.
The big problem is this meant that Lehman couldn't borrow the money it needed because no one wanted to take the risk. No one was confident that they could repay a loan in light of all the loans they already had taken. In addition, the assets that might be securing past loans were not worth as much as before. Bottom line they were no longer liquid. Lehman tried to get someone to bail them out or buy them but again no one wanted to take the risk.
OK so I see why mortgage defaults hurt Lehman. They were apparently holding lots of the debt as assets and they had to "write-down those" assets. That means that they had to re-evaluate how much those mortgage assets were worth.
But there is another way that the "sub-prime" mortgage problem hurt them. Because of the large number of defaults on mortgages (borrowers not paying their loans), credit in general has been drying up. Banks and other financial intuitions have become much more concerned about lending money and the risk involved (the risk of borrowers not paying the money back). Also so much money has ‘disappeared' as the assets that were sub-prime mortgages have been devalued that there is just less cash out there.
Of course Lehman's failure is only making things worse and credit is getting even tighter. If this keeps up no one will be able to borrow anything to keep their business going. Not good for the market!
So here comes the FED. Well actually this is where the FED "discount window" comes in. The FED discount window is supposed to be the "lender of last resort." Normally they would lend to banks on a very short term basis, normally overnight, to allow banks to meet the reserve requirement. The FED requires certain high grade collateral to be put up to get the funds.
However, the FED has changed the rules recently. On September 18, 2007 the FED cut the rate and increased the term from overnight to thirty days. This was intended to pump liquidity into the banking system.
On March 16, 2008 they extended the term to up to ninety days. They also allowed a broader range in the types of collateral it would accept and extended the use of the discount window to a group of non-banks. This was in response to the Bear Stearns problem. It allowed JP Morgan to buy Bear Stearns but to have Bear Stearns' debt essentially guaranteed by the FED.
This time they came in again to try and pump even more liquidity into the financial system, but declined to do anything to help out Lehman. They again expanded the types of collateral that could be put up and promised to add capital in more "auctions" (another method the FED uses to inject capital into the system). The objective? To calm the markets by insuring that there would be liquidity. Remember if liquidity dries up, just about everything stops.
So who is next? The FED has signaled that it has no intentions of supporting any more deals. AIG is tap dancing as fast as it can to try and stay alive. Merrill was acquired by Bank of America. I don't know what's next, but I'm not alone in thinking that another shoe is out there. On Monday the Dow Jones Industrial Average closed down 504 points.
Hopefully this helps explain a little about what's going on.
"Income Trader"
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Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
