Primary Dealers and Their Loss Experience

Author: Bob Eisenbeis, Post Date: August 18, 2008
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Bianco Research periodically has published a compilation of the losses that have accumulated in major banks and investment banks as a result of the so-called subprime crisis.

(1) When Chairman Bernanke hinted in his July 12, 2007 Congressional testimony that losses might reach $100 billion, this seemed alarmingly large.  But the Bianco data now show that this was a very conservative estimate indeed.

Losses recognized to date now amount to nearly $500 billion and clearly are likely to grow larger as foreign institutions begin to release their second-quarter financial statements.  To their credit, the institutions reporting have successfully raised more than $350 billion to replenish capital depleted due to loss recognition.  But a large hole still remains, and there is now reason to suggest that those institutions that have experienced the largest losses – namely Citigroup, UBS, Wachovia, Morgan Stanley, and the others – will need to raise substantial additional capital as a result of having to take nearly $50 billion of auction rate securities back onto their balance sheets as part of the settlements with the attorneys general of New York and other states.  Clearly, there are more securities to bring back on balance sheet and Cumberland’s estimates are that they could go as high as $100 billion.

While the financial turmoil has received wide attention, the extent to which the losses and impacts have been experienced by a relatively few institutions has drawn little notice.   It is noteworthy that most of these institutions are also among the subset of large, complex financial intermediaries that function as primary dealers.  These are the so-called elite institutions qualified, because of their supposed sophistication and financial strength, to deal directly with the Federal Reserve as it conducts its daily open market operations.  Their role in the monetary policy transmission process also explains the special treatment they have received by being granted access to the Primary Dealer Credit Facility (PDCF).

To illustrate the loss concentration, the Bianco data in the table attached, (the document is no longer available at the original site) were first sorted by primary dealer status (the firms listed in bold type) and then by the sizes of the losses institutions have recognized to date.  Four facts are important to note about this list.  First, the 16 primary dealers are among the nearly 60 firms listed but they dominate the universe having experienced $280 billion or (56%) of the total losses reported to date.  Second, these primary dealers have raised about $184 billion in new capital, but they are still are nearly $100 billion short of covering even their reported losses, which is seriously impacting their ability to deleverage as financial markets are now demanding.  Third, only two of the primary dealers have actually successfully replenished their capital, while the remainder has suffered in some cases significant capital impairment.  Finally, Bianco notes that losses aren’t concentrated solely in US firms.  Combined European and Asian losses are virtually equal to those of US institutions, with most ($ 222 billion) being in European headquartered institutions.

This loss experience of the primary dealers raises both short- and longer-term issues.  For example, given that the primary dealers have access to the discount window now, should they now be allowed both to fund and to liquefy the auction rate notes that many are now having to bring back on their balance sheets in significant amounts, by using these securities as collateral for discount window borrowings and participation in the securities lending programs? These instruments are clearly of high quality in most cases and would likely qualify as eligible collateral.  But if they do, then the subsidies granted would more than offset the costs to the institutions of bringing the securities back on their balance sheets.  For example, if the holdings of auction rate securities are funded through the Fed, the cost would be 2 ¼% (the discount rate) whereas current market rates suggest that funding them by issuing only preferred stock would cost about 9%; regardless, additional capital would have to be raised to support the growth in assets.  Clearly, it seems inappropriate to reward what was likely questionable behavior in the auction securities markets by these institutions by cushioning their exit from the market. There is ample evidence, again provided in recent data from Bianco Research, L.L.C. that these dealers are already relying substantially upon the Federal Reserve’s new special lending and other new facilities to finance their assets and have not made significant progress in shrinking their balance sheets.  Keep in mind that these are the elite institutions that have been deemed critical to the functioning of our financial markets.

Over the longer run, the current difficulties raise serious questions about the structure of Federal Reserve daily open market operations and the wisdom of only dealing with a few institutions heavily concentrated in New York.  We learned from 9/11 that serious things can happen and jeopardize the smooth functioning of our money markets and payments systems.  Is there justification for permitting investment banks, that have been among the biggest losers in the subprime debacle, to be primary dealers, given that they aren’t subject to supervision and prudential regulation?  Current daily operating procedures which rely upon only a few select institutions are a legacy of a pre-computer world.  There clearly is no reason today that bids can’t be accepted electronically from any sound member bank.  Bids are processed and allocated electronically, so there are currently no technical limitations to the ability to accept and process bids from institutions across the country.

What these issues mean for investors and market participants is that the concentration of financial difficulties in a relatively few, very large institutions makes the swift return to smooth functioning financial markets more problematic and implies that it will be extremely difficult to quickly withdraw the emergency lending and support facilities that have been put in place for these major financial institutions.  These firms will be faced with continued pressures to de-lever and to raise more equity, and until they do and the full extent of their losses are revealed their stock prices are likely to languish.  It is important to remember, as Peter Fisher of Blackrock pointed out in a recent Bloomberg radio interview, banks can’t de-lever by maintaining their borrowing from either the market or the Federal Reserve.  Finally, the bringing back of auction rate securities to institution balance sheets may help customers, but it will certainly not remedy the problems that have plagued the auction rate markets for some time now.

(1)See Bianco Research L.L.C., “The Latest On the Credit Crisis,” August 12, 2008.

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