I still think Jeremy Grantham's target of $1,100 will be reached sooner than 2010, probably later this year or early next year. I also doubt funds which have withdrawn from the market during the last half year, especially in last several weeks, will re-enter the market anytime soon. The worst case scenario is that they may never re-enter the market at all, especially if they are funds for baby boomers.
There is an interesting book "Bringing Down the House", which turned into a movie called "21". It is about a group of MIT students who were trained as card counters to play blackjack in casinos at Las Vegas. They acted as a group, and played small when the odds were not clear or not at their favor but one of them acting as a super rich person would enter into the table and play huge stake when the odds were at their favor. It is a typical example of using leverage against casinos.
It turns out to be that this highly leveraged technique is also used by banks, especially investment banks. No one is trying to bring them down like in the case of "Bringing Down the House". All the current troubles for this industry are their own making. They can't blame anyone else but themselves. However, now they argue that they need unlimited funding protection and bailout from the government, or more accurately, the taxpayers. Did we ask them to use high leverage? Did they ever share the profit with the public before?
To understand leverage, just look at this WSJ's article yesterday (7/16), LEH market cap of $9B is only 40% of their book value of $23B, and it sounds very cheap. But then look at their assets, they have $160B hard-to-value Level 2 assets and $41B impossible-to-value Level 3 assets. WSJ article applies a 5% haircut on Level 2 and 25% on Level 3 to come up with a $19B future write-offs. However, based on analysis from many other public sources, most of the Level 3 assets are MBS CDOs, even if they are AAA rated, the recovery rate is only about 50%. For Level 2 assets, 10% haircut is actually a conservative estimate. The combination of both will result $36B additional losses, which would more than wipe out their book value of $23B plus their market cap of $9B. This is leverage in the working, unfortunately at the down side.
Let us also look at Fannie Mae and see what the level of leverage they are using. FNM has long term liabilities of about $580B, according to Yahoo Finance. It has a negative duration mis-match of 14 months between its assets and its liabilities. Due to this mis-match, An 1% drop in interest rate will cause roughly 14/12 or 1.17% loss in value, or $7B (1.17% x $580B). And their market cap is only $10B. We are only talking about pure interest rate risk, not even the losses of credit risk from lending practice, delinquency, foreclosure, etc. from the deterioration of the real estate market, which would be much larger than interest rate risk.
People have drawn parallel between the current failure of IndyMac and the failure of Continental Illinois Bank in 1984, with the expectation that IndyMac will cost FDIC about $4B to $8B, when FDIC has only $52B in its insurance funds. But this comparison has missed the whole S&L crisis which losses were much larger than one commercial bank and FDIC was actually not quite involved. For S&L, the Federal Savings & Loan Insurance Corporation (FSLIC) was the show, and it had $5.6B in 1984 to pay claims, by 1989 its balance had turned into an $87B deficit. The total number of failed S&L institutions are estimated to be around 1,000, and GAO (US General Accounting Office) has estimated the total losses for S&L to be $166B for taxpayers.
Today people are trying to estimate how many banks will fail this time. The number probably won't get to the 1,000 mark as in the S&L case, and the figure of a few hundred banks has commonly been quoted. At the end of this crisis, FDIC will be most likely in the red as in the FSLIC situation.
A week ago, Bridgewater Associates has issued a report saying the banking system losses likely to hit $1.6 trillion, but didn't give any breakdowns. This is more than the $1 trillion estimate in my article "Will CDS Replace Subprime To Cause $1 Trillion Total Loss For This Credit Crisis?" in January this year. I actually tried to give a breakdown as follows: $500B for over the counter credit default swaps (CDS), $250B for subprime, and $250B for everything else such as commercial real estate, leveraged loans, credit card losses, auto loans, etc. Due to the deterioration of real estate market and continued losses, I think I underestimated the subprime by about $150B, also I should include some losses for Alt-A and prime mortgages since the losses have already cut into them, especially Alt-A. In addition, CDS has become a larger, deeper and wilder threat to the whole banking system day by day, maybe $1 trillion is a better estimate now. Overall, $2 trillion losses are really not stretching.
So far this year, some financial institutions have touched the single digit territory, such as Fannie Mae, Freddie Mac, Wachovia, Bear Stearns. After the current bear market rally for the banking sector, who would be the next round of candidates to touch and maybe even stay at single digit? It seems that investment banks are still the usual suspects, such as Lehman, UBS, and possibly even Merrill Lynch and Citigroup too.
In order to avoid the domino effect of the current credit crisis to ripple through the whole banking industry, the Fed is currently holding the bag by bailing everyone in trouble out. And so far we are only talking about residential mortgages and their CDO derivatives. If the next wave of credit default swap crisis hits, it would be much wider than LTCM, much worse than S&L, and much deeper than subprime. With raising capital becoming difficult these days, banks have to rely more and more on the Fed with balance sheet of only $800B.
Source: By Thomas Tan, CFA : See his profile at Vestopia