It was as if the market needed to be thrown a body before it could be mollified. On August 5th Bear Stearns, an embattled investment bank that has seen two of its hedge funds holed by subprime mortgages, tossed Warren Spector, its co-president, overboard. The next day its share price, which had plunged by over a third in recent weeks, rallied 5%. The shares of its investment-banking peers, which had also been caught in the storm, bounced back early in the week.
Has the weather turned? Not yet. On August 9th BNP Paribas, a French bank, suspended withdrawals from three funds invested in securities backed by mortgages, citing “the complete evaporation of liquidity in certain market segments.” Financing buy-outs remains hard. Some hedge funds are also suffering. Goldman Sachs, which prides itself on its risk management, reportedly saw returns at its $9 billion Global Alpha hedge fund drop by almost 12% in the past two weeks (the rest of the industry appears to have produced positive returns on average in July, according to Hedge Fund Research).
Understandably, given the opacity of the investment banks’ exposure to credit markets, not least subprime mortgages, investors decided to sell first and ask questions later, walloping the shares of Wall Street firms, especially Bear Stearns, Lehman Brothers and Merrill Lynch. Then came the reappraisal of risk.
Liquidity fears were the biggest hurdle. The evaporation of funding possibilities ultimately drove Drexel Burnham Lambert, a high-flying investment bank, into bankruptcy in the 1980s and threatened Wall Street banks after the implosion of Long-Term Capital Management (LTCM), a gargantuan hedge fund, in 1998.
The disquiet over liquidity is exacerbated by the fact that investment banks —which usually package securities and sell them—have increasingly stuffed their vaults with illiquid assets, such as private-equity investments, “hung” bridge loans (ie, those that are not as temporary as had been hoped), and rarely traded derivatives. According to Fitch, a rating agency, such assets at the top five Wall Street banks ballooned from $144 billion in 2004 to $229 billion at the end of the second quarter of this year, up 59%. That excludes what some estimate to be $300 billion in loans promised to buy-out firms and companies.
However, investment banks claim to have learned some lessons from LTCM. First, they are less reliant on short-term debt for their funding. The proliferation of interest-rate derivatives since the late 1990s means banks can hedge the risks of holding long-term debt. Bankers also say the increased cost of long-term debt is justified when it provides breathing space in a crunch. UBS reckons that brokers today use short-term liabilities for just a fifth of their funding, down from well over 50% a decade ago.
Investment banks have also built up shock absorbers. According to Fitch, the average investment bank holds more than twice as much capital as it does illiquid assets. Goldman Sachs keeps a stockpile of over $50 billion in highly liquid securities in case markets dry up. Wall Street firms have also diversified their funding sources by acquiring deposit-taking banks.
Even Bear Stearns has soothed the doubters, at least temporarily. On August 7th it announced it had managed to raise $2.3 billion in the capital markets, although at a steep price.
But like its peers it continues to keep details of its subprime and other credit exposures to itself. Investors will take a lot of convincing that it is fully seaworthy, having looked so tattered just days ago. Says Eileen Fahey of Fitch, “It is a trust issue more than a liquidity issue.” And if trust goes, liquidity usually follows.