Opinion: The slow train wreck
19th Sep 08, 8:00am
This is the most trying time for capitalism since September 1931. That month saw a contagious collapse of banks in Europe and the USA; Great Britain was forced off the Gold Standard; its government collapsed and was replaced by the first coalition in peacetime. The Royal Navy mutinied. Now, Wall Street is in rout as its system is being devoured in a slow train wreck. In a few days of naked brutality the venerable Lehman Brothers, which had never before made a loss in its 158 year history, plunged into bankruptcy"”a move which may put pressure on its counterparties. Merrill Lynch was sold to Bank of America and AIG, the biggest insurer, was taken over by the state to be dismembered in an orderly way. This follows hard on the bail-out of Freddie Mac and Fanny Mae. But the momentum of the wreck continues. The US Treasury admits that it is concerned for the integrity of more institutions. The market doubts that Morgan Stanley and Goldman can survive in their present form. As bank-to-bank lending atrophies, other institutions that borrowed too much may be going to the wall, including HBOS, and Babcock and Brown in Australia. What is happening? Make no mistake, Wall Street is in crisis. Even Greenspan calls it a "once-in-a-century" financial crisis. The stock market is in panic as indicated by the VIX index, and swap rates are astronomical. Banks are very wary of lending to each other. They do not know what others banks have in their cupboards. No one dared buy Lehman without a government guarantee because they know at one time Lehman were leveraged 40-to-one and might still have many toxic instruments. It may be significant that Lehman's did not try to swap its collateral for credit. Even though the Fed is liberal in discounting shonky assets for cash, Lehman's lacked the sheer impudence to trade its assets for cash. It was active in the CDO market, and perhaps involved in CDO squared and even CDO cubed. Many players bought short and lent long term. Wall Street always closes on Sundays. It is a sacred rule but it was broken this week. The derivative exchanges had to open because players wanted the chance to adjust their positions. This Sunday opening indicates that the Fed is doing everything possible to reduce surprises in the market. Why did this mess arise? Historical analysis is likely to become a massive growth industry. Already, there is a consensus that a wall of money was created, and with cheap interest rates, entrepreneurs chased yield regardless of reasonable risk. There are two views on why a flood of money was created. My column today suggests a structural problem: emerging markets are desperate to find sound, liquid assets and have piled their money into the USA. Others blame the Greenspan administration for reducing the bank-rate essentially to 1%. This was accompanied by massive deregulation which encouraged new asset classifications. Sub-prime mortgages were sliced, diced and repackaged to get them off US bank balance sheets. They contaminated global credit. Huge volumes of financial instruments, about US$370 trillion exclusive of derivatives, were created chasing yield with little regard for risk. Investment banks and hedge funds turned debt into derivatives, and sought new products and new customers. Banks used credit derivatives to diversify their credit portfolios, and sold more assets into markets repackaged as debt securities such as CDO and Leveraged Buy Out instruments. One major problem was that investment banks used their own money to speculate. In the past, they were brokers. Now they get involved, perhaps putting their own interests before their customers. More importantly, they became over-exposed to massive losses when the credit cycle turned against them. They were left holding leveraged buy-out assets and CDOs. Their quantitative experts insisted that they were spreading risk, but they concentrated it in the banks and their hedge funds. Packages of US housing debt, sold under a variety of names, were syndicated and accepted because they had good credit ratings and yields. However, there were escalating defaults. The crisis arose because no one could mark"“to-market a vast array of assets. My belief is that the crisis got out of control for a very simple reason: there was no exchange where assets could be sold. Shares can be sold on exchanges, but CDO's etc. were "over-the-counter instruments", and impossible to price in chaotic situations. Without an exchange, banks, insurers and hedge funds played a kind of pass-the-parcel. They tried desperately to find a buyer who might pay, say, 20c in the dollar for a collection of sub-primes. But as some mortgagees were walking away, it was difficult to justify the price of an asset that could have eleven sub-layers of assets. The top layers were prime, and attested to by rating agencies, but before long the market found that agencies were compromised in their judgment. Banks have since been engaged in hectic deleveraging. As prices feel, banks were forced to bring larger and larger quantities of depreciating assets to market to restore their balance sheets. Banks throughout the world bought toxic assets and in varying degrees destroyed their credit worthiness. Many are undercapitalized shells. Some have merged. Others have raised capital. Almost all have deposited assets with central banks in return for real liquidity. What next? The banking sector is extremely debilitated, especially in the USA. There must be doubts about its ability to function as a positive agent in the economy. Banks have curtailed their lending, their support of IPO's and their important buy-out and merging activity. As far as banks are engines of economic growth, they are now largely lame ducks. The world economy remains positive. But the financial crisis cannot be ring-fenced and it will inevitably impact negatively on economic growth. Several economies have low growth, even recession. Recovery will be harder because the financial sector is negative. Moreover, central banks have concentrated on the stability of the financial sector, to the detriment perhaps of growth. The effort of central banks to rescue financials is a factor in inflation, especially in food and commodities. This has created severe problems for households. The decline of discretionary spending is slowing global growth. The problems are aggravated in the US, UK, Spain and Australasia especially by a housing market in steep decline. Governments know enough to prevent the world from spiraling down into a 1930's-style depression. But there is no end in sight of the wrecking of the financial system. A bear market will persist for some time. Classical economists believe that real growth will not resume until the credit crunch has eradicated debt and surplus capacity. If they are right, the next few years will be painful. ----------------- *Neville Bennett is a long-time Senior Lecturer in History at the University of Canterbury, where he has taught since 1971. His focus is economic history and markets. He is also a columnist for the NBR where a version of this item first appeared.