Boston, Massachusetts, after the great fire of November 9-10, 1872
Here's your ticket, pack your bag;
time for jumpin' overboard
Transportation is here
Close enough but not too far,
maybe you know where you are
Fightin' fire with fire
Hold tight; wait 'til the party's over
Hold tight; we're in for nasty weather
There has got to be a way
Burning down the house
All wet, yeah, you might need a raincoat
Shakedown thieves walking in broad daylight
Three hundred sixty five degrees
Burning down the house
No visible means of support
and you have not seen nothing yet
Everything's stuck together
I don't know what you expect
staring into the TV set
Fighting fire with fire
Burning down the house
Ilargi: Funny to see Wall Street rise this morning on the central banks’ quarter trillion dollar capital injection.
Predictably, it didn’t even last till noon. Both Morgan Stanley and Goldman Sachs, the Wall Street kingmaker, are now under heavy artillery fire. Or perhaps Troy is a more fitting metaphor.
Funny, because the injection can’t save anything at all; instead, it’s nothing but a sign of despair. When I read about it last night, my first reaction was: "Way to go, that worked miracles last time around".
Trillions of dollars have been pumped into the global financial system over the past year, and it hasn’t helped one infinitesimal iota of an inch. That is because the problem is solvency, not liquidity. The world is drowning in liquidity, thanks to Alan Greenspan and his mob-men at the Bank of Japan. It’s just not where the banks would like it; it’s not in their pockets.
The people who do have it refuse to lend it to the banks any longer, because they’ve burned through it like a house on fire. Moreover, all the money central banks have intravenously injected has disappeared into that same burning house. The banks either use it to pay off their endless arrays of debts, or they hoard it for times when paying off the rest of those debts can no longer be postponed.
The alleged idea is to make banks lend to each other, and to potential home-buyers, but that is not happening. It didn’t in earlier money pumping actions, and it won’t this time. Banks still don’t trust each other, and for very good reasons. Bank A refuses to lend to Bank B, because it is afraid that Bank B holds the exact same soiled casino toilet paper in its vaults that Bank A itself has. And no amount of temporary central-bank-furnished borrowed credit can make that toilet paper magically become clean or valuable again, or make it disappear from the vaults.
These banks are insolvent, they are bankrupt. Sooner or later they will go the way of the pterodactyl, unable to pay back the credit they now receive, for which the central banks accept ever more worthless toilet paper as collateral. Sooner or later the FEd and the ECB will be the proud owners of the vast majority of the world’s dirty stinking Kleenex.
And then the central bank will turn to the Treasury, and the Treasury will fork over. You know what the Treasury will give them? Your money, that’s what. So you will be paying through the nose for paper that your central banks and Treasuries have acquired from banks, knowing full well that it wasn’t worth even a fraction of what they're giving the banks in exchange. But they will keep insisting that the markets will rise again, and the paper will regain its value. And the citizens of the countries they reside in, the very people who are duped and cheated out of their money wherever they look, will keep on believing them.
Meanwhile, all this is a plain and simple truth for everyone in the know inside the financial system. Repeating again and again what has so obviously not worked in the past is the ultimate sign of weakness. Not that they don’t appreciate all the added free lunches. It’ll all be metabolized into the black hole, in a few days at the most (more likely a few hours) and then the insatiable sharks will go back to chasing the trail of blood in the water.
Credit injections do not help, because they cannot. Painkillers do not cure cancer. In the public eye, what passes for medical staff in the financial world in the US and EU, in the face of being found out to be a bunch of frauds and quacks, try to keep up the appearance of being in control. Meanwhile, behind the public's back, their friends in the know prepare to make another killing off the public purse. And it takes ever increasing amounts of your money to keep up the charade for ever shorter amounts of time.
This whole thing is not getting better, it’s getting worse. And fast. I have already mentioned the law-bending and breaking by Bernanke and Paulson that has taken place in the US recently, the stocks for T-Bills at the Fed windows, and BoA using its customer deposits for blackjack Merrill "investment banking".
It’s not just the US: UK prime minister Gordon Brown, in facilitating the HBOS takeover by Lloyd’s, is changing British banking laws on the fly, as if they are his to do with as he pleases. You know what’s really funny? Neither Bernanke nor Paulson nor Brown were elected to their posts.
The laws involved are competition related: the new UK super bank holds one third of all deposits and mortgages in the UK. Where I come from, that’s called a cartel. It’s now legal, or passes for it, in Britain.
All of this, the trillions in taxpayer money hand-outs as well as the law breaking, is presented as necessary to "save the system". But that’s a fraudulent claim: the system cannot be saved, the system is bankrupt, as are the banks and the US government.
What the actions achieve is a few days or weeks of additional time to fleece the taxpayers out of an additonal part of the already sorrowfully meagre remnants of what was once rightfully seen as their wealth. And those same taxpayers are not going to clue in before they’ve lost it all: the entire criminal enterprise is presented as protection of the taxpayers, and they all swallow it hook, line and stinker.
The system is way beyond salvation, and has been for years. The sleight-of-hand "efforts to save the sytem" cannot succeed. And it is in no way in the interest of the taxpayer to try to save the system. It’s in the interest of the people that run it, the ones that have one hand on the triggers of the central banks, and one hand in your pockets.
Panic grips credit markets
The panic in world credit markets reached historic intensity on Wednesday, prompting a flight to safety of the kind not seen since the second world war. Barometers of financial stress hit record peaks across the world. Yields on short-term US Treasuries hit their lowest level since the London Blitz, while gold had its biggest one-day gain ever in dollar terms. Lending between banks, in effect, stopped.
Speculation mounted that the Federal Reserve, which refused to cut rates on Tuesday, could be forced into an embarrassing U-turn or might further expand its market liquidity operations. The $85bn emergency Fed loan for the troubled insurance group AIG, announced on Tuesday night, failed to curb the surge in risk aversion. Instead, markets were hit by a fresh wave of anxiety.
One cause for fear came when shares in a supposedly safe money market mutual fund fell below par value – or “broke the buck” – owing to losses on debt in Lehman Brothers, which filed for bankruptcy protection on Monday. This raised the risk that retail investors in other such funds could panic and pull out their money.
All thought of profit was abandoned as traders piled in to the safety of short-term Treasuries, with the yield on three-month bills falling as low as 0.02 per cent – rates that characterised the “lost decade” in Japan. The last time US Treasuries were this low was January 1941.
Shares in the two largest independent US investment banks left standing – Morgan Stanley and Goldman Sachs – fell 24 per cent and 14 per cent, respectively, as the cost of insuring their debt soared, threatening their ability to finance themselves.
Morgan Stanley was holding preliminary merger talks with Wachovia, a troubled regional lender, and could approach other banks and look at other options in the coming days, people familiar with the situation said. Washington Mutual, another regional lender, has hired Goldman Sachs to contact potential buyers.
HBOS, a leading UK mortgage lender pressed into sales talks by the government after its share price halved this week, agreed to a £12bn takeover by Lloyds TSB. A key measure of fear in the fixed-income markets - the so-called Ted spread, which tracks the difference between three-month Libor and Treasury bill rates - moved above 3 per cent, higher than the record close after the Black Monday stock market crash of 1987.
US authorities fired back with the Treasury announcing it was borrowing $40bn to give to the Fed to use for its emergency lending – in essence removing balance sheet constraints on the size of this assistance. The Securities and Exchange Commission announced new curbs on short selling.
Some analysts have criticised US authorities for adopting an arbitrary approach to rescues - saving AIG, but not Lehman - that was impossible for investors to predict and therefore did not boost confidence. The S&P?500 fell 4.7 per cent, led by a 8.9 per cent slump in financials. Equity volatility was near its highest level since March. The dollar fell against other major currencies.
Gold benefited from safe-haven buying, with prices rising 11.2 per cent to a three-week high of $866.47 a troy ounce. Andrew Brenner, co-head of structured products and emerging markets at MF Global, said: “It feels like no one wants to take anyone’s credit...it feels like we are on a precipice.”
Money-Market Rate Slides After Central Bank Action
The cost of borrowing in dollars overnight tumbled after central banks worldwide pumped $247 billion into money markets. The three-month rate rose for a third day, to the highest level since January, according to the British Bankers' Association, signaling that banks are still wary of more failures among financial institutions after Lehman Brothers Holdings Inc. collapsed and the U.S. government took control of American International Group Inc.
"The only thing you can say about today's intervention is that the overnight rate is now better," said Jan Misch, a money-market trader in Stuttgart at Landesbank Baden- Wuerttemberg, Germany's biggest state-owned bank. "There's still a complete lack of confidence in the market though. There is enough cash out there, it's just not being lent out because people have lost faith in each other."
The Federal Reserve, the European Central Bank and the Bank of Japan joined with counterparts in Switzerland, the U.K. and Canada to inject cash into the money markets in a coordinated bid to ease the worst financial-market crisis since the 1920s.
The London interbank offered rate, or Libor, for overnight loans fell 1.19 percentage points to 3.84 percent today, the BBA said. It dropped 1.41 percentage points yesterday after jumping 3.33 points the day before. The three-month rate, which rose yesterday the most since 1999, climbed a further 14 basis points to 3.20 percent today, according to BBA data.
The Fed said on its Web site that it authorized other central banks to auction the dollar funds to financial institutions. A joint release said that the Bank of England, the Bank of Canada and the Swiss National Bank also participated. The ECB, Bank of England and Swiss National Bank allotted a combined $64 billion for one day today.
"The action is designed to address the continued elevated pressures in U.S. dollar short-term funding markets," the central banks said in the statement. "The central banks continue to work together closely and will take appropriate steps to address the ongoing pressures."
The world's biggest financial institutions posted almost $520 billion in subprime-related losses and writedowns since the start of last year. Eleven U.S. banks collapsed since January. Corporate bond sales in the U.S. and Europe slumped 42 percent from a year ago, according to data compiled by Bloomberg.
"The demand for liquidity has soared and has pushed banks to hoard cash," said Eoin O'Callaghan, a London-based economist for BNP Paribas SA. "Market-based liquidity has dried up." Yields on three-month U.S. Treasury bills tumbled 135 basis points this week as investors sought the relative safety of government debt. The bill rate was at 12 basis points today, near the lowest level since World War II.
The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, widened 8 basis points to 310 basis points. That's higher than the 300 basis-point spread reached Oct. 20, 1987, when stocks collapsed around the world on what became known as Black Monday.
The U.S. commercial paper market fell $52.1 billion to $1.76 trillion for the week ended Sept. 17, the Federal Reserve said today in Washington. Overnight commercial paper yields have jumped 1.38 percentage points this week to 3.46 percent, according to data compiled by Bloomberg.
The difference between the Libor for three-month dollar loans and the overnight indexed swap rate, the Libor-OIS spread that measures the availability of funds in the market, widened 17 basis points to 149 basis points today, the most since at least December 2001, adding to yesterday's 31 basis-point increase. The spread averaged 8 basis points in the 12 months to July 31, 2007, before the credit squeeze started.
"No one is really expecting these spreads to come in," said Moyeen Islam, a London-based fixed-income strategist for Barclays Capital and a former U.K. Treasury economist. "There's no let-up in the pressures in what we've been seeing."
U.S. Stocks Rise on Central Bank Actions, Short-Sale Crackdown
U.S. stocks rose as the world's biggest central banks planned to pump $247 billion into the financial system and regulators cracked down on abusive speculation against bank shares.
Bank of America Corp., American Express Co. and General Motors Corp. climbed more than 4 percent as the central bankers' moves helped shore up confidence following a tumble in stocks that wiped out $717 billion in value from U.S. equities yesterday. Washington Mutual Inc., the biggest U.S. savings and loan, surged 20 percent on speculation the nation's largest banks will bid for parts of the company. Kraft Foods Inc. jumped 2.3 percent after being named as the replacement for American International Group Inc. in the Dow Jones Industrial Average.
The Standard & Poor's 500 Index jumped 18.87, or 1.6 percent, to 1,175.26 at 10:16 a.m. in New York. The Dow added 139.31, or 1.3 percent, to 10,748.97. The Nasdaq Composite Index increased 32.25 to 2,131.1. Nine stocks advanced for every two that fell on the New York Stock Exchange.
"Pessimism is very deep right now, but oftentimes that represents a great opportunity for investors to get back into the market," Michael Koskuba, a New York-based fund manager at Victory Capital Management Inc., told Bloomberg Television. Victory Capital oversees $66 billion. "Hopefully we're getting to the point now where confidence will come back into the markets."
The S&P 500, which has fallen 4.7 percent twice this week, rebounded from its lowest level since May 2005 after the Fed said it authorized central banks to auction funds "to address the continued elevated pressures in U.S. dollar short-term funding markets." The Securities and Exchange Commission stiffened regulations against manipulative short-selling after the routs in AIG and Lehman Brothers Holdings Inc.
Russia and China took steps to stanch declines in their stock markets. Russian President Dmitry Medvedev said the government will spend 500 billion rubles ($20 billion) to support the shares. China will scrap the stamp duty on stock purchases and buy shares in three of the largest state-owned banks to shore up investor confidence, the official Xinhua News Agency reported.
About $3.6 trillion of market value has been erased from global stocks this week, triggered by the bankruptcy filing by Lehman, once the fourth-largest U.S. securities firm. Finance officials have struggled to restore confidence in markets as concern mounted more banks will follow Lehman into bankruptcy.
All 10 of the main industry groups in the S&P 500 advanced today, with financials climbing 2.6 percent and energy shares rising 3.3 percent after oil prices rose above $100 a barrel as a weaker dollar boosted the appeal of commodities as a currency hedge.
Bank of America added $1.31 to $28.51. American Express jumped $1.57 to $34.61. GM climbed 51 cents to $10.44.
Washington Mutual rose 42 cents to $2.43. JPMorgan Chase & Co., Citigroup Inc., Bank of America and Wells Fargo & Co. may be interested in buying pieces of WaMu, said three people with knowledge of the discussions, who asked not to be identified because the talks are private.
Morgan Stanley shares rose for the first time in eight days as the securities firm sought to shore up capital. The company is considering selling a larger stake to China Investment Corp., the state-controlled investment fund, and is in talks about a possible merger with Wachovia Corp., said a person familiar with the matter. Morgan Stanley gained 3 cents to $21.78 after losing almost half its value in the previous seven days.
Kraft rose 76 cents to $33.41. It will replace AIG in the 112-year-old Dow average of 30 stocks on Sept. 22. The biggest U.S. insurance company was taken over by the government this week after mortgage-related losses led to credit-rating downgrades that drove the company to the brink of bankruptcy. News Corp.'s Dow Jones Indexes said it declined to add another financial company to the Dow "because of the extremely unsettled conditions" in global markets.
The SEC's new rules on short sales force traders to borrow shares before selling them short and make it a fraud for investors to lie to their broker about locating stock to close positions. The SEC may also require hedge funds to disclose their short-sale positions and plans to subpoena the funds' communication records in an effort to stem turmoil in stock markets.
Stocks rose even after the Labor Department reported that initial jobless claims in the U.S. unexpectedly increased last week and the Conference Board's index of leading economic indicators trailed economists' estimates. U.S. stocks tumbled yesterday as bank lending seized up in the wake of the government's takeover of AIG, raising concern that more of the nation's biggest financial companies will fail.
The 26 percent drop in the S&P 500 since its October peak erased half its gain from the five-year bull market that began in 2002. The S&P 500 is poised to post its first yearly retreat since 2002 after global banks racked up $519 billion in credit losses and asset writedowns stemming from the first nationwide decline in home prices since the 1930s.
Central Banks Pump $247 Billion Into Markets
The Federal Reserve almost quadrupled the amount of dollars central banks can auction around the world to $247 billion in a coordinated bid to ease the worst crisis facing financial markets since the 1920s.
The Fed increased the amount of dollars that the European Central Bank, the Bank of Japan and other counterparts can offer from $67 billion "to address the continued elevated pressures in U.S. dollar short-term funding markets." The Bank of England, the Bank of Canada and the Swiss National Bank also participated.
Policy makers have struggled to revive confidence in markets this week as investors stockpiled money on concern more financial institutions would fail after the bankruptcy of Lehman Brothers Holdings Inc. and the U.S. government bailout of American International Group Inc. The cost to hedge against losses on U.S. government debt climbed to a record yesterday.
"There's a complete lack of faith in the markets," said Jim O'Neill, chief economist at Goldman Sachs Group Inc. in London. "There's a lot of cash hoarding and people losing trust in banks, so the central banks are acting to relieve that. This might not be the last time they have to act."
Markets welcomed the announcement, which was made in statements from each central bank at 9 a.m. Frankfurt time at the start of European trading. The cost of borrowing dollars overnight slid to 3.84 percent from 5.03 percent yesterday. It was 2.15 percent last week and reached the highest since 2001 on Sept. 15.
The Fed, which is adding $50 billion into its own banking system today, will spray dollars around the world via swap lines with other central banks. They can then auction them in their own markets. The ECB, Bank of England and Swiss National Bank allotted a total of $64 billion for one day today.
"The timing, so early in the trading day, shows both the severity of the strains in the interbank market and as well the authorities' determination to resuscitate orderly functioning of the money markets," said Julian Callow, head of European economics at Barclays Capital in London.
Under the new arrangements, the ECB doubled the limit of dollars it can get from the Fed to $110 billion and Switzerland's central bank can offer $27 billion, an extra $15 billion. New swap facilities with the Bank of Japan, the Bank of England and the Bank of Canada amount to $60 billion, $40 billion and $10 billion, respectively. The arrangements are authorized until Jan. 30.
The ECB said it would offer $40 billion "for as long as needed" in overnight funds to the region's banks. It will also increase by $5 billion the amount it lends for 28 days and 84 days to $25 billion and $15 billion. The Swiss National Bank will boost its 28-day auctions to $8 billion and the 84-day offering to $9 billion. Both were previously $6 billion.
The Bank of Canada said it has decided not to draw on its $10 billion swap facility at this time. The Bank of Japan, whose policy board held an emergency meeting today, said it will use its $60 billion as required by market conditions. In auctions of their own currencies, the ECB today lent 25 billion euros in one-day money and the Bank of England 66.2 billion pounds in one-week loans.
The joint action is the latest attempt by central bankers to avert the financial crisis which deepened this week after Lehman and AIG tumbled and Merrill Lynch & Co. was sold. The crisis began over a year ago after the U.S. housing market imploded and has pushed the world economy to the brink of recession.
As markets seized up this week, central bankers pushed more than $200 billion into markets with those in Japan, Hong Kong, South Korea and Australia doing so again today. Wall Street's woes have gone global, forcing the U.K. government to sponsor a rescue of mortgage lender HBOS Plc and Russia to pour money into its banks.
Russia's government said today it would invest in the country's stock market when it reopens tomorrow. The official Xinhua News Agency said China will buy equity stakes in state-owned banks to stabilize its market. Swap lines were first established in December when officials joined forces to boost dollar liquidity around the world after interest-rate reductions in the U.S., the U.K. and Canada failed to ease concerns about bank lending. The Fed increased its link with the ECB in July.
The announcement today boosted European shares and U.S. futures, which have been pummeled this week as contagion spread through financial markets. The Standard & Poor's 500 Index futures expiring in December added 15, or 1.3 percent, to 1,177.9 as of 11:22 a.m. in London. More than $19 trillion has been wiped off the value of global stock markets since Oct. 31.
Failure to calm markets will see central banks inject even more cash, said Robert Barrie, an economist at Credit Suisse Group in London. Other options central banks could take include accepting greater collateral denominated in foreign currencies and increasing lending to banks abroad. "The lack of dollars has been making the financial crisis worse around the world, which is why we now have this coordinated response," Barrie said.
Since the credit squeeze began in August 2007, central banks have sought to keep apart the need to soothe markets and to combat inflation. They argue that interest rates are a blunt tool for helping markets and that price pressures prevent them from cutting rates. While the Fed slashed its key lending rate to 2 percent, the central bank has left it there since April.
The Bank of Japan kept its key rate at 0.5 percent this week and the European Central Bank increased its benchmark to a seven-year high in July. If the spasms in the markets continue and threaten to derail growth central bankers may shift, although for now they will want to wait, said Kevin Gaynor, head of economics at Royal Bank of Scotland Group Plc in London. "Partly this is to keep powder dry and partly because cutting interest rates won't make much difference," he said.
AIG fears lead to commodities sell-off
AIG’s woes reverberated through commodity markets on Wednesday, triggering a wave of selling and forcing two exchanges to make an extraordinary intervention in the markets. The insurer acts as a counterparty to a substantial portion of the $30bn invested in the Dow Jones AIG Commodity Index, the second most popular benchmark for investing in commodities.
The insurer provides derivatives to investors that offer exposure to the index and commodity markets were beset by worries about potential risks on these deals. The London Stock Exchange suspended trading for a range of exchange traded commodities issued by ETF Securities, which are backed by matching products from AIG, after a number of marketmakers stopped trading them.
ETF Securities said 113 of its 129 ETC products were affected, involving about $3bn, or one-third, of its total assets under management. The company stressed that AIG had continued to honour its obligations and normal trading was expected to resume in the next 48 hours.
An emergency sale of AIG’s agricultural commodity positions also was staged by CME Group, the world’s largest futures exchange, after it received approval from US regulators for an unusual block-trading session. In a block trade, two counterparties privately agree an off-exchange transaction, but the deal goes through the exchange’s clearing house. It allows the exchange to facilitate large trades without disrupting the market.
Although block trading is a common part of business in some financial futures, such as the CME’s Eurodollar market, it is unheard-of in agricultural markets. CME Group said it took the action to protect the orderly functioning of the market. It said: “The agreed-upon order permits the limited execution of block trades by AIG in certain commodity futures products, including soybeans, soybean oil, corn, wheat, live cattle and lean hogs, for the purpose of liquidating a portion of AIG’s open positions.”
“It’s a prudent measure,” said Mike Manning, chief executive of Chicago-based Rand Financial Services, a clearing member at the CME. “The markets are crazy as it is without that type of disruption.”
Mounting Fears Shake World Markets As Banking Giants Rush to Raise Capital
Fear coursed through the U.S. financial system on Wednesday, as hope for a resolution to the year-old credit crisis faded.
Stocks tumbled, concern grew about which financial firm would fall next, and investors rushed toward the safe haven of government bonds in the wake of the collapse of Lehman Brothers Holdings Inc. and the crisis at insurer American International Group.
The market turmoil is doing more than inflicting losses on investors. Borrowing costs for U.S. companies have skyrocketed, and the debt markets have become nearly inaccessible to all but the most creditworthy borrowers. The desperation was especially striking in the market for U.S. government debt, long considered the safest of investments. At one point during the day, investors were willing to pay more for one-month Treasurys than they could expect to get back when the bonds matured.
Some investors, in essence, had decided that a small but known loss was better than the uncertainty connected to any other type of investment. That's never happened before. In a special government auction on Wednesday, demand ran so high that the Treasury Department sold $40 billion in bills, far beyond what it needed to cover the government's obligations.
"We've seen crisis. We've seen recession. But we've not seen the core of the financial system shaken like this," says Joseph Balestrino, a portfolio manager at Federated Investors. "It's just crazy."
A 449-point selloff took the Dow Jones Industrial Average to its lowest level in almost three years, leaving it 23% below where it stood a year ago. Volume on the New York Stock Exchange was the second highest in history, falling just shy of the record set on Tuesday. The VIX, a widely watched measure of market volatility that is often referred to as the "fear index," hit its highest level since late 2002.
In Europe, stock markets lost roughly 2% of their value. In Russia, the scene of recent massive declines, trading on the country's major exchanges was halted for the second day in a row, this time only an hour and a half into the session. Gold prices rose 9% to $846.60 an ounce amid the global turmoil. In early trading Thursday, Tokyo stocks were down 3.2%, among other declining markets in the region. "Forget about retail investors, all the pros are scared," says one broker. "People have no idea where to put their money."
For now, "if you have cash, you're going to put it in the short-term, most liquid stuff you can," says Steve Van Order, fixed-income strategist for Calvert Asset Management. Adding to the fear was a loss in a prominent money-market fund, the Reserve Primary Fund, which held Lehman Brothers debt. It was the first time since 1994 that such a fund, which is supposed to be as safe as a bank account, had lost money.
The loss was made worse by a run on the fund. Over two days, investors pulled more than half of their assets from the fund, once valued at $64 billion. "This is a panic situation" in the bond markets, says Charles Comiskey, head of U.S. government-bond trading in New York at HSBC Securities USA Inc. Riskier assets were sold off. Yields on bonds issued by financial companies hit a record high of about six percentage points above U.S. Treasurys.
In the market for credit-default swaps -- essentially insurance against default on assets tied to corporate debt and mortgage securities -- fears increased on Wednesday about whether counterparties would be able to honor their agreements. Investors tried to reduce their exposures to two more big players in the market, Goldman Sachs Group Inc. and Morgan Stanley. That sent the cost of protection on both Wall Street firms soaring to new highs.
In the stock market, the pressure on financial firms continued, with Morgan Stanley stock dropping 24% and Goldman Sachs shares losing 14%. Investors say the government takeover of AIG and Lehman's bankruptcy filing are evidence that the situation is grimmer than all but the most pessimistic had expected. Problems have spread from complex debt markets tied directly to the housing market into plain-vanilla corporate bonds.
"Another front is opening," says Ajay Rajadhyaksha, head of fixed-income research at Barclays Capital. Some people fear that the dwindling ranks of investment banks, coming at a time when commercial banks are pulling back on their own use of capital, will prolong the credit crunch. "It's unclear who is going to be a credit provider going forward, and if having fewer credit providers means higher costs of borrowing going forward," says Basil Williams, chief executive of hedge-fund manager Concordia Advisors.
Ordinarily, bondholders are better protected from losses than stock investors. But the events of the past two weeks have shown that they are vulnerable, too. The Federal Reserve's rescue of AIG doesn't protect the company's bondholders. That's because the deal, which consists of a high-priced loan to the company from the government, requires AIG to pay the Treasury before current bondholders. If AIG can't raise enough cash by selling assets, bondholders won't be fully repaid.
As a result, despite the Fed lifeline, some AIG debt is changing hands at just 40 cents on the dollar, less than half of the price one week ago. Now that Lehman has defaulted on its debt, its senior bonds are worth as little as 17 cents on the dollar, traders say. That's spilled over to other financial names seen as under stress. Bonds of Morgan Stanley are trading at around 60 cents on the dollar. Goldman Sachs's bonds are trading at prices in the range of 70 cents on the dollar.
As bond prices dropped, their yields rose. The spread between yields on corporate bonds and safe U.S. Treasurys have blown out to the widest levels traders have seen in years. On Wednesday, yields on investment-grade corporate bonds were more than four percentage points higher than comparable Treasury bonds, according to Merrill Lynch. Junk bonds ended the day more than nine percentage points over Treasurys, approaching the 2002 high of 10.6 percentage points, according to Merrill.
Short-term debt markets, where companies borrow overnight or in periods up to one year, have dried up. The money-market-fund managers who normally buy such short-term debt have suffered losses on their holdings of debt in Lehman Brothers and other financial institutions. If companies can't borrow in the short-term debt markets, they may be forced to draw down on their revolving credit lines, yet another drain on banks' dwindling capital.
The Lehman bankruptcy also pressured the market for leveraged loans, which are used by private-equity firms to finance buyouts. When the firm attempted to sell some of its loan holdings earlier this week, prices dropped toward 85 cents on the dollar, according to Standard & Poor's Leveraged Commentary & Data.
The damage has gone beyond banks and brokerages. Ford Motor Credit Co., the finance arm of Ford Motor Co., paid 7.5% for Tuesday-night overnight borrowings, says one trader. Typically, the rate for such debt would be about one-quarter percentage point over the federal-funds rate, which is currently 2%, he says.
Even for companies considered of the safest credit quality, the cost of overnight debt is rising. General Electric Co. was forced to pay 3.5% for overnight borrowing on Wednesday, the trader says. In normal times, GE, which has the highest debt rating, would have to pay the equivalent of the federal-funds rate. "There's no evident catalyst for ending the pain," says Guy Lebas, chief fixed-income strategist at Janney Montgomery in Philadelphia.
The Liquidation Trap
The U.S. financial system is caught in a destructive liquidation trap that has falling asset prices cause financial distress, in turn compelling further asset sales and price declines. If unaddressed, it risks sending the economy into deep recession – or even depression.
Current conditions are the result of bursting of the house price bubble and the end of two decades of financial exuberance. That exuberance was fostered by a cocktail of forces.
First, economic policy replaced wages and productive investment as the engines of growth with debt and asset inflation. Second, greed and free market ideology combined to promote excessive risk-taking and restrain regulators. This was encouraged by audacious claims that mathematical economic models mapped reality and priced uncertainty, making old-fashioned precautions redundant.
Recognition of the scale of financial folly has created a rush for liquidity. This is causing huge losses, triggering margin calls and downgrades that cause more selling, damage confidence, and further squeeze credit. That is the paradox of deleveraging. One firm can, but the system as a whole cannot.
Having failed to prevent the bubble, regulatory policy is now amplifying its deflation. One reason is mark-to-market accounting rules that force companies to take losses as prices fall. A second reason is rigid capital standards. Application of mark-to-market rules in an environment of asset price volatility can create a vicious cycle of accounting losses that drive further price declines and losses.
Meanwhile, capital standards require firms to raise more capital when they suffer losses. That compels them to raise money in the midst of a liquidity squeeze, resulting in fresh equity sales that cause further asset price declines. Bad debts will have to be written down, but it is better to write them down in orderly fashion rather than through panicked deleveraging that pulls down good assets too.
This suggests regulators should explore ways to relax capital standards and mark-to-market rules. One possibility is permitting temporary discretionary relaxations akin to stock market circuit breakers.
Later, regulators must tackle the underlying problem of price bubbles. Currently, central banks are only able to control bubbles by torpedoing the economy with higher interest rates. New flexible measures of control are needed. One proposal is asset based reserve requirements, which systematically applies adjustable margin requirements to the assets of financial firms.
The Fed must also lower interest rates, and not just for standard reasons of stimulating spending. Lower short term rates are needed to make longer term assets (including houses) relatively more attractive, thereby shifting demand to them and putting a bottom to asset price destruction.
Fears about a price – wage inflation spiral remain misplaced. Instead, the threat is deep recession triggered by the liquidation trap. If inflation is a wild card, now is the time to use the credibility the Fed has earned. Emergency rate reductions can be reversed when the situation stabilizes.
The great irony is central banks can produce liquidity costlessly. Usually the problem is restraining over-production: today, it is over-coming political concerns about “bail-outs”. Those concerns are legitimate, but they also risk inappropriately restricting liquidity provision and unintentionally imposing huge costs of deep recession.
At the moment the Fed is protecting banks and the treasury dealer network but leaving the rest of the system in the cold. That is perverse given how the Fed went along with expansion of the non-bank financial system. Instead, the Fed should consider an auction facility that makes longer duration loans available to qualified insurance and finance companies too.
The facility’s guiding principle should be an expanded version of the Bagehot rule. Accordingly, the Fed would auction funds at punitive rates, with loans being fully collateralized. The goal should be to facilitate repair of distressed financial companies with minimum market disruption and at no taxpayer expense. By creating an up-front facility, the Fed can get ahead of the curve and reduce need for crisis interventions that are always more costly and disruptive.
Among financial conservatives there is a view that financial markets deserve punishment for their “sins” and only that will cleanse them. This view is often presented in terms of need to restore market discipline and stay moral hazard.
The view from the left is strangely similar, arguing Wall Street “fat cats” need to be punished. Asset prices should fall, banks must eat their losses, and all but the most essential financial firms should be allowed to fail. Both views have a moralistic dimension, and both risk unnecessary economic suffering. The mistakes of the past cannot be undone. All that can be done is to minimize their costs and then truly reform the system so that they are not repeated.
Ilargi: Morgan Stanley is deep inside the US government, and did the Fannie and Freddie deal for the Treasury. If they get sold to a foreign company, especially a Chinese one, that will be a clear sign of how bad the trouble has become.
HSBC, CITIC cited as possible Morgan Stanley suitors
London-based bank HSBC has been cited as a possible buyer of U.S. investment bank Morgan Stanley, broadcaster CNBC reported.
CNBC said according to unnamed sources, Morgan Stanley is in talks to possibly be acquired by China's CITIC Group, though no deal was certain.
"Morgan Stanley's senior management has been in talks with a number of potential buyers, and a deal becomes more likely as the investment bank's stock -- which plunged more than 24 percent Wednesday -- declines further. London-based HSBC has also been cited as a possible suitor for Morgan Stanley," CNBC reported on its Website.
Morgan Stanley Said to Weigh Deal With Wachovia as Shares Sink
Morgan Stanley Chief Executive Officer John Mack received a call today from Wachovia Corp. indicating interest in buying the investment bank, the New York Times reported, citing people briefed on the discussions. Other banks also expressed interest and Morgan Stanley is weighing a potential merger, the Times said.
"The smartest people at this firm are focused on solutions," said Mark Lake, a spokesman at Morgan Stanley. He declined to confirm or deny the Times report. Wachovia spokeswoman Christy Phillips-Brown said it was the bank's policy not to comment on "market rumors or merger speculation."
Morgan Stanley and Goldman Sachs Group Inc., the biggest U.S. securities firms, tumbled the most in at least a decade after a government rescue of American International Group Inc. failed to ease the credit crisis. The cost to protect against a default by the Wall Street firms rose to a record.
"They're fish in the barrel, the short sellers have them targeted," said William Smith, whose firm Smith Asset Management Inc. in New York manages $80 billion, including Goldman stock. "Morgan Stanley's probably going to wind up doing a deal, it's really a matter of survival."
HSBC Holdings Plc, Wells Fargo & Co. and JPMorgan Chase & Co. are among the potential bidders for a Wall Street firm, according to Anton Schutz, president of Mendon Capital Advisors. HSBC, Europe's largest bank, is not in talks with Morgan Stanley and isn't interested in pursuing a deal with the company, people with knowledge of the London-based bank's plans said today.
Goldman and Morgan Stanley have both done deals with Chinese companies: China Investment Corp., the state-controlled investment fund, bought a stake in Morgan Stanley in December, and Goldman invested in Industrial & Commercial Bank of China Ltd. in 2006.
Morgan Stanley dropped $6.95, or 24 percent, to $21.75 in composite trading on the New York Stock Exchange, after sinking as low as $16.08. Goldman slumped $18.51, or 14 percent, to $114.50, a three-year low and the biggest one-day drop in its nine years as a public company. The cost of credit-default swaps protecting against a default on the companies' bonds jumped by a record, with Morgan Stanley's rising to levels typical of companies in distress.
Sellers of credit-default swaps on Morgan Stanley demanded 19 percentage points upfront and 5 percentage points a year to protect the company's bonds for five years, according to broker Phoenix Partners Group. That means it would cost $1.9 million initially and $500,000 a year to protect $10 million in bonds, up from $680,000 a year with no upfront payment yesterday. Contracts on Goldman climbed 2.55 percentage points to 6.75 percentage points, Phoenix data show.
Morgan Stanley and Goldman are based in New York. Morgan Stanley's Mack sent a memo to employees today, urging them to "communicate with your clients" and "make sure they know about our strong performance and strong capital position." "There is no rational basis for the movements in our stock or credit default spreads," Mack wrote. "The Management Committee and I are taking every step possible to stop this irresponsible action in the market."
Executives at Goldman Sachs and Morgan Stanley told analysts and investors yesterday that they see no need to combine with banks even after Merrill Lynch & Co.'s emergency sale to Bank of America Corp. over the weekend and Lehman Brothers Holdings Inc. bankruptcy filing. Goldman and Morgan Stanley said they have adequate capital and cash and don't have any pressing need to borrow new money.
Analysts including David Trone at Fox-Pitt Kelton Cochran Caronia Waller have said the demise of Lehman and Merrill may force Goldman and Morgan Stanley to pursue a sale or some sort of transaction with a bank, to gain a stable funding base of deposits and the confidence of the markets. The firms hold more than $20 of assets for every $1 in capital, making them dependent on lenders.
"From what Goldman said on their conference call, they said they're going to go it alone," Smith said. "But when you're leveraged it's not up to you, it's up to your trading counterparties."
Morgan Stanley's Mack and Goldman's Lloyd Blankfein are trying to navigate declining investor confidence that prompted the emergency sales of Merrill Lynch and Bear Stearns Cos., and the bankruptcy of 158-year-old Lehman. The turmoil spurred the U.S. government late yesterday to lend as much as $85 billion to AIG to prevent the insurer's collapse.
Markets are reacting to "rumor and fear," Colm Kelleher, Morgan Stanley's finance chief, said yesterday after the New York-based company reported better-than-estimated earnings for the third quarter. Credit-default swaps on Morgan Stanley and Goldman rose for the third day. Contracts on Charlotte, North Carolina-based Wachovia Corp. approached a record reached yesterday. Contracts on AIG plunged.
Glenn Schorr, an analyst at UBS AG, said today in a note to investors that the market reaction was "insanity." Goldman and Morgan Stanley aren't at risk of running out of money because they keep plenty of cash on hand and can borrow from the Federal Reserve and a consortium of banks set up over the weekend, he said, noting that both have enough capital to absorb any losses.
"If you have the liquidity and capital to withstand the storm, why should CDS spreads be having such a big impact on stocks?" he wrote. He said investors must be reacting to concern that counterparties or clients will abandon the firms or that the credit-rating companies will cut their ratings. "At the heart of these issues is available funding, all in funding costs and the inherent mismatch of short-term funding and longer duration, levered balance sheets," Schorr said.
Credit markets have been locked up since New York-based Lehman, which was the fourth-largest U.S. securities firm, filed for bankruptcy protection on Sept. 15, raising concern that other financial companies may fail. Investors have been unwilling to take on new debt risk and overnight lending rates have soared. Morgan Stanley's plunge may add impetus to calls from Democrats in Congress for a broader effort by policy makers to address the financial crisis, including setting up a government agency to take on devalued assets.
"The private market screwed itself up and they need the government to come and help them unscrew it," House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, told reporters late yesterday after top lawmakers met with Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke. Frank this week proposed considering an agency to "deal with all the bad paper out there" and get financial markets "out of the box" they are in.
Mergers for Washington Mutual and Morgan Stanley?
It wasn't too many years ago that some federal regulators fretted about the dangers of letting commercial banks merge with the big investment houses on Wall Street. But in the current financial crisis, those mergers might be the only thing that saves some of Wall Street's most storied firms, such as Morgan Stanley and a troubled lender like Washington Mutual.
With Lehman Brothers now history, panicked Wall Street investors sold off shares in both Morgan Stanley and Goldman Sachs, despite the fact that both firms reported relatively strong earnings in recent days. Morgan Stanley's shares plunged 24% on Sept. 17, as investors worried the white-shoe firm would suffer the same liquidity crisis that felled Lehman and threatened Merrill Lynch .
Morgan Stanley executives rushed to condemn the short-sellers they said were driving the sell-off. In a memo to employees, Morgan CEO John Mack expressed his view that the firm was "in the midst of a market controlled by fear and rumors, and short-sellers are driving our stock down."
Short-sellers or no, there's growing sentiment that Morgan Stanley may need to find a partner in a commercial bank that would provide it with stable funding from its deposit base. Shortly after the market closed, The New York Times—citing "people briefed on the discussions"—reported that Mack & Co. were considering a merger with Charlotte-based Wachovia or another bank.
The Times reported that Mack received a phone call on Sept. 17 from Wachovia expressing interest in a merger, and that "other banks have also expressed interest in Morgan Stanley." While Morgan Stanley may still have space to determine its own fate, that moment appears to have passed for Washington Mutual, the $307 billion Seattle-based thrift that is reeling from soured mortgage lending.
On Sept. 17 a large WaMu investor, Texas-based TPG, disclosed that it had waived an anti-dilution measure that it had negotiated as part of a $7 billion infusion it made last April. That move would pave the way for a sale, and, according to the Times, the thrift has attracted several bidders, including JPMorgan Chase, Wells Fargo, and HSBC Holdings.
That such mergers are being broached would have been unfathomable not too many years ago. When the banking industry pressured Washington in the 1990s to dismantle the regulatory wall that had prevented banks from engaging in the activities of Wall Street firms—underwriting stock offerings, handling mergers, writing derivatives contracts—it got pushback from critics who recalled why Congress had imposed the restrictions in the 1930s.
Many historians blamed the financial collapse that triggered the Great Depression in small part on the willingness of banks to let investors buy stocks on margin, feeding a bubble that eventually burst. And in the 1990s most Wall Street firms—mindful that banks, with their larger market capitalizations, would likely be the acquirers in any consolidation—lobbied Congress to keep the banks out of their business.
Their warning to lawmakers: Banks would be reluctant to provide credit to corporate clients that didn't buy any of their investment banking services, an illegal practice known as "tying." The banks won over Congress and received the right to compete with Wall Street firms on their own turf—but with little success.
Bank of America launched a well-publicized effort to build an investment bank from the ground up, but after a decidedly rough quarter last year, CEO Ken Lewis declared that he'd had "all the fun I can stand" in its capital-markets division.
And now, of course, fate is driving Wall Street firms into the arms of the commercial banks. Lewis' acquisition on Sept. 15 of Merrill Lynch gives him in one fell swoop an army of nearly 19,000 brokers to hawk his credit cards, mortgages, and other financial products. And while some analysts had begun speculating that Morgan Stanley and Goldman Sachs—the last two independent Wall Street banks—would eventually need to partner with a commercial bank to gain the security of a bank's stable funding, few expected a merger would occur this week.
But if the raid on Morgan continues, and the wholesale funding that is the mother's milk of Wall Street firms continues to dry up, Mack may conclude that a shotgun marriage with Wachovia or another bank may be his firm's salvation. Despite its well-documented problems stemming from the acquisition of Golden West Financial, Wachovia has been insulated from the runs that felled Bear Stearns and Lehman, thanks to the $300 billion in low-cost deposits that have served as a stable funding base.
Wachovia's problems with Golden West—which could leave both earnings and Wachovia's stock price in the ditch for several years—could be reason enough for Mack to look abroad for a capital infusion. Among the possible candidates: HSBC and China's Citic International Financial Holdings. Mack and Wachovia CEO Bob Steel do share a few tribal bonds: Both are North Carolina natives who went to Duke University and then spent their careers on Wall Street, albeit at different firms.
And though many analysts expected Steel wouldn't broach a merger until he had time to mend Wachovia's balance sheet, a chance to merge with Morgan Stanley—or even his old colleagues at Goldman Sachs—could be too tempting to pass on. In a Sept. 16 appearance on CNBC's Mad Money with Jim Cramer, Steel signaled that he'd be open to a merger.
"We have a great future as an independent company, but we're a public company," he said. "So we're going to do what's right for shareholders. I can promise you that. But we're also focused on the very exciting prospects when we get things right going forward."
Years ago, banks and savings and loans lobbied for the right to grow nationally by arguing that it would give them the geographic diversity to ride out a local economic crisis, like the oil bust that doomed Texas banks in the late 1980s. But that didn't help players like Washington Mutual that became too dependent on one product—mortgages—as it suffered losses from its home loans in California and Florida. That means that regulators and bankers alike are now concluding the best defense is to build financial institutions that are as big, and as diversified, as possible.
"The winning business is going to the universal bank model, similar to that in Europe and Asia," says Bob Ellis, senior vice-president at Celent, a Boston-based consulting firm that specializes in financial services. "You'll have a strong retail bank, a retail brokerage, and an investment bank. That's the winning model—by design or default," Ellis says. "The lesson I'm learning from WaMu is that it's dangerous to be a one-trick pony."
Global credit system suffers cardiac arrest on US crash
The global credit system came close to total seizure yesterday. Key parts of the derivatives market shut down and a panic flight to safety depressed the yield on three-month US Treasury bills to almost zero for the first since the Great Depression in 1934.
The closely-watched TED-spread measuring stress in the interbanking lending market rocketed to 238 as the share prices of Morgan Stanley, Goldman Sachs, Citigroup, Wachovia, and Bank of America all went into a tailspin yesterday.
The collapse in investor confidence is a harsh verdict on the judgment of the US Federal Reserve, which chose to ignore market pleas for a rate cut to halt what amounts to a modern-era run on the banking system. Almost none of the current Fed governors have market experience. Most are academic theorists.
The Fed had hoped that a targeted $85bn (£47bn) bail-out for insurance giant AIG - on onerous terms - would be enough to stabilize the banks after the weekend failure of Lehman Brothers. Instead it set off a cardiac arrest at the heart of the credit system.
Bernard Connolly, global strategist at Banque AIG, said the Fed and the Treasury were doing too little, too late, to stave off disaster. Interest rates need to be cut immediately and dramatically, while Washington must prepare for a wholesale takeover of large parts of the lending system along the lines of the Scandinavian bank rescues in the early 1990s.
"Unless there is a very rapid change of mind, depression - with all its horrors and consequences - will be inevitable. The judgment that letting Lehmans go would not create systemic risk depended, if it was ever going to be anything other than ludicrous, on very rapid action to shore up the financial system. Instead, Hank Paulson seems to be adding to the risk in the system," he said.
"We fear that a virtual nationalisation of the financial system will now be necessary," he said.
America's Reserve Primary Fund suspended withdrawals after shareholders pulled out almost $40bn in two days on news of its heavy exposure to Lehmans' debt. The move came as the fallout from Lehmans' collapse spread worldwide. Japan's Nikkei wire said Japanese banks would suffer almost $2bn of losses on Lehmans' bond defaults.
Russia suspended trading the Moscow bourse after the Micex index crashed 24pc in two days. Officials promised $44bn to support the banking system. As Washington bails out one financial institution after another, investors have begun to doubt the long-term credit-worthiness of the US itself.
The cost of insuring against default on 10-year US Treasuries jumped to an all-time high of 30 basis points yesterday, as measured by the credit default swaps (CDS) on the derivatives markets. Germany is at 13, and France is 20.
"This is historically significant because we have never seen anything like it before," Daniel Pfaender, sovereign credit strategist at Dresdner Kleinwort. "What we don't know yet is whether this a liquidity issue or whether it reflects the credibility of the US financial system."
The Treasury's rescue of the mortgage giants Fannie Mae and Freddie Mac has added $5.3 trillion in liabilities to the US government. It almost doubles the national debt (under IMF definitions), at least on paper. The Fed has now added a further $85bn in debt for AIG. While the sums are manageable so far, what worries investors is the likely avalanche of insolvencies yet to come.
The Federal Deposit Insurance Corporation FDIC has already exhausted half its capital cleaning up after the collapse of IndyMac. It may need half a trillion dollars of fresh money to cope with the 120-odd lenders on its sick list. Professor Nouriel Roubini from New York University warns that several hundred banks will go under before this hurricane has exhausted its fury.
John Chambers, head of sovereign ratings at Standard & Poor's, said America's AAA grade is safe for now. The Fannie/Freddie bail-out is not comparable to ordinary state debt. It is backed by housing collateral, mostly based on prime mortgages.
"In the worst case scenario, the losses from Fannie and Freddie will be 2.5pc of GDP. This is not to belittle the unprecedented actions of the last two weeks. "For the US to lose its AAA we would have to see the sort of financial distress that occurred in the Nordic countries. It could get that bad. There's no God-given gift of a AAA rating. The US has to earn it like everyone else," he said.
Charles Dumas from Lombard Street Research said America's dependency on foreign money would carry a high price. "The ultimate test will be whether this seriously jeopardizes the reserve currency role of the US dollar. China finances the US government. So as long as the Chinese are willing to accept an annual loss of 15pc on their holdings of US bonds in real yuan terms, this can go on, but the decision lies in Beijing. What is clear is that it will take the US decades to pay this off," he said.
Hans Redeker, currency chief at BNP Paribas, says the US debt scare is vastly overblown. America's total government debt is 48pc of GDP on IMF measures, compared to 57pc for Germany, 94pc for Japan and 108pc for Italy.
"The debt levels are nothing compared to Europe, even after Fannie and Freddie. America still has great leeway," he said. "We think the next phase of this crisis is going to be a repatriation story as American investors bring their money back from frontier markets. The US broker dealers were 60 times leveraged and now they need to take assets back onto dollar balance sheets."
Albert Edwards, global strategist at Société Générale, said Washington's serial bail-outs are the inevitable result of the credit bubble of preceding years. "This was all baked in the cake long ago. What we have seen so far is just a dress rehearsal for the deep recession that is coming.
America is going to be losing 500,000 jobs a month. That is when we will see interest rates go to zero. The deficit will be covered with printed money as it was in Japan. The endgame will be helicopters full of cash dropped by Ben Bernanke," he said.
Asia Rethinks American Investments Amid Market Upheaval
Tremors from Wall Street are rattling Asian confidence, leading many investors to question the wisdom of being invested in the United States to the tune of trillions of dollars.
Asian investors were starting to show hesitation even before the financial earthquake of the last week. Now, a wariness toward the United States is setting in that is unprecedented in recent memory, reaching from central banks to industrial corporations, from hedge funds to the individuals who lined up here to withdraw money from the American International Group on Wednesday.
Asia’s savings have, in essence, bankrolled American spending for decades, and an Asian loss of confidence in American financial institutions and assets would have dire consequences for both the United States government and American taxpayers.
The potential for panic is stoked by Asian news organizations, which tend to focus more on business and economics than on politics, which can be touchy here. Their coverage has been obsessive and unrelentingly negative about the bankruptcy of Lehman Brothers, Merrill Lynch’s rush to find a buyer and the turmoil at A.I.G.
The nonstop deluge of bad publicity for American investments seems to be seeping into the consciousnesses of the rich and middle class across Asia. “I do not believe in U.S. financial institutions anymore; I don’t think any U.S. bank is safe anymore,” said Wang Xiao-ning, a Hong Kong homemaker. Even after the Federal Reserve had taken control of A.I.G., she waited in line with dozens of other anxious policyholders at one of the insurer’s customer service centers for the chance to close her investment account.
The asset management operations of American banks have steered many Asian investors into American securities for years. But Thomas Lam, the senior treasury economist at United Overseas Bank in Singapore, said many of these investors had not fully understood what they were buying. They became more curious and more concerned when, for example, Fannie Mae and Freddie Mac were placed in conservatorship.
“All these top executives, Indonesians and others, started asking, ‘What do they really do?’ ” Mr. Lam said. “They bought because the next company did.” Some experts say that with Asia’s phenomenal economic growth, savings are piling up so quickly that those funds will inevitably start flowing again to the United States at a fast clip. (The Chinese economy grew 23 percent in dollar terms last year.)
“The interest for the moment is depressed, but the trend is, we have a lot of savings in Asia and this is a bargain time” for assets in the United States, said Paul Tang, the chief economist at the Bank of East Asia in Hong Kong. For now, though, Asian interest in American assets is wilting, a trend that seems to have started over the summer.
Little-noticed data released by the Treasury Department on Tuesday showed that a sharp shift in international capital movements began in July. Private investors pulled a net $92.9 billion out of the United States, after putting $46.8 billion into American securities in June.
Many investors in Asia think that Asian economies will bounce back from the current global economic downturn faster than the American economy, said Henry Lee, the managing director of the Hendale Group, a well-known Hong Kong investment advisory firm. So they are putting their money in Asian companies. “When the dust settles, I think Asia will come out ahead of the U.S.,” he said.
Central banks, mainly Asian, did continue buying American securities in July. But they did so at a slower pace than usual. They made net purchases of $18.2 billion, compared with an average monthly purchase of $22.3 billion in the first half of this year, according to the latest Treasury data.
The central banks also changed the allocation of their purchases. They bought short-term Treasury bills while slowing their purchases of longer term Treasury bonds and American corporate bonds. And they abruptly switched from being large buyers of bonds from government-sponsored enterprises, like Fannie Mae and Freddie Mac, to becoming net sellers — one of many factors that contributed to the Bush administration’s decision to put Fannie Mae and Freddie Mac into conservatorship.
If cash is king during the current global financial crisis, then Asian governments and financial institutions are emperors. China’s central bank alone has $1.8 trillion in foreign reserves. Those reserves grew $280.6 billion in the first half of this year — a pace of $64 million an hour.
Americans have a huge stake in what China does with that money. Foreign cash coming into the United States to buy American assets holds down interest rates by making plenty of money available for the federal government to borrow to cover its budget deficit, and for consumers to borrow so that they can afford imported cars, DVD players and other goods.
Commerce Department data released on Wednesday showed that the nation’s current-account deficit, the broadest measure of trade in goods and services, had a deficit of $183.1 billion in the second quarter. Changing Asian sentiments have not yet eroded the value of the dollar — although market reaction to the A.I.G. bailout seemed to be doing that Wednesday. Asian skittishness has coincided with heavy selling by Americans of their holdings of stocks and bonds in foreign markets.
“It’s almost a case of everyone bringing money back home,” Americans and Asians, said Ben Simpfendorfer, an economist in the Hong Kong office of Royal Bank of Scotland. But the withdrawal of money from the United States in July was the largest since August of last year, when the subprime housing crisis and resulting credit squeeze first started to seize global markets. Back then, private investors pulled out $140 billion from the United States and central banks withdrew $22 billion.
Mr. Simpfendorfer and other economists cautioned that if the July pattern endured, it could quickly become a problem for the United States. Surprisingly, so far, China’s central bank has actually emerged as a big winner from the American turmoil.
Its bond holdings of government-sponsored enterprises, estimated by credit rating agencies at $340 billion, rose in value by billions of dollars in a single day when the Bush administration made explicit the government guarantee of Fannie Mae and Freddie Mac bonds, causing their interest rate spreads compared with Treasury bonds to narrow by 5 to 35 basis points within hours.
The exact amount of China’s gain cannot be calculated without knowing the maturity and composition of its holdings of these bonds, which Chinese officials have not released, according to specialists in fixed-income securities. Beijing officials regulate international capital flows so tightly that the central bank dominates China’s overseas investments. It holds more than 90 percent of all Chinese-owned bonds from Fannie Mae and Freddie Mac, for example.
“The average person on the street in China has no channel to invest in the U.S.,” said Jing Ulrich, the chairwoman of China equities at JPMorgan. But most private investors elsewhere in the region have considerably more freedom to park their assets in whatever country they please, Mr. Lee, of the Hendale Group, said, and they are very interested these days in assets in Asia.
China state paper urges new currency order after "tsunami"
Threatened by a "financial tsunami," the world must consider building a financial order no longer dependent on the United States, a leading Chinese state newspaper said on Wednesday.
The commentary in the overseas edition of the People's Daily said the collapse of Lehman Brothers Holdings Inc "may augur an even larger impending global 'financial tsunami'." The People's Daily is the official newspaper of China's ruling Communist Party, and the overseas edition is a smaller circulation offshoot of the main paper.
Its pronouncements do not necessarily directly voice leadership views. But the commentary by a professor at Shanghai's Tongji University, as well as an essay in a Party journal, underscored official alarm at the turmoil in world financial markets.
China's central bank earlier this week cut its lending rate for the first time in six years, a move analysts said was aimed at bolstering the economy and the battered stock market. "The eruption of the U.S. sub-prime crisis has exposed massive loopholes in the United States' financial oversight and supervision," writes the commentator, Shi Jianxun.
"The world urgently needs to create a diversified currency and financial system and fair and just financial order that is not dependent on the United States." But Vice Premier Wang Qishan, on a visit to the United States, told U.S. trade officials in a meeting on Tuesday that China and the United States needed to maintain close economic ties with global markets going through such turbulence.
"The Chinese government is well aware of the fact that the United States, which is the world's largest developed country, and China, which is the world's largest developing country, should have constructive and cooperative economic and trade relations," he said.
China is a major buyer of U.S. Treasury bonds, and through its sovereign wealth fund it has taken stakes in two large U.S. financial institutions. In July 2005, China revalued the yuan and freed it from a dollar peg to float within managed bands. But the yuan and China's trade remains tightly linked to the fortunes of the dollar.
The commentary suggested China must brace for grave economic fallout and look to alternatives, saying the crisis brings to mind the Great Depression of the 1930s. "Lehman Brothers announced bankruptcy will not only have a domino effect on the global financial world, it will bring a shock to the world economy," the front-page comment stated.
In the Chinese Communist Party's chief ideological magazine, Seeking Truth, a deputy governor of the Agricultural Bank of China, Luo Xi, warned that the U.S. crisis and consequent slump will have a "serious impact on our country's export sector."
In this week's issue of the magazine, Luo said China must beware of the loose currency policies, poor regulation and reckless credit he blamed for America's crisis. With China also worried about excessive real estate investment and speculation, the U.S. troubles "serve as a particular warning for our country's macro-economic policies and micro investment decisions," Luo wrote.
Abroad, Bailout Is Seen as a Free Market Detour
Is the United States no longer the global beacon of unfettered, free-market capitalism?
In extending a last-minute $85 billion lifeline to American International Group, the troubled insurer, Washington has not only turned away from decades of rhetoric about the virtues of the free market and the dangers of government intervention, but it has also probably undercut future American efforts to promote such policies abroad.
“I fear the government has passed the point of no return,” said Ron Chernow, a leading American financial historian. “We have the irony of a free-market administration doing things that the most liberal Democratic administration would never have been doing in its wildest dreams.”
The bailout package for A.I.G., on top of earlier government support for Bear Stearns, Fannie Mae and Freddie Mac, has stunned even European policy makers accustomed to government intervention — even as they acknowledge the shock of the collapse of Lehman Brothers.
“For opponents of free markets in Europe and elsewhere, this is a wonderful opportunity to invoke the American example,” said Mario Monti, the former antitrust chief at the European Commission. “They will say that even the standard-bearer of the market economy, the United States, negates its fundamental principles in its behavior.”
Mr. Monti said that past financial crises in Asia, Russia and Mexico brought government to the fore, “but this is the first time it’s in the heart of capitalism, which is enormously more damaging in terms of the credibility of the market economy.”
In France, where the government has long supported the creation of “national champions” and worked actively to protect select companies from the threat of foreign takeover, politicians were quick to point out the paradox of what is essentially the nationalization of the largest American insurance company.
“Today the actions of American policy makers illustrate the need for economic patriotism,” said Bernard Carayon, a lawmaker of President Nicolas Sarkozy’s center-right governing party, UMP. “I congratulate them.”
For the “evangelists of the market, this is a painful lesson,” he added. National economies are entering “an era where we have much more regulation and where the public and the private sector will mix much more.”
In parts of Asia, the bailouts stirred bitter memories of the different approach the United States and the International Monetary Fund adopted during the economic crises there a decade ago.
When the I.M.F. pledged $20 billion to help South Korea survive the Asian financial crisis of the late 1990s, one of the conditions it imposed was that the Korean government allow ailing banks and other companies to collapse rather than bail them out, recalled Yung Chul Park, a professor of economics at Korea University in Seoul, who was deeply involved in the negotiations with the I.M.F.
While Mr. Park says the current crisis is different — it is global rather than limited to one region — “Washington is following a different script this time.” “I understand why they do it,” he added. “But they’ve lost credibility to some extent in pushing for opening up overseas markets to foreign competition and liberalizing economies.”
The ramifications of the rescue of A.I.G. will be felt for years within the United States, too. A.I.G. was a different kind of company than Fannie Mae or Freddie Mac, which enjoyed government sponsorship, or Bear Stearns, which was regulated by the federal government.
“This was an insurance company that wasn’t federally regulated,” said Gary Gensler, who served as a top official in the Treasury Department during the Clinton administration. Nor did A.I.G. have access to Federal Reserve funds or deposit insurance, like a commercial bank. “We’re in new territory,” Mr. Gensler added. “This is a paradigm shift.”
A.I.G. is also in a different league because of the breadth of its businesses and its extensive overseas operations, especially in Asia. What’s more, it fell into something of a regulatory gap under the current rules.
While the company, based in New York, is better known for selling conventional products like insurance policies and annuities overseen by state regulators in the United States, it is also deeply involved in the risky, opaque market for derivatives and other complicated financial instruments that operate largely outside regulation.
Along with the threat to the plain-vanilla insurance policies held by millions of ordinary consumers, it was the threat posed by these arcane financial instruments that led Washington to bail out A.I.G. So far that rescue has not steadied markets.
“It’s pure crisis management,” Mr. Chernow said. “It’s the Treasury and the Federal Reserve lurching from crisis to crisis without a clear statement on how financial failures will be handled in the future. They’re afraid to articulate such a policy. The safety net they are spreading seems to widen every day with no end in sight.”
UK Government Did 'Everything' Possible to Ensure Lloyds' HBOS Purchase
(including breaking its own laws)
U.K. Prime Minister Gordon Brown, stung by plunging approval ratings and criticism over last year's nationalization of Northern Rock Plc, worked to ensure Lloyds TSB Group Plc's purchase of HBOS Plc today, heading off the demise of Britain's largest mortgage lender.
Brown discussed the deal with Lloyds' Chairman Victor Blank 48 hours before the banks' boards voted on the 12.2 billion pound ($22.2 billion) transaction as the government rewrote rules to prevent a veto by competition authorities. Officials have been involved in talks with the banks for weeks.
"For some time, it was obvious to us that there was concern about HBOS, and we have been monitoring the situation for several weeks," Chancellor of the Exchequer Alistair Darling told BBC Radio4 today. "We have said we would do everything we possibly can. They weren't pushed. It was clear -- and HBOS knew it -- that they were going to have to do a deal, so of course we helped."
The collapse of HBOS would have deepened Brown's political woes after a dozen Labour lawmakers called for a vote on a new leader. Brown was criticized last year for moving too slowly when a run on Northern Rock forced the government to take it over. Brown pressed for a deal this week as HBOS lost more than half its market value and a global credit squeeze choked off access to funds.
An Ipsos-Mori Ltd. poll published today showed the opposition Conservative Party's popularity was at its highest in 20 years. Inflation last month accelerated to the fastest pace in at least 11 years and unemployment reached a 16-year high amid sliding house prices.
"They have learned their lesson from the Northern Rock debacle, which is principally, if you are going to get a deal done, it had better be done quickly," Danny Gabay, director of Fathom Financial Consulting and a former economist at the Bank of England, said. "The role the government has played is that it has waived its own rules to get this done."
Government financial agencies have stepped up monitoring of Britain's lenders and are considering how they might react were a bank to run into difficulties. The government's role during the later stages of the talks between the two lenders was to make sure existing rules on competition wouldn't undo the deal when examined by watchdogs.
Officials at the Treasury and the Department of Business, Enterprise and Regulatory Reform were involved from late on Sept. 16. The merged bank would have a 28 percent share of Britain's mortgage market, above the 25 percent threshold that triggers a probe by competition authorities.
Lloyds TSB Chief Executive Eric Daniels said today his bank had wanted government approval for the deal. In 2001, competition authorities blocked Lloyds from buying Abbey National Plc on the grounds that consumers would lose choice.
This time, Darling said, commercial considerations were most important. The business department agreed to include financial- services companies in the groups where ministers can ignore competition rules on public-interest grounds.
"In this case financial stability must trump competition," Darling said. Government officials worked into the night on Sept. 16 and early yesterday to make sure obstacles were cleared. Brown and Blank spoke as HBOS shares slumped amid concern it would become the next victim of the credit famine that sunk Northern Rock. The two met at a reception hosted by Citigroup Inc. late on Sept. 15.
The Bank of England, which was also criticized for not acting fast enough to prevent a run on Northern Rock, also moved to counter "the current disorderly market conditions" by extending a program that allows banks to swap securities damaged by the credit rout for government bonds to Jan. 30.
The program was due to expire next month, and as recently as last week King indicated his opposition to renewing it, saying it was a "temporary measure" to deal with "the one-off events of the last year."
HBOS shares earlier plunged as much as 52 percent on speculation it would become the latest casualty of a market rout that has claimed Freddie Mac, Fannie Mae, Lehman Brothers Holdings Inc. and American International Group Inc. this month alone. Darling today said the government's involvement was "absolutely necessary."
Morgan Stanley, Goldman bonds take a beating
U.S. corporate bonds were battered on Wednesday, extending more than a week of heavy losses as a government rescue of insurer American International Group failed to restore calm to financial markets.
Bonds of Morgan Stanley and Goldman Sachs were especially hard hit and their credit insurance costs surged amid lingering worries about their ability to remain independent. Some Morgan Stanley bonds traded at distressed levels, and credit default swaps on both companies traded at levels commonly seen on junk-rated names.
The investment banks' troubles capped a week of financial system upheaval, with Lehman Brothers filing for bankruptcy, Merrill Lynch selling itself to Bank of America and the government arranging an $85 billion rescue of insurer AIG. "The selloff is causing yields on corporate bonds to be at astronomical, unsustainable, in effect high-yield levels," said Jake Dollarhide, chief executive of Longbow Asset Management Co in Tulsa, Oklahoma.
"I just shake my head in disbelief at how many investors, or investment managers and portfolio managers, are selling corporate bonds at these distressed prices, when nine out of 10 major issues are going to make it through this," he said. New issuance remained frozen as investors shunned corporate bonds in favor of safe Treasuries, sending yields on corporate debt to record highs relative to those on government bonds.
Average investment-grade bonds closed on Tuesday at 411 basis points over Treasuries, up 31 basis points on the day and an all-time high, according to Merrill Lynch data. Junk bond yields rose by 24 basis points to 929 basis points over Treasuries, the highest since the bankruptcy wave of 2002. "Corporate bonds are feeling a lot of pain right now for obvious reasons," said one trader.
"Liquidity is down to nothing and everybody is trying to fit through the same door."
Underwriters have not brought a U.S. high-grade corporate bond new issue to market since last Wednesday, when General Electric Capital Corp sold $86 million of medium-term notes, according to Thomson Reuters data. The junk bond market has not seen a deal since Friday, when Frontier Oil Corp sold a $197 million deal.
The main index of investment-grade credit default swaps rose to 203 basis points on Wednesday from 200 basis points at Tuesday's close, according to Markit Intraday. Morgan Stanley's credit default swaps rose to 16 percent upfront, plus 500 basis points annually, according to an analyst. Morgan Stanley's swaps had closed at 681 basis points a year on Tuesday, trading on a spread basis, which is considered less distressed. Goldman Sachs' credit default swaps rose by 252 basis points to 687 basis points, an analyst said.
Gold soars as safe haven from Wall Street
Gold logged its biggest price advance ever on Wednesday and oil snapped a two-day rout as fears that the bailout of U.S. insurer AIG would not end the turmoil on Wall Street restored the luster of an established safe haven.
Gold's 8.97 percent futures rally was the largest daily percentage gain in since February 2000. In absolute terms, bullion had a record day, leading a recovery across the commodities asset class after several days of liquidation sales to raise cash.
The benchmark New York gold futures contract hit a five-week high, storming back above $850 an ounce as traders raced to buy back short-sale bets put on when gold was sliding to $740, a week ago. In March, gold traded at a record high near $1,050.
Money moved back into commodities as the Dow Jones industrials average tumbled 340 points by late afternoon. The Reuters Jefferies CRB Index was up 3.2 percent, halting a steep two-day slide. "The commodity markets are no exception to what's happening in all asset classes. Commodities are suffering from the de-leveraging process that's going on," said Tobias Merath, head of commodities research at Credit Suisse.
Still, fears that the Wall Street meltdown was spreading pummeled shares of Morgan Stanley and Goldman Sachs, profitable investment banks which had been perceived as relatively insulated from the mortgage derivatives nightmare that this week claimed AIG, Lehman Brothers and Merrill Lynch.
Commodity markets struggled to digest the enormity of the financial troubles at AIG, which co-sponsors one of the largest commodity indexes used by investors. Asset management firms in Japan reported that at least seven Japanese investment funds that track the Dow Jones-AIG Commodity Index have not been able to trade since Tuesday due to the unavailability of prices from the local provider of the index.
December gold settled up $70 at $850.50 an ounce on the COMEX division of the New York Mercantile Exchange. Spot goldrose to $866.10 by midafternoon New York, from Tuesday's close at $777.55, which beats an $85 gain from the January 1980 gold bull market.
"With the stock markets declined sharply all over the world, you definitely see gold reacting as a safe haven and a hedge against stock market volatility," said Carlos Sanchez, precious metals analyst at research firm CPM Group. NYMEX October crude rose $6.01, or 6.6 percent, to $97.16 per barrel, following a two-day drop of nearly 10 percent, which was the steepest since December 2004.
"I think it was a flight of capital out of the futures markets and now we are coming back to fundamentals," said Simon Wardell of Global Insight in London. Supportive fundamentals included Hurricane Ike, which toppled several platforms in the Gulf of Mexico over the weekend and shut much of the Gulf Coast region's crude oil and refined fuel production.
Also, Nigerian militants threatened on Wednesday to broaden their "oil war" to offshore oil fields and announced attacks on a pipeline in the Niger Delta and another Shell-operated facility. At the Chicago Board of Trade, December wheat jumped 35-3/4 cents to settle at $7.25-3/4 per bushel, corn was up 21-3/4 cents to $5.54 per bushel and November soybeans went up 15 cents to $11.39.
On Tuesday the Chicago Mercantile Exchange permitted AIG to conduct block trades, held outside the public auction market to reduce positions in agriculture futures. AIG got the thumbs-up from traders on Wednesday for the orderly block sale of its large positions in grains and livestock which spared the futures markets excess price volatility.
COMEX December copper bucked the commodities rebound, falling 4.65 cents, or 1.5 percent, to $3.0425 per lb as demand worries and the financial turmoil prompted risk-adverse investors to reduce positions.
America will need a $1 Trillion bail-out
One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it.
But can this extraordinary vote of confidence in the dollar last? Perhaps, but as investors step back and look at the deep wounds of America’s flagship financial sector, the public and private sector’s massive borrowing needs, and the looming uncertainty of the November presidential elections, it is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen and unfold.
It is true that the US government has very deep pockets. Privately held US government debt was under $4,400bn at the end of 2007, representing less than 32 per cent of gross domestic product. This is roughly half the debt burden carried by most European countries, and an even smaller fraction of Japan’s debt levels.
It is also true that despite the increasingly tough stance of US regulators, the financial crisis has probably already added at most $200bn-$300bn to net debt, taking into account the likely losses on nationalising the mortgage giants Freddie Mac and Fannie Mae, the costs of the $29bn March bail-out of investment bank Bear Stearns, the potential fallout from the various junk collateral the Federal Reserve has taken on to its balance sheet in the last few months, and finally, Wednesday’s $85bn bail-out of the insurance giant AIG.
Were the financial crisis to end today, the costs would be painful but manageable, roughly equivalent to the cost of another year in Iraq. Unfortunately, however, the financial crisis is far from over, and it is hard to imagine how the US government is going to succeed in creating a firewall against further contagion without spending five to 10 times more than it has already, that is, an amount closer to $1,000bn to $2,000bn.
True, the US Treasury and the Federal Reserve have done an admirable job over the past week in forcing the private sector to bear a share of the burden. By forcing the fourth largest investment bank, Lehman Brothers, into bankruptcy and Merrill Lynch into a distressed sale to Bank of America, they helped to facilitate a badly needed consolidation in the financial services sector.
However, at this juncture, there is every possibility that the credit crisis will radiate out into corporate, consumer and municipal debt. Regardless of the Fed and Treasury’s most determined efforts, the political pressures for a much larger bail-out, and pressures from the continued volatility in financial markets, are going to be irresistible.
It is hard to predict exactly how and when the mega-bail-out will evolve. At some point, we are likely to see a broadening and deepening of deposit insurance, much as the UK did in the case of Northern Rock. Probably, at some point, the government will aim to have a better established algorithm for making bridge loans and for triggering the effective liquidation of troubled firms and assets, although the task is far more difficult than was the case in the 1980s, when the Resolution Trust Corporation was formed to help clean up the saving and loan mess.
Of course, there also needs to be better regulation. It is incredible that the transparency-challenged credit default swap market was allowed to swell to a notional value of $6,200bn during 2008 even as it became obvious that any collapse of this market could lead to an even bigger mess than the fallout from subprime mortgage debt.
It may prove to be possible to fix the system for far less than $1,000bn- $2,000bn. The tough stance taken by regulators this past weekend with the investment banks Lehman and Merrill Lynch certainly helps. Yet I fear that the American political system will ultimately drive the cost of saving the financial system well up into that higher territory.
A large expansion in debt will impose enormous fiscal costs on the US, ultimately hitting growth through a combination of higher taxes and lower spending. It will certainly make it harder for the US to maintain its military dominance, which has been one of the linchpins of the dollar.
The shrinking financial system will also undermine another central foundation of the strength of the US economy. And it is hard to see how the central bank will be able to resist a period of allowing elevated levels of inflation, as this offers a convenient way for the US to deflate the mounting cost of its private and public debts.
It is a very good thing that the rest of the world retains such confidence in America’s ability to manage its problems, otherwise the financial crisis would be far worse. Let us hope the US political and regulatory response continues to inspire this optimism. Otherwise, sharply rising interest rates and a rapidly declining dollar could put the US in a bind that many emerging markets are all too familiar with.
Ilargi: I’m going to put Nouriel Roubini’s latest here in its entirety. It is a long read, but the man has so much valuable information to offer. Note that Roubini now takes the same stance that many of us are pondering: this is not socialism we are looking at, it’s Benito Mussolini’s corporate fascism.
The transformation of the USA into the USSRA (United Socialist State Republic of America) continues at full speed with the nationalization of AIG
Last week we argued that, with the nationalization of Fannie and Freddie, comrades Bush, Paulson and Bernanke had started transforming the USA into the USSRA (United Socialist State Republic of America). This transformation of the USA into a country where there is socialism for the rich, the well connected and Wall Street (i.e. where profits are privatized and losses are socialized) continues today with the nationalization of AIG.
This latest action on AIG follows a variety of many other policy actions that imply a massive - and often flawed - government intervention in the financial markets and the economy: the bailout of the Bear Stearns creditors; the bailout of Fannie and Freddie; the use of the Fed balance sheet (hundreds of billions of safe US Treasuries swapped for junk toxic illiquid private securities); the use of the other GSEs (the Federal Home Loan Bank system) to provide hundreds of billions of dollars of “liquidity” to distressed, illiquid and insolvent mortgage lenders; the use of the SEC to manipulate the stock market (restrictions on short sales); the use of the US Treasury to manipulate the mortgage market (Treasury will now for the first time outright buy agency MBS to manipulate and prop up this market); the creation of a whole host of new bailout facilities (TAF, TSLF, PDCF) to prop and rescue banks and, for the first time since the Great Depression, to bail out non-bank financial institutions; the recent extension of the collateral available for the TSLF and PDCF facilities to a much wider range of toxic securities including equities and thus allowing the Fed to effectively manipulate even the stock market; and a whole range of other executive and legislative actions (including the recent bill to provide a public guarantee to mortgages for banks willing to reduce their face value).
So, with the nationalization today of AIG, comrades Bush, Paulson and Bernanke welcome you again to the USSRA. At least in the case of Fannie and Freddie these two institutions were semi-public to begin with as they were Government Sponsored Enterprises (GSEs). Now we get instead the first pure case of a fully private company, actually the largest insurance company in the world, being nationalized. So the US government is now the largerst insurance company in the world. So the transformation of the USA into the USSRA goes a step further.
Let me now flesh out in more detail my arguments on why this government AIG takeover is reckless, flawed and should have and could have been avoided. There were other ways to deal with the potential systemic effects of collapse of AIG…
First, note that the Fed and the Treasury claimed to draw a line in the sand on moral hazard with their decision not to bail out Lehman ; but two days later the financial tsunami of the century wiped out that line and led to the continuation of the mother of all moral hazard bailouts with the nationalization of AIG.
It is likely that AIG’s shareholders (both preferred and common) may be substantially wiped out; but then why does the government take only a 80% equity share in AIG? Why not 100% as it should? So, if by miracle, AIG is not liquidated, such private shareholders instead of being fully wiped out get any upside benefit from this government action.
Compared to the Fannie and Freddie bailout the risk taken by the government in the AIG case seems more limited: then, the preferred shares of the government were senior to common shares and other preferred shares but junior to the unsecured subordinated and senior debt of the agencies. In the case of AIG it appears that the US “loan” has as collateral all of the assets of AIG; if this were to be the case (a point to be clarified as the Fed statement was not clear about the seniority of a loan that has equity-like characteristics) the creditors of AIG would not be scot free as the government claim would have priority over any other secured and unsecured creditors of AIG, including possibly the insurance policy holders of AIG.
If this is truly the case (and I say “if” because the Fed has not been fully clear on the nature of its claims in the pecking order of the capital structure of AIG) the objective of the Fed in its intervention on AIG (i.e. avoiding the systemic effects of a collapse of a large and too big to fail institution) may not be achieved: i.e. if the claims of the government are senior to those of all creditors of AIG then AIG bondholders and also other creditors of AIG get whacked if AIG is insolvent (i.e. if in the effective liquidation of AIG the assets of the firm are lower than its liabilities).
But if the action of the Fed are aimed at facilitating an orderly selling of AIG’s assets how does the Fed ensure that its investment in AIG is safe? In a formal bankruptcy (Chapter 7 and 11) there is a stay on the claims of a firm’ creditors; thus a roll-off of their claims cannot occur. But in this government takeover of AIG how does one ensure that such roll-off of claims does not occur?
The only way to avoid such risk is to impose a stay - like in a formal Chapter 7 or 11 – on such claims. But if the objective of the government was to avoid a disorderly workout that a formal bankruptcy would have entailed how does one ensure – short of an effective stay on all creditors claims – that the public money provided to AIG (the $85 billion “loan”) is not used by the unsecured creditors of AIG to roll off their exposure and run out of AIG scot free? Short of such a stay the apparent seniority of the government claims implies that any short term creditor of AIG should cut off its exposure and run. And if instead (“if” because again the Fed has not given any details on this crucial issue) the government claims are ensured by an effective stay on such creditors’ roll off then why did the government intervene in AIG rather than letting it go into Chapter 7 or Chapter 11 bankruptcy court?
So this is the conundrum of the government intervention in AIG: it was made to avoid a disorderly collapse of AIG with the provision of short term liquidity; but in order to avoid short term creditors of AIG to run and be full on their claims you need to impose an effective stay on such claims; otherwise some creditors are bailed out (those with short term claims who can run) and some creditors are whacked even more (those with longer term claims that are junior to the government) and such short term creditors become effectively senior to the government. But if the government has to be truly senior relative to all of the creditors of AIG you need to impose a stay on all creditors. And if you impose such a stay you whack all creditors, you impose losses on all the AIG debt holders and you risk the systemic panic and disaster that you wanted to avoid in the first place.
If this is the case it would have been better to push formally AIG in Chapter 11 or 7 bankruptcy court and then provide the government financial support in the form of traditional debtor-in-possession (DIP) financing. If this had been done such DIP financing would be formally – as provision of new money – senior to all of the other claims on the firm. So the government decision to avoid formal Chapter 11 (or 7) is puzzling: either the government loan is truly senior to all of the claims of AIG – in which case you need a formal stay to avoid short term creditors to run away (but such stay will impose the same potential systemic risks of a formal bankruptcy) – or if such a stay is not imposed then the government claims are junior to those of the short term creditors of AIG and the objective of avoiding a run on the claims of AIG cannot be avoided.
In the case of IMF loans to distressed governments such loans have effective – but not de jure - seniority over the claims of other foreign creditors of the country but the objective of such loans – in cases of illiquidity not insolvency – is to allow the roll off of short term claims of a solvent but illiquid sovereign under the assumption that financing the capital flight will stabilize the problem and stop, at some point, the run ("Catalytic finance") (for more on this matter and issues of seniority of claims in sovereign debt crises see the book I wrote in 2004 with Brad Setser on “Bailouts versus Bailins: Responding to Financial Crises in Emerging Markets”).
But in the case of AIG we have a problem of solvency and the need for an orderly wind down of AIG so as to prevent a global systemic crisis. So it is rational for short term claimants of AIG to run if their claims are junior to those of the government. And if instead those claims were not junior (i.e. a stay is formally imposed) the systemic effects of such a stay will cause massive losses to all of the creditors of AIG and will thus not prevent the systemic crisis that the government intervention was meant to avoid.
The reality is that it would have been more honest and clean and proper to take AIG to bankruptcy court and then provide the government support (the $85 billion loan) in the form of a formal debtor-in-possession (DIP) financing. Why was this solution not taken? It is not clear. Going to court may imply a credit event that triggers formal default and consequences for creditors and CDS holders and the guarantees made by AG on toxic fixed income securities.
But what has happened is effectively a credit event and such triggers should be occurring regardless of whether AIG goes into formal bankruptcy court or not. The Fed and Treasury should immediately clarify on whether their intervention includes or not a formal stay on all the creditors of AIG including the holders of the short term claims against AIG.
Any fuzziness and lack of transparency on this matter would be severely destabilizing for markets and investors. To truly safeguard the government claims such a stay should be imposed; and it is not imposed the government action will allow short term creditors of AIG to run scot free with two consequences: the government claims will be at risk putting taxpayers’ money at risk; and the claims of longer term creditors of AIG will be whacked more down the line as short term creditors were allowed to be bailed out.
But in that case why should different creditors of AIG be treated differently with some being bailed out and some not and with the consequence that the bailout of some implies much bigger losses to the longer term creditors of AIG? Again a formal bankruptcy court would have allowed a more fair process for allocating losses between shareholders and short term and long term creditors of the firm.
The Fed statement is also fuzzy on the claims of the insurance policy holders of AIG. Are these insurance contracts junior or senior to the government claims?
You may think that holders of standard insurance (life, casualty, etc.) should be treated as senior (in the same way as small depositors of banks are insured from loss)? But should only such policy holders (individuals and non-financial firms) should be bailed out and be senior or should also the holders of AIG insurance of fixed income assets (hundreds of billions of dollars of such insurance) be bailed out? If all of such insurance contracts are safe and made whole by the government why should the government bail out investors that bought insurance of toxic products (MBS, CDOs, etc) from AIG? There is no rationale for that.
If we start bailing out those creditors of AIG (holders of bond insurance policies) we may as well nationalize also all of the other private monoline insurers. And we treat differently different bond insurers (we make whole those who bought bond insurance from a too big to fail AIG and we let go bust those who bought the same protections for a non-systemically important bond insurer) we exacerbate moral hazard as in the future no one will buy bond insurance protection from truly private and smaller bond insurers and everyone will buy it from large too-big-to-fail institutions such as AIG where such bond insurance comes now with the additional protection of an implicit government guarantee of insurance. So the US government may become – on top of the biggest insurer in the world with its takeover of AIG – also the biggest re-insurer in the world.
And how will the government decision to protect fully the small insured claimants of AIG (those who hold life and casualty insurance) affect the competition in the insurance business? If the government makes such policy holders senior to the government large and too big to fail private insurer have a massive competitive advantage relative to smaller insurance companies where the claims of the policy holders are at greater risk if the insurance company goes bust?
And, as in the case of banks involved in mortgages, where were the insurance regulators that were asleep at the wheel while AIG was using the policy holders premia not to invest into safe long term bonds but rather to insure toxic MBS and CDOs and other junk? Why were they asleep at the wheel while AIG was conducting the scam of the century getting involved into a business – bond insurance – that was toxic and caused its demise? Why was AIG allowed to become too-big-to-fail but letting it get into a business - bond insurance – where it should have not been in the first place and that caused its current bankruptcy?
So there are tons of questions that remain to be answered and the pathetic Fed statement of the Fed on the takeover of AIG does not answer creating much greater uncertainty and confusion. AIG should have been allowed to go into bankruptcy court and any government financial help to avoid systemic risk should have occurred in the form of a formal debtor-in-possession (DIP) financing. Bankruptcy court have laws and a judicial history of how claims of an insolvent firm are treated and they provide clarity to the pecking order of such claims while avoiding – via a stay – some creditors running and be made whole while others are inflicted - because of such a run - even greater losses.
So instead of doing the right thing – pushing AIG into bankruptcy court and providing government DIP financing – the Fed and Treasury have formally nationalized AIG and they have created a legal mess where there will be endless confusion and lack of transparency of the government claims relative to junior and senior creditors of AIG, short term creditors and long term creditors, insurance policy holders of a traditional sort and of a non-traditional sort (life and casualty holders versus bond insurance holders).
And by nationalizing AIG the government that two days ago drew a line in the sand on no more bailout with its decision to let Lehman to go bust has now opened again the floodgates of moral hazard and of private firms’ demands to be bailed out. Already Ford and GM are requesting loans guarantees and Congress is considering them. Next will be airlines and lots of other non-financial corporate who expect now the government to bail them out.
The argument of the supplicants will be: “If we are bailing out Wall Street firms such as Bear, Fannie and Freddie, AIG and soon enough banks why shouldn’t we bail out Main Street firm such as Ford and GM that are also systemic ally important? After all Bear was employing only 20 thousands or so folks while Ford and GM have hundreds of thousands of employees."
So soon enough the transformation the USA into the USSRA (United Socialist State Republic of America) will be complete: we have defeated the USSRR to create a communist economy in the most advanced free market economy in the world. And calling it socialism (even socialism for the rich, the well connected and Wall Street) is giving a bad name even to a failed experiment like socialism; this is more akin to the creation of a corporatist state (like the Italian fascism or the Germany Third Reich) where private sector interest are protected (gains privatized and losses socialized) where the government is taken over by corrupt and reckless private interests.
The paradox is that this this whole mess was creaete by a bunch of zealot fanatics who believed in the laissez faire ideology of free markets unbound by propers rules, regulation and supervision.
As I wrote after the nationalization of Fannie and Freddie:
This biggest bailout and nationalization in human history [Fannie and Freddie] comes from the most fanatically and ideologically zealot free-market laissez-faire administration in US history. These are the folks who for years spewed the rhetoric of free markets and cutting down government intervention in economic affairs. But they were so fanatically ideological about free markets that they did not realize that financial and other markets without proper rules, supervision and regulation are like a jungle where greed – untempered by fear of loss or of punishment – leads to credit bubbles and asset bubbles and manias and eventual bust and panics.
The ideologue “regulators” who literally held a chain saw at a public event to smash “unnecessary regulations” are now communists nationalizing private firms and socializing their losses: the bailout of the Bear Stearns creditors, the bailout of Fannie and Freddie, the use of the Fed balance sheet (hundreds of billions of safe US Treasuries swapped for junk toxic illiquid private securities), the use of the other GSEs (the Federal Home Loan Bank system) to provide hundreds of billions of dollars of “liquidity” to distressed, illiquid and insolvent mortgage lenders, the use of the SEC to manipulate the stock market (restrictions on short sales), the use of the US Treasury to manipulate the mortgage market (Treasury will now for the first time outright buy agency MBS to manipulate and prop up this market), the creation of a whole host of new bailout facilities (TAF, TSLF, PDCF) to prop and rescue banks and, for the first time since the Great Depression, to bail out non-bank financial institutions, and a whole range of other executive and legislative actions (including the recent bill to provide a public guarantee to mortgage for banks willing to reduce their face value).
This is the biggest and most socialist government intervention in economic affairs since the formation of the Soviet Union and Communist China. So foreign investors are now welcome to the USSRA (the United Socialist State Republic of America) where they can earn fat spreads relative to Treasuries on agency debt and never face any credit risks (not even the subordinated debt holders who made a fortune yesterday as those claims were also made whole).
Like scores of evangelists and hypocrites and moralists who spew and praise family values and pretend to be holier than thou and are then regularly caught cheating or cross dressing or found to be perverts these Bush hypocrites who spewed for years the glory of unfettered wild west laissez faire jungle capitalism (and never believed in any sensible and appropriate regulation and supervision of financial markets) allowed the biggest debt bubble ever to fester without any control, have caused the biggest financial crisis since the Great Depression and are now forced to perform the biggest government intervention and nationalizations in the recent history of humanity, all for the benefit of the rich and the well connected.
So Comrades Bush and Paulson and Bernanke will rightly pass to the history books as a troika of Bolsheviks who turned the USA into the USSRA. Fanatic zealots of any religion are always pests that cause havoc and destruction with their inflexible fanaticism; but they usually don’t run the biggest economy in the world. But these laissez faire voodoo-economics zealots in charge of the USA have now caused the biggest financial crisis since the Great Depression and the nastiest economic crisis in decades. So let them be shamed in public for their hypocrisy and zealotry that has caused so much financial and economic damage.