Children picket at a waiters strike at the Raleigh Hotel in Washington, D.C.
Ilargi: The IMF has agreed on a $16.5 billion loan for the Ukraine. After seeing the terms demanded for a loan to Pakistan, which costitute a de facto economic take-over of that nation, one must wonder what the terms for the Ukraine are. Since the country looks to be two steps away from a civil war, there's no doubt that strict 'guarantees‘ have been built in, as well as interest rates worthy of credit card issuers. Kiev has signed away its independence as a nation.
History has shown us time and again that the IMF and the World Bank have one objective only: power over countries, their populations and most of all their resources. In name they are international organizations created for the benefit of struggling economies. In reality they are 100% controlled by the US government and American corporations eager to benefit from countries’ economical problems.
Today's developments offer a unique opportunity to wrestle the Ukraine away from Russian hands. It's a dangerous game, make no mistake about it. Washington this week reiterated its intention to make the Ukraine a NATO member, something that has come a lot closer now the country has become a financial slave to US interests. But Moscow will never accept such a move. Never. The most tragic aspect is perhaps that until not so long ago, the Ukraine was the prosperous grain basket of the entire region, with its uniquely fertile black earth; then came Stalin.
Still, Putin and Medvedev have bigger fish to fry right now. The oligarch class, created through IMF and World Bank meddling in post-communist Russia in the Yeltsin years, has managed to rack up $530 billion in foreign debt, of which 10% has to be repaid before Christmas. The $530 billion is more that Russia has in foreign reserves, and with the collapsing oil price there is a whole lot more trouble brewing on the way.
The World Bank, meanwhile, operates on its preferred terrain: the murky hardly publicized shadows of the world’s poorest nations in times of trouble. The US can use the coming massive losses on the balance sheets of Latin American countries and the European banks that lent to them, to regain hold of the reins across the continent. There too, a formidable opponent awaits in the shape of Hugo Chavez. But like Putin, Chavez sees his power wane in the face of falling oil prices.
The US ruling class has taken dictatorial control over the domestic economy, which it will now use as collateral to get similar power abroad. Financial warfare, disaster corporate fascism. Still, there is no guarantee that it can execute all the looks-good-on-paper plans, at least not for long. If the US economy barrels down fast and furious, the situation becomes unpredictable, no matter how well they have prepared for what's to come.
And they know they need to weaken China first as well, or all bets are off. The financial crisis sets the stage for a new round of global resource grabs, and it will be merciless.
Europe on the brink of currency crisis meltdown
The crisis in Hungary recalls the heady days of the UK’s expulsion from the ERM. The financial crisis spreading like wildfire across the former Soviet bloc threatens to set off a second and more dangerous banking crisis in Western Europe, tipping the whole Continent into a fully-fledged economic slump. Currency pegs are being tested to destruction on the fringes of Europe’s monetary union in a traumatic upheaval that recalls the collapse of the Exchange Rate Mechanism in 1992.
“This is the biggest currency crisis the world has ever seen,” said Neil Mellor, a strategist at Bank of New York Mellon. Experts fear the mayhem may soon trigger a chain reaction within the eurozone itself. The risk is a surge in capital flight from Austria – the country, as it happens, that set off the global banking collapse of May 1931 when Credit-Anstalt went down – and from a string of Club Med countries that rely on foreign funding to cover huge current account deficits.
The latest data from the Bank for International Settlements shows that Western European banks hold almost all the exposure to the emerging market bubble, now busting with spectacular effect. They account for three-quarters of the total $4.7 trillion £2.96 trillion) in cross-border bank loans to Eastern Europe, Latin America and emerging Asia extended during the global credit boom – a sum that vastly exceeds the scale of both the US sub-prime and Alt-A debacles. Europe has already had its first foretaste of what this may mean. Iceland’s demise has left them nursing likely losses of $74bn (£47bn). The Germans have lost $22bn.
Stephen Jen, currency chief at Morgan Stanley, says the emerging market crash is a vastly underestimated risk. It threatens to become “the second epicentre of the global financial crisis”, this time unfolding in Europe rather than America. Austria’s bank exposure to emerging markets is equal to 85pc of GDP – with a heavy concentration in Hungary, Ukraine, and Serbia – all now queuing up (with Belarus) for rescue packages from the International Monetary Fund. Exposure is 50pc of GDP for Switzerland, 25pc for Sweden, 24pc for the UK, and 23pc for Spain. The US figure is just 4pc. America is the staid old lady in this drama.
Amazingly, Spanish banks alone have lent $316bn to Latin America, almost twice the lending by all US banks combined ($172bn) to what was once the US backyard. Hence the growing doubts about the health of Spain’s financial system – already under stress from its own property crash – as Argentina spirals towards another default, and Brazil’s currency, bonds and stocks all go into freefall. Broadly speaking, the US and Japan sat out the emerging market credit boom. The lending spree has been a European play – often using dollar balance sheets, adding another ugly twist as global “deleveraging” causes the dollar to rocket. Nowhere has this been more extreme than in the ex-Soviet bloc.
The region has borrowed $1.6 trillion in dollars, euros, and Swiss francs. A few dare-devil homeowners in Hungary and Latvia took out mortgages in Japanese yen. They have just suffered a 40pc rise in their debt since July. Nobody warned them what happens when the Japanese carry trade goes into brutal reverse, as it does when the cycle turns. The IMF’s experts drafted a report two years ago – Asia 1996 and Eastern Europe 2006 – Déjà vu all over again? – warning that the region exhibited the most dangerous excesses in the world.
Inexplicably, the text was never published, though underground copies circulated. Little was done to cool credit growth, or to halt the fatal reliance on foreign capital. Last week, the silent authors had their moment of vindication as Eastern Europe went haywire. Hungary stunned the markets by raising rates 3pc to 11.5pc in a last-ditch attempt to defend the forint’s currency peg in the ERM. It is just blood in the water for hedge funds sharks, eyeing a long line of currency kills. “The economy is not strong enough to take it, so you know it is unsustainable,” said Simon Derrick, currency strategist at the Bank of New York Mellon.
Romania raised its overnight lending to 900pc to stem capital flight, recalling the near-crazed gestures by Scandinavia’s central banks in the final days of the 1992 ERM crisis – political moves that turned the Nordic banking crisis into a disaster. Russia too is in the eye of the storm, despite its energy wealth – or because of it. The cost of insuring Russian sovereign debt through credit default swaps (CDS) surged to 1,200 basis points last week, higher than Iceland’s debt before Götterdammerung struck Reykjavik.
The markets no longer believe that the spending structure of the Russian state is viable as oil threatens to plunge below $60 a barrel. The foreign debt of the oligarchs ($530bn) has surpassed the country’s foreign reserves. Some $47bn has to be repaid over the next two months. Traders are paying close attention as contagion moves from the periphery of the eurozone into the core. They are tracking the yield spreads between Italian and German 10-year bonds, the stress barometer of monetary union.
The spreads reached a post-EMU high of 93 last week. Nobody knows where the snapping point is, but anything above 100 would be viewed as a red alarm. The market took careful note on Friday that Portugal’s biggest banks, Millenium, BPI, and Banco Espirito Santo are preparing to take up the state’s emergency credit guarantees. Hans Redeker, currency chief at BNP Paribas, says there is an imminent danger that East Europe’s currency pegs will be smashed unless the EU authorities wake up to the full gravity of the threat, and that in turn will trigger a dangerous crisis for EMU itself.
“The system is paralysed, and it is starting to look like Black Wednesday in 1992. I’m afraid this is going to have a very deflationary effect on the economy of Western Europe. It is almost guaranteed that euroland money supply is about to implode,” he said. A grain of comfort for British readers: UK banks have almost no exposure to the ex-Communist bloc, except in Poland – one of the less vulnerable states. The threat to Britain lies in emerging Asia, where banks have lent $329bn, almost as much as the Americans and Japanese combined. Whether you realise it or not, your pension fund is sunk in Vietnamese bonds and loans to Indian steel magnates. Didn’t they tell you?
Hedge Fund Redemptions Are Driving This Market
You need to understand the staggering amount of money in play. The newspapers blame the weakening economy and somber earnings forecasts for the sharp selloffs we've been experiencing. Declining earnings and recession fears play into the declines, to be sure, but the real story -- which does not get the headlines it truly deserves -- is the mass liquidation that is occurring within the highly leveraged hedge fund community.
The mind-boggling size of the redemptions -- resulting in the need to sell at any price, especially if leverage is involved -- renders obsolete even the most seasoned professional's playbook. Gaming investor sentiment and using valuation as a guide have proved to be folly in the face of the avalanche of forced selling.
The good news is that valuations will matter eventually, and the incredible amount of cash that is currently on the sidelines will be put to work. For now, though, it is imperative that investors realize that the selling we are seeing now is not the work of rational human beings. Rather, it is the result of the largest deleveraging in financial history.
The numbers are staggering. Although estimates vary, the total size of the hedge fund industry was about $1.8 trillion at the end of the third quarter, with about a third of that controlled by funds of funds, which are notorious for their itchy trigger fingers. Redemptions in August and September were substantial, at about $60 billion according to Eurekahedge, with most of the money coming out of long/short equity funds.
The high level of redemptions, together with the negative performance, has resulted in hedge fund assets falling precipitously in the third quarter. The total decline in hedge fund assets was on the order of $160 billion. That was the third quarter. Unfortunately, the damage has been much, much worse so far in the month of October.
Although data are sketchy at this point, many believe that hedge funds are facing redemptions on the order of half a trillion dollars. This is certainly not a surprising number given the amount of money that funds of funds control, and given the fact that many absolute return strategies are losing money -- a lot of money -- institutions and individuals alike have been losing at least a little faith in the entire asset class.
The bad news is that the hedge funds are not done liquidating, and the constant selling creates a vicious cycle -- a negative feedback loop -- on both Wall Street and Main Street. Funds are forced to sell as valuations move lower, and Main Street grows ever more frightened by unending incineration of wealth.
The headlines attribute each successive drop in the market averages to the latest earnings disappointment or lowered forecast, but the real story is the forced selling. The forced sales -- especially of the margined funds -- have overwhelmed the market, and the situation is only made worse as programs and humans have piled on to the downside.
Note the extreme moves at the end of each day, as the margin clerks try to give the foundering funds a chance for the market to turn in their favor. Ultimately, however, the collateral must be protected and the funds are forced to unwind their positions.
The good news is that many in the hedge fund and mutual fund industry have been somewhat ahead of the curve, raising cash on the way down. That means there is currently a tremendous amount of cash on the sidelines. That money at some point will move back in to the market, but so far most trading desks have not been seeing buying of any real consequence.
It will happen, though. There are a great many stocks that are trading at levels that discount the very worst of outcomes. Stable, defensive businesses with high levels of cash and prodigious amounts of cash flow are now trading at extremely low valuations. I will focus on some of those opportunities in future columns, because I am confident that investors will realize sizable gains from these levels over the next few years. So, yes, there is hope.
But for now, valuation and sentiment does not matter. It is imperative for investors to realize that and to acknowledge exactly what they are up against. This is the Great Deleveraging of 2008, the likes of which nobody has ever seen.
IMF, Ukraine agree in principle on $16.5 billion loan
The International Monetary Fund said on Sunday it had reached an agreement in principle with Ukraine for a $16.5 billion loan package to ease the effects of the financial crisis.
"An IMF staff mission and the Ukraine authorities have today reached agreement, subject to approval by IMF management and the executive board, on an economic program supported by a $16.5 billion loan under a 24-month stand-by arrangement," IMF Managing Director Dominique Strauss-Kahn said in a statement.
"Consideration by the board would follow approval of legislative changes to Ukraine's bank resolution program," he added.
The Washington-based lender said its staff in Kiev and Ukraine authorities had reached an agreement on a package that would meet the balance of payments needs created by the combined effects of the collapse of steel prices and the global credit turmoil.
"The authorities' program is intended to support Ukraine's return to economic and financial stability, by addressing financial sector liquidity and solvency problems, by smoothing the adjustment to large external shocks and by reducing inflation," Strauss-Kahn said. "At the same time, it will guard against a deep output decline by insulating household and corporations to the extent possible."
He said the package was equivalent to 800 percent of Ukraine's quota at the fund. Each IMF member country is assigned a quota based on its size in the world economy and determined the amount of money it can lend. Under normal IMF lending program, countries can draw up to 300 percent, or three times, their quota. "The strength of the program justifies the high level of access," Strauss-Kahn added.
Ukraine suffers from the economic crisis along with the rest of Eastern Europe
It was as if MPs had spent Black Wednesday ripping up the House of Commons carpet and using the mace to jam the lobby doors. After years of easy credit and a property boom that had turned the Ukrainian capital, Kiev into a Asia-style boom town, Eastern Europe's biggest country abandoned the defence of its currency in the dying hours of last week's market trading. This week it hopes to enter the equivalent of receivership, but only if it can meet the terms of a $14 billion International Monetary Fund (IMF) bail-out.
It is a big if. The markets were torrid last week but the country's parliament was a melee. Prime Minister Julia Timoshenko's supporters sought to prevent a December general election being called at any cost. With strips of tinfoil, coins and paper clips, followers of the charismatic former gas trader caused an electronic sytem breakdown of the chamber's voting system. The immediate aim was to prevent a vote on demands for a general election by President Victor Yushchenko, Mrs Timoshenko's great rival and one time Orange Revolution ally. But the scenes called into question the country's ability to adopt reforms demanded by the IMF to provide the financial lifeline desperately need to stave-off a punishing financial meltdown.
The head of Ukraine's central bank was forced to plead with the country's politicans to stop bickering. "It's like slow death," said Volodymyr Stelmakh. "The more we delay, the more problems will multiply." Ukraine's currency, the hryvnia, has lost a fifth of its value in the last eight days. It now leads a host of former Soviet-controlled states in Eastern Europe that, severely exposed by the new mood of fiscal rectitude on the financial markets, have turned to the IMF to stave off collapse.
The Eastern bloc states, Hungary and Belarus, have joined Ukraine in making formal applications for IMF bailouts but others, including the Baltic States, all members of the EU, have entered secret consultations for international help. With a range of continuing disputes with the Kremlin during an intractable domestic political dispute, economic collapse has rendered Ukraine vulnerable to a resurgence of Russian influence. Last week a Russian consortium was seen as a leading contender to take over the failed Ukrainian bank, Prominvest. Ukraine's pro-Moscow opposition has spent months warning that the government had steered disastrously away from Russia, a path that jeopardised its economy. Last week Serhyi Taruta, the country's leading steel magnate, compounded its crisis by warning of mass lay-offs in the vital industry.
"Elections are coming, and the steel industry employs 500,000 people," said leading analyst, Peter Vanhecke, head of investment banking for Renaissance Capital in Ukraine. "If no supportive measures are taken by the government, the steel industry will most likely have to reduce its headcount substantially. Output has gone down due to the global economic slowdown." The fallout from the crisis goes beyond the realms of the economic. Ukraine's efforts to join Nato and set up a close alliance with the EU is in Moscow's cross-hairs. The Kremlin last week formally renewed its requestion for an extension of the lease on the Crimean port of Sevastopol, home its Black Sea fleet.
"There's broad consensus that the aspiration for Ukraine to join Nato in the near future is now highly unlikely," said Mr Vanhecke. "The last thing you want to do is to start haggling with your energy suppliers at a time of economic downturn. My sense is that Ukraine will move closer to a more neutral, non-provocative position towards Russia." The stakes in the second round of Lithuania's general election today could not be higher. The expected winner, Andrius Kubilius of the right-wing Homeland Union last week warned that he would be forced to grapple with an economic collapse if he takes office. "I see a serious crisis," he said. "In Lithuania's case, we have a double crisis: one that we've built up ourselves due to economic overheating. On top of that, we are also experiencing the impact of the global financial crisis."
It amounts to a double-whammy that jeopardises many of the gains made by the ex-Soviet satellites since the collapse of the Soviet Union. Some in the Baltic states are now blaming the EU for their woes. "The main effect on Latvia has been a dramatic fall in economic growth, from 12 per cent when we joined the EU to 1 per cent now," said MEP Rihard Piks, who was the Latvian foreign minister when the country joined the EU in 2004. The crisis has seen the region cracking into spheres of influence. Estonia, which like the other Baltic nations has been a target of Russia's increasingly hostile foreign policy, has pleaded with Swedish banks not to pull the plug on its heavily indebted economy.
With more than 10 per cent of its domestic lending denominated in Swiss francs, Hungary has been forced to hike interest rates to double digits and give guarantees to lenders to staunch a run on the florint. Belarus, a dictatorship that is widely seen as the "last dictatorship in Europe", has already borrowed heavily from Moscow. Now it is so fearful that a currency collapse would grant Russia complete control of its economy that its mercurial president, Alexander Lukashenko, appealed for an unprecedented gesture of support from the West, through the IMF. "He is trying to avoid total dependence on Russia," said Fyodor Lukyanov, editor of Russia in Global Affairs. "He prefers to hang on to two ropes rather than one. Belarus is a very vulnerable country."
World Bank to double loans to poor countries
The World Bank plans to increase loans to poor countries to make up for dwindling private fund flows to these economies, Japan's business daily Nikkei reported on Sunday.
The international lender aims to double its long-term loans to those countries from $13.5 billion in 2007 to help them cope with the global credit crisis, the paper said. The move came as the International Monetary Fund (IMF), another Washington-based multinational lender, offered help to crisis-struck countries, such as Iceland and Ukraine.
The World Bank loans will be targeted at around 10 poor countries in Asia and Africa, such as Ghana, Bangladesh and Cambodia, as the IMF focuses on emerging, middle-income economies, the Japanese daily said.
The World Bank will offer long-term loans of 15 to 20 years at an interest rate roughly on a par with London Inter-bank Offered Rate, or LIBOR. The bank is also considering emergency loans to these countries, the paper added.
The Coming Global Stag-Deflation (Stagnation/Recession plus Deflation)
Last January – at a time when the consensus was starting to worry about rising global inflation - I wrote a piece titled Will the U.S. Recession be Associated with Deflation or Inflation (i.e. Stagflation)? On the Risks of “Stag-deflation” rather than “Stagflation” where I argued that the US and other economies would soon have to worry about price deflation rather than price inflation. As I put it at that time last January:
the S-word (stagflation that implies growth recession cum high and rising inflation) has recently returned in the markets and analysts’ debate as inflation has been rising in many advanced and emerging markets economies. This rise in inflation together with the now unavoidable US recession, the risk of a recession in a number of other economies (especially in Europe) and the likelihood of a sharp global economic slowdown has lead to concerns that the risks of stagflation may be rising.
Should we thus worry about US and global stagflation? This note will argue that such worries are not warranted as a US hard landing followed by a global economic slowdown represents a negative global demand shock that will lead to lower global growth and lower global inflation. To get stagflation one needs a large negative global supply-side shock that, as argued below, is not likely to occur in the near future. Thus the coming US recession and global economic slowdown will be accompanied by a reduction – rather than an increase – in inflationary pressures. As in 2001-2003 inflation may become the last of the worries of the Fed and one may actually start hearing again concerns about global deflation rather than inflation.
Let me elaborate next why… …unlike a true negative supply side shock – that reduces growth while increasing inflation - a US recession followed by a global economic slowdown is a negative demand shock that has the effect of reducing US and global growth while at the same time reducing US and global inflationary pressures. Specifically such a negative demand shock will reduce inflation and across the world because of a variety of channels.
First, a US hard landing will lead to a reduction in aggregate demand relative to the aggregate supply as a glut of housing, consumer durables, autos and, soon enough, other goods and service takes places. Such reduction in aggregate demand tends to reduce inflationary pressures as firms lose pricing power and then to cut prices to stave off the fall in demand and the rising stock of inventories of unsold goods. These deflationary pressures are already clear in housing where prices as falling and in the auto sector where the glut of automobiles is leading to price discounts and other price incentives. Obviously, inflation tends to fall in recession led by a fall in aggregate demand.
Second, during US recessions you observe a significant slack in labor markets: job losses and the rise in the unemployment rate lead to a slowdown in nominal wage growth that reduces labor costs and unit labor cost, thus reducing wage and price inflationary pressured in the economy.
Third, the same slack of aggregate demand and slack in labor markets will occur around the world as long as the negative US demand shock is transmitted – through trade, financial, exchange rate and confidence channels – to other countries leading to a slowdown in growth in other countries (the recoupling rather than decoupling phenomenon). The reduction in global aggregate demand – relative to the global supply of goods and service – will lead to a reduction in inflationary pressures.
Fourth, during any US hard landing and global economic slowdown driven by a negative demand shock the US and global demand for oil, gas, energy and other commodities tends to fall leading to a sharp fall in the price of all commodities. A US hard landing followed by a European, Chinese and Asian slowdown will lead to a much lower demand for commodities pushing down their price. The fall in prices tends to be sharp because – in the short run – the supply of commodities tends to be inelastic; thus any fall in demand leads to a greater fall in price – given an inelastic supply curve – to clear the commodity prices.
And indeed in recent weeks the rising probability of a US hard landing has already lead to a fall in such prices: for example oil prices that had flirted with a $100 a barrel level are now down to a price closer to $90; or the Baltic Dry Freight index – that measures the cost of shipping dry commodities across the globe and that had spike for most of 2007 given the high demand and the limited supply of such ships – is now sharply down by over 20% relative to its peak in the fall of 2007. Similar downward pressure in prices is now starting to show up in other commodities.
Note that a cyclical drop in commodity prices – led by a US hard landing and global economic slowdown - does not mean that commodity prices will remained depressed over the middle term once this global growth slowdown is past. If in the medium term the supply response to high prices is modest while the medium-long term demand for commodities remains high once the US and global economy return to their potential growth rates commodity prices could indeed resume their upward trend. But in a cyclical horizon of 12 to 18 months a US hard landing and global economic slowdown would lead to a sharp fall in commodity prices.
Note that even in the case of oil that is the commodity with the weakest supply response to prices – as the investments in new production in a bunch of unstable petro-states (Nigeria, Venezuela, Iran, Iraq and even Russia) are limited - a cyclical global slowdown could lead to a very sharp fall in oil prices. Indeed while oil today is closer to the $90-100 range in the last 12 months oil prices drifted downward at some point close to a $50-60 range even before a US hard landing and global slowdown had occurred. Thus, one cannot rule out that in such a hard landing scenario oil prices could drift to a price close to $60.
The four factors discussed above suggest that – conditional on the negative global demand shock (US hard landing and global economic slowdown) materializing even the risks of stagflation-lite are exaggerated; rather US and global inflationary force would sharply diminish in this scenario and, if anything, concerns about deflation may reemerge again.
This is not a far fetched scenario as one looks back at what happened in the 2000-2003 cycle. Until 2000 the Fed was worried about the economy overheating and rising inflation risk. But once the economy spinned into a recession in 2001 US and global inflationary pressures diminished and by 2002 the great scare became one of US and global deflation rather than inflation. Indeed the Fed aggressively cut the Fed Funds rate all the way to 1% and Ben Bernanke – then only a Fed governor – wrote speeches about using heterodox policy instruments to fight the risk of deflation once and if the Fed Funds rate were to reach its nominal floor of zero percent.
Today, following a US hard landing and a global economic slowdown, the risks of outright deflation would be lower than in the 2001-2003 episode because of various factors: US inflation starts higher than in 2001; the Fed needs to worry about a disorderly fall of the US dollar that may increase inflationary pressures; the rise and persistence of growth rates in Chindia and other emerging market economies implies that – even if such economies likely recouple to the US hard landing – a global growth slowdown will not turn into an outright global recession that would be truly deflationary. Still, while the scenario outlined here – US recession and global slowdown – may not lead to outright deflationary pressures it would certainly lead to a slowdown of US and global inflation.
The fact that the most likely scenario in the global economy in 2008 is one of a negative global demand shock is the one that is priced by bond markets: if investors were really worried about a rise in US and global inflation – or about true stagflationary shocks – the yield on long term government bonds would have not fallen as sharply as it has since last summer. With US 10 year Treasury yield now well below 4% and sharply falling in the last few weeks it is hard to see a bond market that is worried about global inflation or global stagflation. And while until recently commodity prices pointed to the other directions, recent weakness in oil prices, the cost of shipping commodities and the price of some other commodities also signals that commodity markets are now pricing the risk of a US recession and the risk that – with a lag – a US recession will lead to a broader global economic slowdown.
So in conclusion “stag-deflation” (i.e. low growth or recession with falling inflation rates and possible deflationary pressures) is more likely than “stagflation” (low growth or recession with rising inflation rates) if a US hard landing materializes and leads – as likely – to a slowdown in global demand and growth.
So last January I argued that four major forces would lead to a risk of deflation (or stag-deflation where a recession would be associated with deflationary forces) rather than the inflation risk that at that time – and for most of 2008 – mainstream analysts worried about: slack in goods markets, re-coupling of the rest of the world with the US recession, slack in labor markets, and a sharp fall in commodity price following such US and global contraction would reduce inflationary forces and lead to deflationary forces in the global economy.
They’re Shocked, Shocked, About the Mess
My hypocrisy meter konked out last week. It started acting up on Wednesday, spinning wildly as executives from the nation’s leading credit-rating agencies testified before Congress about their nonroles in the credit crisis. Leaders from Moody’s, Standard & Poor’s and Fitch all said that their firms’ inability to see problems in toxic mortgages was an honest mistake.
The woefully inaccurate ratings that have cost investors billions were not, mind you, a result of issuers paying ratings agencies handsomely for their rosy opinions. Still, there were those pesky e-mail messages cited by the House Committee on Oversight and Government Reform that showed two analysts at S.& P. speaking frankly about a deal they were being asked to examine.
“Btw — that deal is ridiculous,” one wrote. “We should not be rating it.” “We rate every deal,” came the response. “It could be structured by cows and we would rate it.”
Asked to explain the cow reference, Deven Sharma, S.& P.’s president, told the committee: “The unfortunate and inappropriate language used in these e-mails does not reflect the core culture of the organization I am committed to leading.” Maybe so, but that was a lot for my malarkey meter to absorb.
Then, on Thursday, my meter sputtered as Alan Greenspan, former “Maestro” of the Federal Reserve, testified before the same Congressional questioners. He defended years of regulatory inaction in the face of predatory lending and said he was “in a state of shocked disbelief” that financial institutions did not rein themselves in when there were billions to be made by relaxing their lending practices and trafficking in exotic derivatives. Mr. Greenspan was shocked, shocked to find that there was gambling going on in the casino.
My poor, overtaxed, smoke-and-mirrors meter gave out altogether when Christopher Cox, chairman of the Securities and Exchange Commission, took his turn on the committee’s hot seat. His agency had allowed Wall Street firms to load up on leverage without increasing its oversight of them. But he said on Thursday that the credit crisis highlights “the need for a strong S.E.C., which is unique in its arm’s-length independence from the institutions and persons it regulates.” He said that with a straight face, too.
There was more. Mr. Cox went on to suggest that his hapless agency should begin regulating credit-default swaps. This, recall, is that $55 trillion market at the heart of almost every big corporate failure and near-collapse of recent months. Trading in these swaps, which offer insurance against debt defaults, exploded in recent years. As the market for the swaps grew, so did the risks — and the interconnectedness — among the firms that traded them.
During the years when these risks were ramping up unregulated, Mr. Cox and his crew were silent on the swaps beat. How exasperating. After all the time and taxpayer money spent trying to resolve the financial crisis, we’re still in the middle of the maelstrom. The S.& P. 500-stock index was down 40.3 percent for the year at Friday’s close. Yes, the problems are global, and made more complex by Wall Street’s financial engineers. And a titanic deleveraging process like the one we are in, where both consumers and companies must cut their debt loads, is never fun or over fast.
Still, as the stock market continues to grind lower, something more may be at work. And that something centers on trust and credibility, which have been lacking in corporate and government leadership in recent years. Like the boy who cried wolf, corporate and regulatory officials have issued a lot of hogwash over the years. Until recently, investors were willing to believe it. Now they may not be so easily gulled. Companies, even those in cyclical businesses, routinely told investors that the reason they so regularly beat their earnings forecasts was honest hard work — and not cookie-jar accounting. They were believed.
Politicians proclaiming that the economy was strong and that the crisis would not spread kept our trust. Brokerage firms insisting that auction-rate securities were as good as cash won over investors — and, as we all know now, that market froze up. Wall Street dealmakers were fawned over like all-knowing superstars, their comings and goings celebrated. No one doubted them. Banks engaging in anything-goes lending practices assured shareholders that safety and soundness was their mantra. They, too, got a pass.
Directors who didn’t begin to understand the operational complexities of the companies they were charged with overseeing told stockholders that they were vigilant fiduciaries. Investors suspended their disbelief. And regulators, asserting that they were policing the markets, convinced investors that there was a level playing field. Is it any surprise that virulent mistrust seems to own the markets now?
Janet Tavakoli, a finance industry consultant who is president of Tavakoli Structured Finance, said the stock market’s gyrations are a result of a severe lack of confidence in the very officials who are charged with cleaning up the nation’s mess. “It is not enough to throw money at a problem; you also have to use honesty and common sense,” Ms. Tavakoli said. “In fact, if you leave out the last two, you are wasting taxpayers’ money.” What Ms. Tavakoli means by common sense is a plan that will force institutions to get a fix on what their holdings are actually worth.
“If you are going to hand out capital, you have to first revalue the assets or take over so that you can force a mark to market,” she said. “Force restructurings, mark down the assets to defensible levels and let the market clear.” She also suggests that financial regulators impose a form of martial law, allowing them to rewrite derivatives contracts that bind counterparties to terms they may not even comprehend. “If I were queen of the world, I would wade in there with a small army of people and just start straightening out these books,” she said.
“Start stripping them down and simplifying contracts so people can start to understand what they own. It would be unprecedented, but so is everything else we are doing.” That move, which would begin the much-needed healing process for investors, would be unprecedented in another way. It might get the people who run our companies and our regulatory agencies into the business of telling the truth. Naïve, I know. But something to wish for — I’d like to give my hypocrisy meter a breather.
UK recession is here to stay, experts warn
Filing into Number 11 Downing Street last Thursday morning, Britain’s banking chiefs were aware that the eyes of the country were once again upon them. John Varley, chief executive of Barclays, Eric Daniels, his opposite number at Lloyds TSB and Royal Bank of Scotland director Gordon Pell had been summoned to sit down with Chancellor Alistair Darling and Business Secretary Lord Mandelson to talk about corporate lending.
That they were told to come to the Chancellor’s residence and not the more discreet environs of the Treasury was significant. Having signed off on a £37bn capital injection into three of the country’s biggest banks, the Government was keen to show it was acting to shore up the real economy, all too aware that the events of an extraordinary week meant it was under scrutiny from a general public suddenly fearful for its future. It was the week in which small businesses across Britain awoke to the fact that, while the Government might have succeeded in averting a banking meltdown, a recession was inevitable.
The flow of bad news seemed inexorable. The pound fell to its lowest level against the dollar in five years, carmakers signalled a return to the 1970s after reintroducing the three-day week and retailers braced themselves for the worst Christmas in more than a decade. All of that against a backdrop of soaring government spending and dwindling tax receipts. At the beginning of the week some in the City were still daring to believe that any recession would be sharp and short-lived. By close of trading on Friday the optimists were nowhere to be found. “This is a once-in-a-lifetime crisis, and possibly the largest financial crisis of its kind in human history,” Bank of England Deputy Governor Charlie Bean told the Scarborough Evening News.
Any lingering hopes that the UK could avoid recession had been dashed on Tuesday night when Mervyn King, the Governor of the Bank, became the first major Treasury minister or leading bank official to use the 'R-word’. At a black-tie Institute of Directors dinner, Mr King delivered a hard-hitting speech, warning that house prices and the pound would continue to tumble and economic hardship last for years. “The combination of a squeeze on real take-home pay and a decline in the availability of credit poses the risk of a sharp and prolonged slowdown in domestic demand. It now seems likely that the UK economy is entering a recession.”
Confirmation came on Friday when figures released by the Office for National Statistics showed that the economy shrank for the first time in 16 years between July and September. News that gross domestic product fell by 0.5pc rocked stock markets and sent the pound sharply lower after economists had predicted just a 0.2pc fall. The UK will be classed as officially being in recession if the economy slows in the fourth quarter.
Commentators are prepared for the worst. “The UK may well experience a recession that is significantly deeper than we had expected,” said Philip Shaw, chief economist at Investec. That view is rapidly being priced into the currency markets with sterling falling to $1.584 against the dollar by the end of the week. With $2 sterling still fresh in the mind for many British people, the pound’s decline has been breathtaking. The UK currency has lost a quarter of its value over the past year — eclipsing the slumps of 1967, 1975 and Black Wednesday in 1992. At one stage on Friday it had fallen 9.6 cents against the dollar, its biggest intra-day decline on record and economists believe it will soon break the psychologically important $1.50 barrier.
For King it was just the latest in “an extraordinary, almost unimaginable, sequence of events”. As the banking crisis has raged, people outside the financial services industry have dared to dream they would be spared from the fallout. The events of the past week shattered those illusions. Retailers, manufacturers and the services industry each took the stage last week to reveal the extent of their problems. While manufacturers will have welcomed the falling pound and its potential boost to the export market, a survey from the CBI suggests the sector is prepared for the worst. Confidence among UK manufacturers suffered its sharpest single-quarter fall for 28 years in the three months to the end of September, the CBI said.
Carmakers are already feeling the chill in the face of slumping global demand. In a horrendous week for the auto sector, Renault and Peugeot-Citroen issued profit warnings and Nissan said it would cut production and move to a three-day week in the run-up to Christmas. In a sign that the repercussions of the credit crisis were spreading beyond the developed world, Volvo said orders of its heavy trucks had fallen from 42,000 in the third quarter last year to just 115 in the same period in 2008. The situation on the high street appears equally dire.
Retailers are facing their worst Christmas for more than a decade, according to research company Verdict, which said non-food sales would fall in the run-up to the festive period for the first time since 1995. Neil Saunders, consulting director at the company, warned that further retailers would go bust in the wake of the failures of high street names such as Mark One and Dolcis. “The consumer has been on a spending binge, with growth in spending outstripping the growth in income by some margin. That was not sustainable,” Saunders said. “That kind of pattern could never have continued.”
While some retail bosses claim problems have been exaggerated — DSG International chief John Browett tried to keep spirits up by insisting “what we are not seeing is the end of the world” — sales figures from Argos and Currys owner DSG suggest the pressure is real. Argos sales declined by record amounts in the six months to the end of August, leading to a 19pc drop in pre-tax profits at parent company Home Retail. While job losses on the high street and beyond have so far been kept to a minimum, economists believe unemployment, now at 5.7pc, could rapidly spiral higher. One harrowing reality from the financial crisis thus far is that it has been only the pessimists who have predicted the future with any success. Business leaders will be praying that it is not a trend that persists.
“There is every possibility that the downturn in activity may be as severe as the one the UK experienced in the early 1980s, when unemployment reached almost 12pc of the labour force,” warned David Shepherd, professor of economics at Westminster Business School. “The pessimists would argue that things may get even worse than that.” In the three months to the end of August unemployment jumped the most in 17 years, up 164,000 to 1.79 million. Economists now see 2 million unemployed as a best case scenario — 12 per cent would leave some 3.8 million people out of work.
While politicians and policy makers will do their best to remain upbeat, experts warn that, with government spending already sky high — public sector borrowing rose 75pc to a record £37.6bn in the first half — and tax receipts falling, the options are limited. Speaking after Gordon Brown followed King in admitting the UK was entering a recession, Darling did little to restore confidence. “It will be a difficult period, but I am absolutely confident we will get through it, “ Darling said. “We have got to make sure in the medium term we live within our means.”
At the Bank, Bean tried to add a positive note. “Compared to the early 1990s, we are in a better position in that we are free to set monetary policy to try and stabilise the economy,” he said. That is likely to come in the form of further rate cuts. Economists agree that with inflation under control it is a case of when, not if, the Bank of England lowers its 4.5pc rate. Brian Hilliard, economist at Société Générale, said the GDP figures underlined “the need for dramatic rate cuts — which we think the Bank of England will deliver”. He added: “We’re looking for a 50 basis point cut in November and a rapid succession of cuts to about 2.5pc by the middle of next year.”
Business leaders hope the government’s £37bn intervention to help the ailing banking industry earlier this month could help give it a second powerful option to boost corporate Britain. By taking stakes in high street banks, the Government has greater leverage to encourage, if not force, them to kickstart the business lending and mortgage markets. At the Downing Street meeting the Government succeeded in persuading banking chiefs to hold a regular forum with small business leaders but further concessions have yet to be agreed. “Where there are issues about the availability of lending and the terms of lending, they can thrash these out and tease out the problems,” Lord Mandelson said of the forum.
Small businesses, which employ 14 million people and are central to attempts to revitalise the economy and protect jobs, feel victimised and are crying out for the banks to help. “Whatever they are saying at the top, it’s not filtering down to branch managers,” said Stephen Alambritis, spokesman for the Federation of Small Businesses, who has called for a £1bn survival fund from the government. “If a bank was approving seven in 10 applications, we want to see that again. If its average overdraft was two points above base rate, we want that repeated.”
That is likely to be a forlorn hope, say commentators, but banks will be mindful that leaving businesses to collapse is in no-one’s interest. Anything less than further dramatic intervention could have commentators harking back to US President Harry Truman’s comments of 50 years’ ago: “It’s a recession when your neighbour loses his job; it’s a depression when you lose yours.”
Spending Stalls and Businesses Slash U.S. Jobs
As the financial crisis crimps demand for American goods and services, the workers who produce them are losing their jobs by the tens of thousands. Layoffs have arrived in force, like a wrenching second act in the unfolding crisis. In just the last two weeks, the list of companies announcing their intention to cut workers has read like a Who’s Who of corporate America: Merck, Yahoo, General Electric, Xerox, Pratt & Whitney, Goldman Sachs, Whirlpool, Bank of America, Alcoa, Coca-Cola, the Detroit automakers and nearly all the airlines.
When October’s job losses are announced on Nov. 7, three days after the presidential election, many economists expect the number to exceed 200,000. The current unemployment rate of 6.1 percent is likely to rise, perhaps significantly. “My view is that it will be near 8 or 8.5 percent by the end of next year,” said Nigel Gault, chief domestic economist at Global Insight, offering a forecast others share. That would be the highest unemployment rate since the deep recession of the early 1980s.
Companies are laying off workers to cut production as consumers, struggling with their own finances, scale back spending. Employers had tried for months to cut expenses through hiring freezes and by cutting back hours. That has turned out not to be enough, and with earnings down sharply in the third quarter, corporate America has turned to layoffs. “People have grown very nervous,” said Harry Holzer, a labor economist at Georgetown University and the Urban Institute, tracing cause and effect. “They have seen a lot of their wealth wiped out and as they cut back their spending, companies are responding with layoffs, which hurts consumption even more.”
The unemployment is widespread, with Rhode Island the hardest hit. For Dwight and Rochelle Stokes of Phenix City, Ala., the layoffs are a family event. He lost his job two weeks ago as an aviation mechanic at the Pratt & Whitney jet engine facility near his home — a few days after his wife lost hers as a cosmetologist at Great Clips, a family-owned barbershop and beauty salon. “It got really slow in July and August,” Ms. Stokes said. “I would sit there for two hours, and some days we had only 10 clients, four of us for 10 clients.”
The broadening layoffs are most pronounced on Wall Street, in the auto industry, in construction, in the airlines and in retailing. The steel mills, big suppliers to many sectors of the economy, are shutting 17 of the nation’s 29 blast furnaces — a startling indicator of how quickly output is declining as corporate America struggles to adjust to the spreading crisis.
“We have seen a softening order book in the most dramatic ways in the last week,” said Tom Conway, a vice president of the United Steelworkers of America, adding that layoffs in the industry “are just starting now.” In September alone, 2,269 employers each laid off 50 people or more, the Bureau of Labor Statistics reported, up sharply from the spring and summer months, and the highest number since September 2001, when the aftermath of the 9/11 attacks coincided with a recession to spook employers. A spike in 2005 was related to Hurricane Katrina.
The financial services industry has been cutting jobs since last summer, when the credit crisis took hold. By some estimates, 300,000 jobs will disappear from banks, mutual fund groups, hedge funds and other financial services companies before the crisis subsides — 35,000 of them in New York. Goldman Sachs alone, among the best performers on Wall Street, has announced plans to cut 10 percent of its work force, which stood at 32,594 at the end of last month.
The current unemployment rate, 6.1 percent — up more than a percentage point since April — is still relatively mild by post-World War II standards. The highest level since the Great Depression, 10.8 percent, came in November and December of 1982 as the economy was shaking off a severe recession. The unemployment rate hit 9 percent during the mid-1970s recession, and 7.8 percent in the 1990-1991 downturn. The next peak, 6.3 percent, occurred in June 2003, during a long jobless recovery in the aftermath of the 2001 recession.
Dwight and Rochelle Stokes, both in their late 20s, have just joined the layoff rolls. So has Mr. Stokes’s father, Warren, 48, who lost a $30-an-hour job this month on the assembly line of the Chrysler truck plant in Fenton, Mo., near St. Louis., where the father had worked for 12 years. “They just cut back,” the son said. Just a year ago, he and Rochelle, and their two very young children, moved to Phenix City from Fenton so he could take the mechanic job at the Pratt & Whitney plant in nearby Columbus, Ga. Airlines send engines there for periodic overhauls, and when Mr. Stokes arrived 400 workers were tearing down and rebuilding 15 engines a month.
But as the airlines reduced their flights — and announced 36,000 job cuts, nearly all of them taking place in the current fourth quarter — that number fell to three engines this month and “it was going to be worse for November, just one or two,” Mr. Stokes said. “We came in on Monday morning and our supervisor told us not to touch an engine, and we knew there would be layoffs,” he said. By lunchtime, Mr. Stokes and 100 others had been escorted out of the building, with four weeks’ pay as severance, along with four weeks of health insurance and a $1,000 departure check.
As a starting mechanic, Mr. Stokes’s pay, $11.50 an hour, was just over half of what he had earned as the manager of a chain of pawn shops in Missouri. But he took the job anyway, moving with his family, because Pratt & Whitney offered full college tuition. Mr. Stokes immediately enrolled in Embry-Riddle Aeronautical University to pursue a bachelor’s degree in management and a minor in engineering sciences. Using all his spare time, he had earned half the necessary credits when the layoff came.
The severance included extended tuition, and Mr. Stokes, piling on course work, hopes to earn his degree by early summer. But he will do so by correspondence course; the family is returning to Missouri, moving in rent free with Mr. Stokes’s sister in Fenton. “I am going to take seven or eight courses and hurry up and get my degree, and my wife will go back to cutting hair,” Mr. Stokes said, “and when I have my degree in June, I’ll apply for a management position. Even though things are bad, I hear there are openings in St. Louis requiring a bachelor’s degree.”
Insurers next for state bailout
AEGON, the giant European insurance group, is in weekend talks with the Dutch government about the possibility of joining a €20 billion (£16 billion) state recapitalisation scheme. The group, which employs more than 3,000 people in the UK through its Scottish Equitable division, has been heavily hit by credit-market losses and has warned of a further €275m of writedowns in the third quarter.
Although the company is not thought to be in danger of breaching solvency rules, Aegon is said to be examining whether to use the Dutch scheme to boost its solvency ratios. The scheme was designed last weekend to facilitate a cash injection into ING, the banking and insurance group.
The Aegon talks come amid further signs of financial bailout schemes being extended to insurers. Two of America’s biggest insurance companies are in talks with the US Treasury about a possible state-cash injection. MetLife and Prudential Financial are meeting Treasury secretary Hank Paulson this weekend in a move that may result in them tapping funds from the $700 billion (£440 billion) bailout designed to save the banking system. A third insurer, the New York Life Insurance Co, is also believed to be involved in the discussions.
Fears are mounting that rapidly falling stock markets, coupled with losses from the collapse of institutions such as Lehman Brothers and Washington Mutual, could put insurers around the world under pressure. If insurers hit financial difficulties it could spark a new wave of selling in the markets. The US Treasury is said to be particularly concerned about the ability of the insurance sector to buy bonds. Several Nordic governments are expected to reveal bank bailout plans this week.
Sterling caught up in 'currency market tsunami'
Sterling is caught up in a “currency market tsunami” as money pours out of emerging markets and into the dollar and the yen, experts said yesterday.
Bob Munro, senior consultant at currency experts HiFX, said that the dollar’s strength against the pound would continue as hedge funds liquidated assets in emerging markets and kept the money in cash. He said: “Most of these hedge funds are dollar-denominated and so money is pouring into the dollar.” Munro added: “This is not a vote of confidence in the US economy, more a technical move as people get out of anything risky. "There is a currency market tsunami washing over everything, and we will have to wait until the waves recede to see what’s left,” he said.
The pound, which has lost a quarter of its value against the dollar in the past year, fell 3.5 cents to $1.5837 on Friday, as hedge funds pulled cash out of emerging markets amidst gloomy global forecasts. The move by investors away from emerging markets is contributing to the strength of the dollar and the Japanese yen. Some of the cash is being used to repay low-interest loans in yen that had been financing investments. These loans, known as carry trades, have depressed the yen for years. The currency rose to a 13-year high against the dollar on Friday.
After liquidating their emerging market assets, the hedge funds are holding them in either US cash or US government debt, contributing to the dollar’s strength. Philip Shaw, chief economist at Investec Securities, said that although depressing economic news from the British Government on Friday had not helped sentiment, the pound’s fall was mainly due to global economic circumstances. “Assets are being sold off in emerging markets, and cash is the only safe haven,” he said. “This de-leveraging is causing the dollar strength.”
He said another factor was that worldwide interest rate forecasts are being revised downward, which has increased interest in the US where rates have already been slashed. Hedge funds which had invested heavily in emerging markets are unwinding as many investments as possible, as fears of a deepening global recession continue. George Buckley, chief UK economist at Deutsche Bank, said that although this week’s fall in the pound against the dollar had been “precipitous”, its previous position at over $2 to the pound was “possibly unsustainable in the first place.”
Lawsuit claims Barclays is guilty of fraud
Barclays shunted hundreds of millions of dollars of toxic mortgage assets into two secretive investment vehicles that it had created itself. It did this just as the collapse of two Bear Stearns hedge funds last year alerted executives to the extent of the coming troubles in the credit markets, according to a lawsuit.
Barclays must decide this week if it will try to persuade a US court to throw out the suit, which alleges that the bank defrauded investors in the two structured investment vehicles "SIV-lites". Both went bust just weeks after the transfers. The bank must file for dismissal by Friday or face a trial. Barclays, under its president Bob Diamond, is now expanding its US investment banking operations aggressively, and the case threatens to hurt its reputation and reveal details of how it responded to the emerging crisis in the credit markets last year.
The transfers of toxic mortgage derivatives into its SIV-lites occurred as another division of the bank was facing big losses on its investment in the Bear Stearns funds, which Barclays is now alleging were used by that bank as a dumping ground for toxic assets of its own.
Across the world, lawyers have begun to pick through a vast network of inter-connected investment vehicles created during the credit market boom, through which increasingly complex mortgage derivatives were spread around the financial system. Civil lawyers and criminal investigators are looking for evidence deep in the contracts that defined these vehicles and set out the relationships between the banks that created them, the hedge funds that managed them and the investors that bet on them.
In the latest case, Barclays is being sued by a French asset manager in a New York court over the collapse of two investment vehicles designed in London and managed out of the tax havens of Jersey and Guernsey. Oddo Asset Management says it lost its $50m (around £30m) investment in two SIV-lites, Mainsail and Golden Key, because of a scheme cooked up between Barclays and its partners.
The two vehicles purchased, at face value, several hundred million dollars of mortgage derivatives that had previously been sitting on Barclays' balance sheet and threatened to cause big losses for the UK company. SIV-lites were a risky investment vehicle that took on huge amounts of debt in order to buy a variety of complex mortgage derivatives. They exploded into view last year when they became unable to service their debts, and dozenscollapsed. Some of the banks that created them took them on to their own books; others let them fail.
Barclays offered $2.5bn in credit lines to Golden Key and Mainsail in August 2007, but this was not enough to save them. Oddo claims that although both vehicles were ostensibly managed independently – Golden Key by Avendis (now in liquidation), Mainsail by Solent Capital Partners – Barclays manipulated them to get them to buy mortgage assets from itself, at what the bank knew were inflated prices. "Barclays created these vehicles and hired investment advisers to manage the funds who were beholden to it," said Geoffrey Jarvis, Oddo's lawyer.
In June 2007, over the objections of Oddo but with the support of other investors, Golden Key bought mortgage assets from Barclays at face value – even though there were signs that their market value was far lower. A similar transaction took place at Mainsail. Within weeks, the credit rating agency Standard & Poor's reversed its view that both SIV-lites were as safe as government bonds and downgraded the pair's debt rating to junk status. Days later, they went bust. A Barclays spokesman refused to comment on whether it would file a motion to dismiss, but said it would defend the lawsuit vigorously.
The case has parallels with a suit launched by the UK bank against Bear Stearns last year. In that case, which is pending in New York, Barclays said Bear Stearns and two of its fund managers – Ralph Cioffi and Matt Tannin, who have since been served with criminal charges – duped it into investing in two hedge funds where Bear Stearns dumped the toxic mortgage assets it couldn't sell. Those funds were forced to resell many of those assets at depressed prices in June.
So When Will Banks Give Loans?
“Chase recently received $25 billion in federal funding. What effect will that have on the business side and will it change our strategic lending policy?”
It was Oct. 17, just four days after JPMorgan Chase’s chief executive, Jamie Dimon, agreed to take a $25 billion capital injection courtesy of the United States government, when a JPMorgan employee asked that question. It came toward the end of an employee-only conference call that had been largely devoted to meshing certain divisions of JPMorgan with its new acquisition, Washington Mutual. Which, of course, it also got thanks to the federal government. Christmas came early at JPMorgan Chase.
The JPMorgan executive who was moderating the employee conference call didn’t hesitate to answer a question that was pretty politically sensitive given the events of the previous few weeks. Given the way, that is, that Treasury Secretary Henry M. Paulson Jr. had decided to use the first installment of the $700 billion bailout money to recapitalize banks instead of buying up their toxic securities, which he had then sold to Congress and the American people as the best and fastest way to get the banks to start making loans again, and help prevent this recession from getting much, much worse.
In point of fact, the dirty little secret of the banking industry is that it has no intention of using the money to make new loans. But this executive was the first insider who’s been indiscreet enough to say it within earshot of a journalist. (He didn’t mean to, of course, but I obtained the call-in number and listened to a recording.)
“Twenty-five billion dollars is obviously going to help the folks who are struggling more than Chase,” he began. “What we do think it will help us do is perhaps be a little bit more active on the acquisition side or opportunistic side for some banks who are still struggling. And I would not assume that we are done on the acquisition side just because of the Washington Mutual and Bear Stearns mergers. I think there are going to be some great opportunities for us to grow in this environment, and I think we have an opportunity to use that $25 billion in that way and obviously depending on whether recession turns into depression or what happens in the future, you know, we have that as a backstop.”
Read that answer as many times as you want — you are not going to find a single word in there about making loans to help the American economy. On the contrary: at another point in the conference call, the same executive (who I’m not naming because he didn’t know I would be listening in) explained that “loan dollars are down significantly.” He added, “We would think that loan volume will continue to go down as we continue to tighten credit to fully reflect the high cost of pricing on the loan side.” In other words JPMorgan has no intention of turning on the lending spigot.
It is starting to appear as if one of Treasury’s key rationales for the recapitalization program — namely, that it will cause banks to start lending again — is a fig leaf, Treasury’s version of the weapons of mass destruction. In fact, Treasury wants banks to acquire each other and is using its power to inject capital to force a new and wrenching round of bank consolidation. As Mark Landler reported in The New York Times earlier this week, “the government wants not only to stabilize the industry, but also to reshape it.” Now they tell us.
Indeed, Mr. Landler’s story noted that Treasury would even funnel some of the bailout money to help banks buy other banks. And, in an almost unnoticed move, it recently put in place a new tax break, worth billions to the banking industry, that has only one purpose: to encourage bank mergers. As a tax expert, Robert Willens, put it: “It couldn’t be clearer if they had taken out an ad.” Friday delivered the first piece of evidence that this is, indeed, the plan. PNC announced that it was purchasing National City, an acquisition that will be greatly aided by the new tax break, which will allow it to immediately deduct any losses on National City’s books.
As part of the deal, it is also tapping the bailout fund for $7.7 billion, giving the government preferred stock in return. At least some of that $7.7 billion would have gone to NatCity if the government had deemed it worth saving. In other words, the government is giving PNC money that might otherwise have gone to NatCity as a reward for taking over NatCity. I don’t know about you, but I’m starting to feel as if we’ve been sold a bill of goods.
The markets had another brutal day Friday. The Asian markets got crushed. Germany and England were down more than 5 percent. In the hours before the United States markets opened, all the signals suggested it was going to be the worst day yet in the crisis. The Dow dropped more than 400 points at the opening, but thankfully it never got any worse.
There are lots of reasons the markets remain unstable — fears of a global recession, companies offering poor profit projections for the rest of the year, and the continuing uncertainties brought on by the credit crisis. But another reason, I now believe, is that investors no longer trust Treasury. First it says it has to have $700 billion to buy back toxic mortgage-backed securities. Then, as Mr. Paulson divulged to The Times this week, it turns out that even before the bill passed the House, he told his staff to start drawing up a plan for capital injections. Fearing Congress’s reaction, he didn’t tell the Hill about his change of heart.
Now, he’s shifted gears again, and is directing Treasury to use the money to force bank acquisitions. Sneaking in the tax break isn’t exactly confidence-inspiring, either. (And let’s not even get into the less-than-credible, after-the-fact rationalizations for letting Lehman default, which stands as the single worst mistake the government has made in the crisis.)
On Thursday, at a hearing of the Senate Banking Committee, the chairman, Christopher J. Dodd, a Connecticut Democrat, pushed Neel Kashkari, the young Treasury official who is Mr. Paulson’s point man on the bailout plan, on the subject of banks’ continuing reluctance to make loans. How, Senator Dodd asked, was Treasury going to ensure that banks used their new government capital to make loans — “besides rhetorically begging them?”
“We share your view,” Mr. Kashkari replied. “We want our banks to be lending in our communities.” Senator Dodd: “Are you insisting upon it?” Mr. Kashkari: “We are insisting upon it in all our actions.”
But they are doing no such thing. Unlike the British government, which is mandating lending requirements in return for capital injections, our government seems afraid to do anything except plead. And those pleas, in this environment, are falling on deaf ears. Yes, there are times when a troubled bank needs to be acquired by a stronger bank. Given that the federal government insures deposits, it has an abiding interest in seeing that such mergers take place as smoothly as possible. Nobody is saying those kinds of deals shouldn’t take place.
But Citigroup, at this point, probably falls into the category of troubled bank, and nobody seems to be arguing that it should be taken over. It is in the “too big to fail” category, and the government will ensure that it gets back on its feet, no matter how much money it takes. One reason Mr. Paulson forced all of the nine biggest banks to take government money was to mask the fact that some of them are much weaker than others.
We have long been a country that has treasured its diversity of banks; up until the 1980s, in fact, there were no national banks at all. If Treasury is using the bailout bill to turn the banking system into the oligopoly of giant national institutions, it is hard to see how that will help anybody. Except, of course, the giant banks that are declared the winners by Treasury.
JPMorgan is going to be one of the winners — and deservedly so. Mr. Dimon managed the company so well during the housing bubble that it is saddled with very few of the problems that have crippled competitors like Citi. The government handed it Bear Stearns and Washington Mutual because it was strong enough to swallow both institutions without so much as a burp. Of all the banking executives in that room with Mr. Paulson a few weeks ago, none needed the government’s money less than Mr. Dimon. A company spokesman told me, “We accepted the money for the good of the entire financial system.” He added that JP Morgan would use the money “to do good for customers and shareholders. We are disciplined to try to make loans that people can repay.”
Nobody is saying it should make loans that people can’t repay. What I am saying is that Mr. Dimon took the $25 billion on the condition that his institution would start making loans. There are plenty of small and medium-size businesses that are choking because they have no access to capital — and are perfectly capable of repaying the money. How about a loan program for them, Mr. Dimon?
Late Thursday afternoon, I caught up with Senator Dodd, and asked him what he was going to do if the loan situation didn’t improve. “All I can tell you is that we are going to have the bankers up here, probably in another couple of weeks and we are going to have a very blunt conversation,” he replied. He continued: “If it turns out that they are hoarding, you’ll have a revolution on your hands. People will be so livid and furious that their tax money is going to line their pockets instead of doing the right thing. There will be hell to pay.”
Let’s hope so.
Recessions hurt us all, but how unfair if Africa is punished for Western excess
After another week of madness and mayhem in London, it seemed a good idea to escape and have a look at the world from the calm of Nigeria. I kid you not, for Abuja, the specially planned political capital, is very different from the great, heaving commercial and financial centre of Lagos, the capital until 1991. But it is also a good discipline to look at the world from the other side. To take one example: the emergency meeting of Opec over oil prices looks quite different if you are sitting in the country that is the world's eighth-largest oil exporter, rather than filling up the car in Britain.
It also looks different if you are in Belarus, Ukraine, Hungary or Pakistan – countries that have recently gone to the IMF for a bailout. Indeed, last week was one in which many emerging economies found their credit and their currencies hitting the rocks. The global financial crisis has now moved far beyond its US starting place and the Western European markets that were hit next.
Even so, notwithstanding the recent fall in the price of oil, in Nigeria the emphasis is on coping with growth rather than trying to ward off recession. Thanks to oil, growth is around 7 per cent a year. But oil contributes some 90 per cent of government revenues and a still higher proportion of export receipts. The result is an unbalanced economy, with huge wealth in some quarters alongside declining life expectancy, power cuts and the need to invest heavily in infrastructure.
Take the movement of people into cities. Work by Goldman Sachs suggests that, by 2050, there will be another half a billion moving into urban centres in Africa – some 150 million of these in Nigeria. There is a huge amount of investment needed, particularly in mobile telephony, electricity and roads, of which more than one-third is in Nigeria.
As the credit crunch rolls out to hit the developing world, many of these projects are going to be delayed. That will further reduce demand in the world economy, quite aside from delaying the improvements in quality of life that such investment would bring. So there is a global social cost to the crash, not just an economic one, and that cost will be felt throughout the world.
Naturally, oil producers are better insulated than oil consumers. Nigeria does its public accounts on the basis of an oil price of under $40 (around £25) a barrel, so there is plenty of scope for the price to fall further without damaging the country's spending plans. (A case could be made that Nigeria is too conservative in its accounting, and there would be welfare benefits and greater economic efficiency with more investment in infrastructure.) But the big point here is that, at present levels, the oil price is still historically high; it is just a little less stratospheric than it was.
So for the oil consumers of the emerging world, it has been and will continue to be tough. And now they have been struck by a sudden loss of confidence: the price of bonds issued by several countries, not just those that have gone or are likely to go to the IMF, has plunged; currencies have plunged. The loss of confidence has even spread to Russia, the world's second-largest oil producer, one that should be among the winners in the global financial chaos.
Even countries that seemed well-insulated from the storm are being caught up in it. This is scary stuff. The governments and central banks of the developed world are now fully involved in containing the banking crisis, and while there will probably be more bad news to come, they seem to be succeeding. They may not be able to prevent a recession, but they can buffer its effects and make sure the financial institutions are secure enough to finance the recovery.
But one of the things which most of us had assumed would happen is that the downturn in the developed world would be offset, to some extent at least, by continued growth in the emerging economies. I think this is, broadly speaking, still right. But what has happened in the past few days must make us question that. There are two things involved here. One: can the stronger emerging economies continue to grow reasonably strongly? Two: will the spread of financial disruption to these countries have a knock-on effect, further weakening not only their own banking systems but also those of the West?
As far as the first is concerned, this is mostly about China. Yes, what happens in the rest of the emerging world is important, but if you are looking at global demand, it is China that matters. This year it probably added more demand to the world economy than the US and Europe combined. But the current forecasts of around 8 per cent growth next year look credible, which would be a significant slowing from the 11 per cent rate in the first half of this year. That is still a lot of growth, so the idea is wrong that as the US goes into recession, China hits the buffers too. But since, aside from raw materials and food, China's imports are limited, its growth will be largely internalised. Meanwhile, other emerging nations will suffer from lack of access to capital.
As for the second concern, there is of course a danger. The Western financial system is vulnerable to shocks from the emerging markets, as the 1980s Latin American crisis and the East Asian and Russian crises of the 1990s showed. The question is really: is there a link between developed and developing markets that we don't understand. There shouldn't be, for the banking crisis has been brewed in the financial markets of the West, not in the emerging world. But the loss of confidence has now gone global, and there may well be hidden weaknesses yet to emerge.
What we have to acknowledge is that the spread of this loss of confidence to the emerging world is troubling for the developed one. We have to ratchet down our expectations for global growth by another couple of notches. You cannot avoid the point that the world economy is looking more and more like it was before the recession of the early 1990s. That is clearly what stock markets around the world now expect. I still think there is a good possibility that, when the final tally is made, the UK will have come through in better shape than it did then, but the past week was discouraging. And we must acknowledge that most forecasters now expect the UK to do rather worse than other developed nations, not better.
But in any measure of human values, a recession in the US or Europe does less damage than economic disruption in Africa, and Nigeria is lucky in having a strong hand to play in the world economy. How well it plays its cards is its business; but other African countries have weaker hands, some much weaker, and it would be desperately unfair if the excesses of Western bankers clobber them too.
This haunted market won't recover until its ghosts are exorcised
What can one sensibly say, viewed from a distance, about the current panic? My own best frame of reference is the end of 1974, when the old FT30 share index plunged below 150 and all faith in the government's ability to do anything about it vanished. As it turned out, the market bounced back swiftly in the January, so while there was a lot of bad economic news ahead – the mid-1970s recession vied with the early 1980s one as the worst since the Second World War – the market began, haltingly, to look towards some growth ahead.
Well, the good news is that things don't feel nearly as bad now as then. We are not staring into the abyss of hyperinflation and, for the record, the housing boom of the early 1970s was just as heady as that of the early 2000s. But there seems to me to be three main things spooking the market, and fortunes won't recover until these ghosts are exorcised.
One is the point noted above – that financial chaos is spreading to the emerging economies, and this will bounce back and damage the rest of us too. The second is that there is some big unknown in the banking/ insurance linkages which has yet to emerge, and that when it does, the authorities will lack either the firepower or the acumen to cope. The first part of this is entirely possible, and until it happens the second element cannot be determined either way. My view is that the turning point was on 6/7 October when the world's banking system nearly did collapse and was saved by the central banks and governments. If they have to prove they are up to it again, they will do so.
The third is more parochial, the way in which the UK is being targeted by the markets. You could justify that partly because we have had a relatively big housing bubble, a particularly large financial sector and a relatively large fiscal deficit. But there may be something more: a lack of confidence in the Government itself, or the "Soros effect" – that we are easy for speculators to hit. In a sense, the markets are betting against Gordon Brown.
Putin to rescue Deripaska over $2.5bn loan
Russian Prime Minister Vladimir Putin will bail out Oleg Deripaska, the oligarch at the centre of the "yachtgate" affair, with a $2.5bn (£1.6bn) loan refinancing this week. Mr Deripaska has until the end of the month to find the money to repay the syndicate of 13 banks, including Royal Bank of Scotland and Merrill Lynch, that provided a loan so that he could take a 25 per cent stake in mining giant Norilsk Nickel.
He approached Vnesheconombank (VEB), the state-owned bank where Mr Putin is chairman of the supervisory board, earlier this month to refinance the loan. Sources close to Rusal, the aluminium group that Mr Deripaska owns, and which he used to buy the stake, said the Kremlin has confirmed that it will provide the money. A London-based banker who was involved in the original syndicate said "positive noises are coming out of the Kremlin".
However, he added that the lenders would give no more than a seven-day extension to Friday's deadline before they seized control of the Norilsk stake. "The signs are favourable but we'll give him [Mr Deripaska] a week extension tops – we can't let this go on for weeks or months." There had been reports that the Kremlin would demand the Norilsk stake in return. However, it is understood VEB has not set this as a condition of the refinancing and would rather a Russian held a major stake in one of the country's most powerful companies, rather than a set of overseas banks.
Rusal has been involved in a power struggle for Norilsk since last year. Mr Deripaska wants to merge the groups to create a national mining champion, but rival tycoon Vladimir Potanin, who in effect controls Norilsk, is against the move. There are suggestions that the Russian government, which would be able to veto a merger, is starting to support Mr Deripaska's plans. The Kremlin plans to buy stakes in prominent Moscow-listed companies to support them during the financial crisis.
It is understood that one of the targeted groups is Norilsk, and that the share purchases will begin in the next few weeks. Rusal executives believe the government will vote with them at an extraordinary general meeting on 26 December. Mr Deripaska's allies have called the vote to change the composition of Norilsk's board in the hope of loosening Mr Potanin's grip.
George Osborne, the shadow Chancellor, is said to have sought a donation to the Conservative Party from Mr Deripaska aboard his yacht this summer, although Mr Osborne denies soliciting any funds. Nat Rothschild, the hedge fund manager who is a friend of both Mr Deripaska and Lord Mandelson, has since turned on Mr Osborne for apparently leaking comments of a private conversation about Gordon Brown. Lord Mandelson was said to have "dripped pure poison" about Mr Brown during the same trip. Atticus Capital, Mr Rothschild's hedge fund, has reportedly lost $5bn this year.
Chrysler makes a poor fit for GM
General Motors Corp. is having trouble lining up the financing to acquire Chrysler LLC -- either by merging it into its operations or as a scaled-down subsidiary. Observers may blame the credit crisis and the present reluctance of banks to lend. While that makes GM's task more difficult, it certainly is not the central reason why the acquisition should not go forward.
Simply put, Chrysler has two good franchises that would complement GM's product mix, but those are hostage to an otherwise uncompetitive corporate structure. GM can't fix those problems easily. Jeep and Chrysler minivans are great brands. Although these products are in shrinking market segments, these segments will continue to be large and important. Properly managed, the Jeep and Chrysler minivans could be the survivors that reap large profits. Moreover, their brands and architecture could be extended into smaller more efficient crossovers like the Nissan Rogue, which are sorely needed now in the U.S. market.
However, Chrysler products suffer from poor quality -- reliability issues and poor product appointments to compensate for high labor costs and clumsy management. Those issues might be better solved by a joint venture with a Japanese manufacturer such as Mazda or Toyota. I like Mazda best, because the Jeep and minivans complement its strengths in sedans very well, and it could get trucks from its other partner, Ford. Ford sells the most pickups on the planet for a reason: The marketplace finds them the best!
The recently negotiated UAW contract does not adequately reduce hourly labor costs and/or remove the burden of legacy costs. It only potentially moves most of those to other corners of the balance sheet. If GM acquired the Jeep and minivan franchises, GM would still have to pay heavy severance bonuses to workers it laid off in streamlining operations. Similar payments would be required to shutter much of Chrysler's unattractive truck and car operations, and GM would still have to fund the union health care fund for retired Chrysler employees. Those costs are simply more than the Jeep and minivan franchises are worth.
The simple fact is that the best solution for Chrysler is Chapter 11 to remove the burdens of the UAW contract and scale down the company to something one-half to two-thirds its current size. That would serve GM's interests, too -- both Ford and GM would benefit from some capacity and cars going off the market. Suggestions are emerging that Uncle Sam take a stake in the combined company. Rewarding two of the worst run companies on the planet makes little sense to me. It would be better to formulate a comprehensive strategy for the industry to encourage the build out of high efficiency vehicles.
Washington should require much higher mileage standards for automobiles than the 35 miles per gallon target set for 2020, offer incentives for consumers to trade in their gas guzzlers, and provide substantial product development assistance to U.S.-based automakers and suppliers. The latter includes Toyota and Honda, as well as the Detroit Three, battery makers and other suppliers to accelerate the production of high-mileage innovative cars.
The condition for assistance would be that beneficiaries do their R&D and first large production runs in the United States, and share their patents at reasonable costs with one another. The huge U.S. market would attract producers from around the world and rejuvenate the U.S. auto supply chain.
AIG Has About Eight Weeks of Cash
AIG continues to bleed cash and is running out of time to sell off assets as vultures are waiting in the wings. The insurance giant, as of Wednesday, had borrowed $72.3 billion of the $85 billion federal bailout facility. Additionally, it had used $18 billion of the Federal Reserve Bank of New York$37.8 billion securities lending facility. At this rate, AIG will run dry in eight weeks and according to interviews given by Mark Tucker, CEO of Prudential PLC, The U.K. financial services company, which has insurance interests in the U.K., U.S. and Asia, is licking its chops waiting for the right moment to pounce.
AIG CEO Edward Liddy said in a PBS interview aired on Wednesday that the requirement for additional cash depends on "our ability to stop the bleeding." Liddy added "but it's also what happens in the capital markets. To the extent they continue to go down and we have to keep posting collateral.,.. it's possible it may not be enough." This scenario was identified as a possibility two weeks ago and, if the government had not offered the securities facility, AIG would have already bled dry.
Prudential's approach is eerily similar to that of another British predator, Barclays, which initially indicated interest in Lehman Brothers' assets only to withdraw. After Lehman failed, Barclays then moved in and picked off the best bits for a bargain price. Prudential, however, has picked on a huge animal and there are many parts of AIG that have little appeal. AIG has been given a lifeline by the Fed and needs to use it before the requirement for more cash becomes a desperate plea.
The Fed did not enter into this transaction to do the right thing for the shareholders of AIG. The government said it acted because "a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance." Since then, however, the markets have tanked on worldwide recession fears.
The Fed should act on behalf of the U.S. taxpayer and pressure AIG into taking action now and not delaying asset sales. The press release at the time of the initial bailout said "this loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy."
AIG's director of public relations, Joe Norton, would not comment on the interest that Prudential has displayed in some insurance assets and made clear that unless a deal was signed there would be no comment forthcoming from AIG about any disposals. As time passes and the cash dwindles, however, the offer price from any buyer will drop. Prudential reportedly has already indicated that any interest is at a very early stage, and it appears that negotiations will not be hurried.
Cash is AIG's blood now, and it's provided by the Fed. The two credit facilities offered to AIG are not really comparable, nor are they linked together by anything other than the fact that AIG cannot raise funds from anywhere else other than the Fed at the moment because the company's credit in a poisoned credit world is considered toxic.
Norton said that with the $85 billion bailout fund "AIG is using the funds primarily for collateral obligations for the credit default swap portfolio and general corporate funding." The additional $37.8 billion facility is being used by the securities lending program that AIG operates as part of fulfilling the normal cash needs of the life insurance companies.
As the credit markets are trying to free up liquidity, the fear of a general worldwide recession is growing and adding to the downward pressure on the world's stock markets. This is hurting AIG by reducing values of collateral that AIG is shoring up with Fed cash. At the same time, the value of investment-grade bonds is dropping, reducing the ability of AIG to raise cash, even from the Fed. This is putting severe pressure on AIG's ability to operate freely.
On Oct. 9, according to Norton, AIG only had $37.2 billion in assets available for the securities program. The third-quarter results will give an indication of how bad things were at the time the Fed stepped in. They will show the writedowns AIG has taken and provide an indicator of the maximum amount of cash that can be raised.
Norton would not disclose the date that AIG will release the earnings report. If AIG announces that the results will be published on Nov. 4 or 5, perhaps taking a leaf from the political handbook, it could be seen as a sign of extremely bad news that could be covered overlooked by the excitement of the presidential election.
Nothing concrete has emerged on AIG's asset-disposal program aside from the key appointment on Thursday of Paula Rosput Reynolds as vice chairman and chief restructuring officer with the direct responsibility of overseeing the divestiture of assets. Reynolds has little time to settle into the role as assets must be sold immediately.
In Beijing, World Leaders Pledge Broad Reform of Financial System
Leaders from Asia and Europe on Saturday called for new rules for and stronger regulation of the global monetary and financial system at the close of a two-day summit in Beijing as China assumed a leadership role in the crisis. Chinese Premier Wen Jiabao said the world's economic problems had become so massive that measures beyond the many multibillion-dollar bailout packages announced might be necessary to avert further damage.
"We are very glad to see that many countries have taken measures that have initially proved effective. But this is not enough given the current situation, and more needs to be done," Wen said Saturday, a day after dire corporate earnings reports from all over the world pushed Wall Street to a five-year low. Wen also said stricter regulation might be key to recovery. "Lessons should be learned from the financial crisis, and the responsibilities should be clarified for governments, companies and supervision, respectively," he said.
The Asia-Europe Meeting, last held in 2006, traditionally does not result in any policymaking. The gathering this year, however, took on a new urgency with the world teetering on the edge of a recession. In a joint statement, the more than 40 leaders in attendance -- including Japanese Prime Minister Taro Aso, German Chancellor Angela Merkel and French President Nicolas Sarkozy -- said they recognized "the need to improve the supervision and regulation of all financial actors, in particular their accountability" and pledged "to undertake effective and comprehensive reform of the international monetary and financial systems."
Although the leaders spoke only of broad principles and did not offer specific proposals, it was clear the groundwork was being laid for a Nov. 15 meeting that President Bush is hosting in Washington. The Beijing meeting appeared to be a victory for Sarkozy, who has taken the lead in representing his European Union colleagues in pushing for an overhaul of the world's financial systems and the creation of a "regulated capitalism" as soon as possible. Sarkozy has said such steps cannot wait until a new U.S. president takes office.
Bush has said, however, that translating ideas into law "must be a top priority for the next president and the next Congress." Sarkozy said Asian leaders have joined their European counterparts in expressing a "willingness for the Washington summit to be a place where we make some decisions, and we have all understood that it would not be possible to simply meet and have a discussion. We need to turn it into a decision-making forum." The major issues expected to be addressed by world leaders in the coming months and years include the International Monetary Fund's role in stabilizing economies, currency reform and measures to help prop up cross-border banks.
The participants in the summit said the IMF "should play a critical role in assisting countries seriously affected by the crisis." Merkel called for the IMF to become a "guard for the stability of the international finance system." As more developing countries are being hit by the turmoil, the IMF is proposing an emergency program that would double borrowing limits and waive some of the fund's standard conditions for loans. The fund has agreed to lend Iceland $2.1 billion after the country's banking system collapsed.
For the past few weeks, China has stood on the sidelines as country after country became caught up in the financial maelstrom.
Many countries have looked to China for leadership as the world's fastest-growing major developing economy. But Chinese leaders offered a standard response: China's first priority was protecting its economy. China was slow to respond to calls for a meeting to discuss regional measures and was noncommittal about whether it would attend the Nov. 15 meeting, which will bring together the Group of 20 top economic powers and developing nations. But with news this week that China's growth had decelerated to 9 percent, its lowest rate since 2003, the country's leaders appeared to step up.
On Saturday, Wen emphasized that China would not only attend the U.S.-hosted talks but also play an active role. "I think what we should do to cope with the crisis can be summarized as confidence, cooperation and responsibility," he said. Shortly before the Asia-Europe Meeting began, China joined South Korea, Japan and 10 Southeast Asian nations in announcing the creation of an $80 billion fund that the countries could use to fight currency speculators. China also announced that it had agreed to more "timely" phone conversations with Japan, with which it has had a tense relationship over apologies and reparations for atrocities committed during World War II.
'Out of Control' CEOs Spurned Davos Warnings on Risk
Once upon a time, the World Economic Forum was the ultimate Wall Street jamboree. Now, in the riptide of the worst financial crisis since the Great Depression, WEF officials and delegates say many of the chief executive officers who gathered in Davos, Switzerland, over the last five years didn't listen to warnings from their peers. Davos organizers also say they failed to play tough with the financial-industry bosses, opting to accept their funding and let them turn Davos into a rave-up for Wall Street excesses.
"The partying crept in," says Klaus Schwab, the 70-year- old WEF founder and executive chairman. "We let it get out of control, and attention was taken away from the speed and complexity of how the world's challenges built up." The fallout has left the WEF riddled in buyer's remorse, with officials throughout the organization asking what they have wrought and, like Wall Street, whether they offered too much of a good thing. Schwab says the delegates treated him like "Cassandra" whenever he questioned the logic of their wisdom on asset-price bubbles in housing, stocks and other financial instruments.
WEF Chief Operating Officer Kevin Steinberg says the vast sums of money that rolled in from Wall Street celebrities for marquee billing in Davos contributed to complacency among forum organizers and often obliged them to publicly massage the viewpoints, wishes and status of their superstar guests. "We catered to what the financial leaders wanted: solo speaking slots, luxury hotels and VIP treatment we wouldn't afford anyone else," Steinberg, 38, says. "We gave them a soapbox. It was all political. We try to minimize the politics, but can't."
In his office outside Geneva, about a three-hour drive from Davos and overlooking the French Alps, Schwab says the WEF began issuing warnings in 2003 to investment banks, insurance companies and hedge funds about the systemic risk gnawing at the foundation of the global economy. "But the financial community didn't listen," Schwab says. "They were told that any serious look at the economic fundamentals showed that we were in an unstable situation. It was denial, total psychological denial."
For next year, Schwab says his goal is to transform Davos into the "Bretton Woods of the new millennium," a meeting targeted at establishing a fresh set of global rules for commercial and financial relations, much as the original Bretton Woods conference in New Hampshire did in the summer of 1944. As for the merrymaking, Schwab vows "it won't happen again." Unlike Bretton Woods, companies will still pay as much as $750,000 each in annual fees to send executives to Davos. William Browder, founder of Hermitage Capital Management Ltd. in London and an eight-year WEF veteran, isn't so sure Schwab can pull it off.
"An exercise in moderation is something the private sector doesn't do very well," Browder says. Each January, global financial titans and their entourages gathered in the Alpine hamlet. A band of fluegelhorns wandered in hotel lobbies, heralding the arrival of delegates such as Lehman Brothers Holdings Inc. CEO Richard Fuld Jr., Freddie Mac CEO Richard Syron and U.S. Treasury Secretary Henry Paulson, along with actresses such as Angelina Jolie and Sharon Stone.
Bundled in cashmere coats and goose-down parkas, the WEF's 2,500 "global leaders" set off to attend a medley of 500 public and private sessions designed to isolate economic problems, clarify disturbing market trends and forge innovative solutions. In the days leading up to the conference, volunteers in lederhosen draped the village with hundreds of white and blue banners that declared the 38-year-old conclave's purpose: "Committed to Improving the State of the World." WEF organizers often pulled stunts to hoodwink delegates who preferred partying and meeting privately with clients over attending forum sessions.
In the "Why Do Brains Sleep?" meeting in 2007, a cadre of eminent psychologists and psychiatrists explored whether financial leaders got enough rest and "what that tells us about the quality of their decision-making." To spur delegates into addressing financial-market alienation, a session in 2004 was held to discuss whether extraterrestrials had taken control of Wall Street: "Have Extraterrestrials Made Contact With Government Leaders?" The ruse didn't work.
Steinberg recalls the attitude among some of the delegates at Davos from 2003 through last January. "It was clear irresponsibility on their part and it's more damning than anyone can imagine," says Steinberg, who has been with the WEF for more than a decade. The former McKinsey & Co. management consultant supervises the forum's finance-industry delegates. "By 2003, the over-leveraging of the system was a serious topic of conversation, but the some 60 of WEF's corporate members from the financial world never had an understanding of how big a problem it was," Steinberg adds. "We had assembled the world's greatest economic experts to confer with them, and the financial community was not aware of that expertise."
In 2005, Schwab says WEF's delegates from Wall Street were eyebrow-deep in booming markets, easy money and intense pressure to take greater risks, borrow more and seek higher returns. One of WEF's sessions that year was "Spotting the Next Bubble Before It Bursts." Goldman Sachs Group Inc. CEO Lloyd Blankfein ran the meeting with Syron, then CEO of Freddie Mac, the now-discredited U.S. government-sponsored mortgage buyer and reseller that along with Fannie Mae in September required a $200 billion U.S. government bailout.
The Blankfein-Syron mission: "Spotting where and when the next bubbles are likely to occur and how we can get better at spotting and resisting bubbles," according to the program. Yet Wall Street ignored the solutions offered at the meeting, says WEF Senior Director W. Lee Howell, 44, whose office created the session. "I often wonder how many members were actually listening to what was being said," Howell says. "I know the American financial community didn't show up in Davos to listen."
Another "bubble" session the following January looked at real estate and was led by Stephen Roach, then Morgan Stanley's chief economist, who now is chairman of Morgan Stanley Asia Ltd. "A sharp decline in housing prices could have a tremendous impact on the global economy; in the U.S. alone, 40 percent of new jobs since 2001 have been related to the housing sector. With low interest rates and excess liquidity, other bubbles may follow," the program read.
Steinberg says the most-discussed housing issue among some delegates centered on Davos's Belvedere Hotel, where corporate chieftains and their deputies were "more interested in entering into bidding wars to secure the biggest party room than they were in attending sessions held there." As Steinberg tells it, Wall Street arrived in Davos with a "divide-and-conquer strategy" that focused on using WEF to woo new clients and "launch sales campaigns" instead of "collectively taking action to mitigate the evident systemic risk."
The five-day annual forum, which also attracts scholars and scientists, has always been eclectic. Racing Audis on the ice of a nearby lake and attending snow-polo matches in St. Moritz have been popular diversions. The dress code was casual, and the garb of Wall Street, Schwab says, was perhaps unsuited to the cold and candid camaraderie of Davos. "There is a certain discomfort with snow," Schwab says.
Steinberg says there were scores of "intelligent people" raising storm flags in Davos for the last five years. In 2007, former U.S. Treasury Secretary Lawrence Summers warned of complacency. He returned to the village in 2008 to say "a cascading loss of confidence" threatened to paralyze the global economy, comparing the market mood with the economic sentiment that prevailed just before World War I.
uidance was offered by monetary-policy makers such as European Central Bank President Jean-Claude Trichet and Bundesbank President Axel Weber as well as economic wise men, including Yale University Professor Robert Shiller, U.S. Congressman Barney Frank and World Bank Director of Governance and Anti-Corruption Daniel Kaufmann. Such advice was swatted away by American confidence salesmen such as Michael Klein, co- president of Citigroup Inc.'s investment-banking unit, and David Rubenstein, managing director at the Carlyle Group buyout firm.
"I warned them all about global risk and the abusive nature of their actions, but they had no incentive to change," says Kaufmann, recalling his seven years as a global leader at Davos. "And why should they have listened to us? I see it with my 10- year-old daughter, who scolds me because I don't put the garbage in the correct bin. Let's not delude ourselves. It's impossible to teach old dogs and investment bankers new tricks unless you change the incentive structure."
"It was all laid out in Davos," says WEF delegate Daniel Loeb, 46, owner of Third Point LLC, a New York-based hedge fund. "The investment bankers got so caught up in competing with each other that they used the place to schmooze, instead of actually learning about what was going on in the world." Howell describes the Davos attendees in zoological terms: "The investment banks, private-equity funds, hedge funds and insurance companies were the animals Davos was most fascinated with. But they were exotic animals that people who ran these businesses never took the time to grasp what the world at large thought they knew."
History's Biggest Margin Call
The entire world was seemingly positioned for a particular financial backdrop and received an altogether different one. Some years ago I wrote something to the effect that “financial crisis is like Christmas.” After all, during the Greenspan era periods of heightened financial and/or economic pressures were almost cause for celebration within the leveraged speculating community. Aggressive rate cuts and “easy money” were the trumpeted solution to any problem, which equated to easy financial fortunes for the savvy market operators. Over time this culture of leveraging, speculation and financial shenanigans fanned out across the globe – throughout finance, commerce and government endeavors.
This mindset was firmly ingrained when our subprime crisis erupted in the spring of 2007. The whole world apparently was of the view that the unfolding U.S. mortgage and housing crisis ensured “easy money” as far as eyes could see. “Helicopter Ben” was at the controls; dollar devaluation was in full-force; dollar liquidity was barreling out of the U.S. Credit system; financial systems across the globe had succumbed to Credit Bubble dynamics; inflationary fires blazed everywhere; and speculative finance was literally inundating the world. In most places, making “money” had never been so easy.
This backdrop created epic price distortions and some incredibly maligned market perceptions. It’s now clear that unprecedented leverage became deeply embedded in markets and economies everywhere. These excesses had been unfolding over a longer period of time, but terminal speculative “blow off” dynamics really engulfed the global economy when U.S. housing vulnerability began to emerge. A confluence of many extraordinary and related dynamics was severely undermining the global system. The U.S. financial sector was desperately overheated, the U.S. mortgage/housing Bubble was bursting, the expansive international Bubble in leveraged speculation was in “blow-off” mode, global imbalances were at dangerous extremes, and inflationary psychology took hold throughout global financial systems, asset markets and real economies. It was an unparalleled period of synchronized global Credit, asset market, and economic Bubbles.
Only today is it readily apparent what a mess the global pricing system had become. Think in terms of a net Trillion plus U.S. dollars inflating the world each year, of which a large part was recycled through Chinese and Asian purchases of U.S. securities (inflating domestic Credit systems and demand in the process). Think in terms of rapidly inflating economies with several billion consumers (Brazil, Russia, India, and China). Think in terms of the surge of inflation that forced thoughtful policymakers in economies such as Australia, New Zealand and elsewhere to significantly tighten monetary policy.
Rising rates, however, only enticed more disruptive speculative finance flowing loosely from (low-yielding) Credit systems including the U.S., Japan, and Switzerland. Speculation could have been as simple as shorting a low-yielding security anyplace to finance a higher-returning asset anywhere. Or, why not structure a complex leveraged derivative transaction that, say, borrowed in a cheap currency (i.e. yen or swissy), played the upside of rising emerging equities markets, and at the same time had triggers to hedge underlying currency and/or market exposure. And the counterparty exposure for a lot hedges could be wrapped up in collateralized debt obligations (CDOs).
And the more loose global finance inflated the world, the more the leveraged speculating community inundated “commodity” economies such as Australia, Canada, Brazil, South Africa and Russia. Of course, speculative inflows ignited domestic asset market and Credit systems, in the process fostering dangerous Bubbles. And in concert with the deflating dollar, speculating on virtually any emerging market or commodity was immediately profitable. The more leverage the stronger the returns, and the world was introduced to the concept of the billionaire hedge fund manager. In commodities markets, wild price inflation and volatility forced both producers and commodity buyers to employ aggressive hedging strategies. More often than not, derivatives employed trend-following trading mechanisms. These “hedging” mechanisms covertly created huge buying with leverage on the upside and, more recently, liquidation and a collapse of prices and leverage on the downside.
It was Hyman Minsky “Ponzi Finance” on a grand scale. It was also a bout of George Soros “Reflexivity” of epic proportions. The more markets perceived a New Era of endless cheap finance and rising asset and commodities prices, the more U.S. and global Credit systems created the necessary inflationary fuel to perpetuate the Bubble. Markets believed the hedge fund and private equity game could go on indefinitely. Participants thought that Wall Street would securitize loans and be in a position to expand finance forever. Prime brokers would always be willing outlets to finance leveraged securities holdings on the cheap.
The derivatives market would always provide an efficient and effective marketplace for placing bets, as well as for hedging myriad risks. Why not speculate aggressively when insurance was so easy to obtain? At the same time, contemporary “repo” and money markets were viewed as an endless source of inexpensive finance. And, in the event of anything unexpected, the Fed (and global central bankers) would always ensure liquid markets - and inflate as required. Again, why not speculate? The markets had unwavering faith in enlightened contemporary finance and central banking.
But it was all part of the greatest mania in human history. As it turned out, the markets could not have been more wrong on the sustainability of the financial backdrop, the economic environment, asset price inflation, and all types of sophisticated financial structures and strategies. Markets were not only absolutely wrong, they were absolutely wrong on so many things on such an unprecedented global basis. Now things are blowing up. In the thick of it all, confidence in the securitization, “repo” and derivatives markets has been broken.
As a result, Wall Street simply no longer has the wherewithal to apportion ample finance for securities speculation. Without speculative demand for high-yielding loans and securities, Bubble economies are starved of sufficient finance. And with asset markets bursting everywhere, this has quickly evolved into History’s Biggest Margin Call. Scores of derivative structures used to speculate in the asset Bubbles have collapsed - because of counterparty issues, illiquidity, or the structures just didn’t make any sense to begin with. Moreover, the whole notion that derivatives would provide an effective hedging mechanism is proving a fallacy.
Again, counterparty issues and illiquidity are the culprits. Markets can’t hedge themselves, as there is no one with the wherewithal to take the other side of the trade (especially during devastating bear markets). In particular, the Credit default swap structure is proving an unmitigated disaster - for bond, equities and currency markets. Hopefully this period of liquidation and deleveraging is over very soon.
Smoke, mirrors ... and how a handful of missed mortgage payments started the global financial crisis
Last week, something happened which I never expected to see in my lifetime. There was a general run on the entire British banking system, something that hasn't happened before, even in wartime. Ordinary people started moving their money around from bank to bank in fear that they might lose their cash. Millions of pounds were flowing across the Irish sea for the safe haven of the Irish government's recently-announced 100% depositor guarantee. The UK's banks were on the verge of losing public trust, and public trust is the one thing that banks need to survive.
We are witnessing what the commentator Martin Wolf of the Financial Times calls "the disintegration of the financial system". But how did we get here? How did a few dodgy sub-prime mortgages in American inner cities lead to what is beginning to look like the collapse of capitalism?
This is the great unanswered question in the midst of this extraordinary crisis, as banks implode one after the other across the world. We hear endless talk these days about "de-leveraging", "derivatives", "collateralised debt obligation" and "credit default swaps" most of which is completely incomprehensible - and very often designed to be. A lot of what has been going on is essentially fraudulent. But underneath all the jargon is a fundamental truth about banking: that it is based on a kind of confidence trick.
It's called "fractional reserve banking". Alone among commercial institutions, banks are allowed to create value out of nothing - in other words, they are allowed to lend out money they don't have. To explain more fully: at any one time a bank may have, say, £1 billion in assets, but it will have lent out at least £10bn. That £10bn will yield interest, earning money for the bank - but it's interest on money the bank doesn't actually own, that is not based on deposits in its accounts. Magic. Money for nothing.
But this magic only works if the debtors the bank has lent to don't default on their loans and that the savers who have placed deposits in a bank do not all try to take them out all at once. If they did, then the bank would rapidly become insolvent, because of the £9bn it has lent out that it never had in the first place. That's what started to happen last week: the confidence trick began to fail.
Banking practice dates from medieval times when kings and aristocrats deposited their gold with goldsmiths for safekeeping. The goldsmiths noted that the owners didn't all ask for all the precious metals back at the same time, so they started to lend it out. This is why, until very recently, bank notes "promised to pay the bearer on demand" a sum of sterling silver. It was all based on precious metals. But not any more.
Currency ceased to be linked to precious metals in 1971 when America abandoned the gold standard and ordained that, instead, the world should regard their dollar as being "as good as gold" and use it as the universal medium of exchange. This is called "fiat" money, and some economists believe that it is the root of all evil because, with no intrinsic value, governments cannot resist printing more and more of it, thus devaluing their currency.
The prevailing view nowadays among economists is that central banks can maintain the value of their currencies by manipulating interest rates up or down to control inflation. But this depends on the willingness of the banks to do so. It also depends on the wisdom and prudence of the banks who manufacture this magic stuff called credit. For the past 20 years, central banks have seen economic growth as more important than combating inflation, and banks have thrown prudence to the winds.
After the 1987 crash, central banks cut interest rates and economic life resumed. Again in the late 1990s, after the Asian financial crisis and the near-collapse of the hedge fund Long Term Capital Management, banks cut interest rates again. After the dotcom crash in 2001, the US Federal Reserve, followed by the Bank of England, cut rates dramatically yet again, and kept them low for the next three years, stimulating house price bubbles in both countries. At the same time, the bankers made saving money a loser's game - interest rates were held below the rate of inflation, so anyone who saved actually lost money.
The bankers knew perfectly what they were doing - the former Bank of England governor, Sir Eddie George, told a Commons Select Committee two years ago that the housing boom was "unsustainable" but that he and Gordon Brown deliberately inflated it to prevent a recession. Unfortunately, it got a bit out of hand. The other problem with central banks always cutting interest rates was that this encourages the banks to stop behaving themselves. Huge institutions, including Lehman Brothers and HBOS, started to think they were invincible, masters of the universe, "too big to fail".
Banks like HBOS piled into property, believing that house prices would never fall, and if they did, the Bank of England would slash interest rates and house prices would rise again. Banks like Northern Rock stopped bothering about the boring business of attracting deposits from savers and started borrowing money on the international money markets to fund ever more ludicrous mortgage lending - such as their 125% so-called "suicide" loans. Northern Rock was still selling these "together" loans six months after it was nationalised.
This confidence that central banks would ride to the rescue led banks to take bigger and bigger risks. Instead of lending 10 times the value of its underlying assets, investment banks including Lehman started lending out 30 times their asset value. This is called leveraging, and allowed the hedge funds and private equity groups financed by Lehman to go on buying sprees across corporate world. They were getting colossal quantities of almost free money.
"Leveraged buy-outs" (LBOs) became the name of the corporate game. Groups of investors would get together, target a company - for instance, the AA in the UK - borrow to buy it, load it up with more debt, sell it, and move on. Hedge funds flipped multi-billion companies the way amateur property speculators in California flipped houses. But it was all based on credit, and the dark side of credit is debt. All of this leveraging works only as long as the underlying assets retain their value. Using leverage seemed like free money. But when assets decline in value, the ugly side of debt appears in the form of "de-leveraging".
If a bank has loaned out 30 times its assets, it has loaned out £3 trillion on the basis of only £100bn in reserves. If those assets lose half their value, the bank finds itself in the hole to the tune of £1.5trn. Greatly simplified, this is what has happened in the last year. A class of complex paper assets called "securities", which are based on the value of residential mortgages, started to lose their value as US house prices started to slide. The banks suddenly stopped trading these mortgage-backed securities because they were afraid of the potential losses that might show up if they did.
These assets included the now-infamous sub-prime loans - money lent to Americans who couldn't possibly pay, in what was essentially fraudulent behaviour - which were packaged up into "collateralised debt obligations" and sold on to other banks and governments who didn't really know what they were buying.
That's about where we stood at the time of the collapse of Northern Rock in August 2007. A general panic among banks froze inter-bank lending. Governments then stepped in, first to nationalise Northern Rock, then to pump billions of so-called "liquidity" loans into the system. In essence, the Bank of England agreed to exchange valuable Treasury bonds for dodgy mortgage assets. The banks could then use these Treasury bonds as a kind of currency, because everyone accepted their value was underwritten by the government - ie, by you and me.
But then something else happened. Huge Wall Street investment banks such as Bear Stearns started to discover that their assets were declining even more rapidly than expected, and investors started withdrawing their funds from them, causing a kind of bank run. To prevent widespread defaults, the US government stepped in and forced another bank, JP Morgan, to buy Bear at a fraction of its value. But this didn't stop the contagion. Within the space of six months all the big investment banks on Wall Street had collapsed or been merged with other institutions in one of the greatest banking crashes of all time.
Then the big mortgage banks on either side of the pond started to go under - including IndyMac, Washington Mutual, Wachovia, HBOS and Bradford & Bingley. The two huge state-supported US mortgage banks, Freddie Mac and Fannie Mae - responsible for $5trn in mortgages - had to be nationalised, along with the world's largest insurance company, AIG. Banks which had previously handled hundreds of trillions of investments were finding that they were becoming insolvent almost overnight. Because of the global reach of these companies, this became a crash even more severe than the series of banking failures that led to the Great Depression in the 1930s.
We are now reaching what might be called the terminal stage in this crisis. The contagion has spread through the entire banking structure of the West. It has moved from a crisis of liquidity to a crisis of insolvency and, finally, to a crisis of confidence in the banking system - everyone wants their money out because no-one trusts their banks. The essential trust that allowed the goldsmiths to lend on the basis of their borrowed gold has begun to evaporate.
To prevent Ireland's banks going bust, the Taoiseach last week decided to guarantee all of the deposits in Irish banks, even though it would be impossible for the Irish government to pay up if everyone withdrew. Money is now flooding out of British banks to this "safe haven", causing fury in the UK. So, what made the collapse quite so catastrophic that even hundreds of billions of pounds in liquidity loans was not enough to staunch the flow? Well, the answer appears to lie in what is called the "shadow banking system". This refers to the unregulated dealing by banks in what are called "derivatives" - these are financial instruments which don't have a value in themselves, but relate to a future value.
Originally, derivatives were things like pork belly futures - essentially bets on the value of that year's cull of hogs. But a hugely complex market evolved in the trading of derivatives called credit default swaps, which are like insurance policies taken out on corporate debt. In the space of five years the value of credit default swap contracts rose to $62trn, larger than the combined value of all the world's stock markets. The Bank for International Settlement in Basel calculated that the total value of all derivatives in the world last year amounted to some $500trn.
The market in these "over-the-counter" derivatives is unregulated, and traders are allowed to make bets and enter into contracts without having assets to back them up. The derivatives banks thought they had removed the risk by using complex mathematical formulae which seemed to indicate that they could so finely calculate the likelihood of making a loss that they could insure against it. These derivatives and the mathematics underlying them are immensely complicated and very few people understand them. Indeed, it has emerged that the people who devised them didn't seem to understand them either, because the whole derivatives pyramid is now collapsing.
But through all the confusion the simple essential fact is that banks have hugely over-lent, their assets are declining, debtors are defaulting and their losses, multiplied by complex derivatives and de-leveraging, have become almost incalculable. The banks have had to cut back their lending drastically to build up their capital reserves, and they are now appealing to governments for direct injections of capital.
This is what the $700bn Troubled Asset Relief Programme was all about - using taxpayers money to try to shore up banking capital by buying their worthless assets. But the trouble with this scheme, devised by the former Goldman Sachs boss Henry Paulson, who is now the US treasury secretary, is that no-one really knows how big the losses of the banks are because of this huge amorphous cloud of impenetrable derivatives contracts. But the story isn't over there. Not only did the banks lend too much and binge on dodgy derivatives, they based most of their devilish formulae on a presumption that house prices always go up. Now, statistically speaking, this is arguably the case - over time, house prices have always risen in the long run.
However, in the short run, the graph can be a very lumpy one, with rises and big falls. For some reason, the banks forgot this, and thought that the bubble in house prices that was ignited by the 2001 interest rate cuts would continue forever. This was utter madness. House prices are now falling to trend - which means to their historic values. This means a reduction of something like 30%-50%, because the graph of prices always overshoots on the upside and downside. Look at any historical table of house prices and this is blindingly obvious - but for some reason the banks believed that the laws of economics had been suspended by their brilliant mathematics.
So now what happens? Well, as house prices continue to fall - as fall they must - the value of the assets in companies like HBOS will continue to be marked down. This is why Lloyds TSB shareholders are very reluctant to take on HBOS at any price, because it is stuffed with dodgy mortgages which are falling in value. The banks all hoped that by now the central banks would have cut interest rates and people would all have started buying houses again. But house prices are simply too high and have to fall, even with cuts in interest rates. The banks know this, which is why they are refusing to lend unless people can put up large deposits.
This creates a vicious circle which can only be resolved by the assets being revalued. House prices must come down; the banks' assets must be repriced; insolvent banks must be closed; interest rates must encourage saving; consumers will have to stop borrowing to spend and everyone will have to start paying their debts. It's a tall order, and governments across the world are in denial. But the only way out of this mess is some very hard medicine. The longer governments and banks put off swallowing it, the longer the slump will last.