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turmoil in financial markets « Previous | |Next »
September 16, 2008

The names read: Bear Sterns, Fannie Mae, Freddie Mac, Lehman Bros and Merrill Lynch. Financial pillars of Wall Street. The pillars of US capitalism. Gone. Even the Wall Street Journal admits that the American financial system was shaken to its core on Sunday.

The credit crisis signifies a marked failure of US regulation of Wall Street in the sub-prime mortgage market. Stocks in the US, Europe, Asia, and Australia have crashed as a result of the freezing up of credit and a downward spiral in asset values. Lots of unemployment on Wall Street. Have the markets adjusted?

The US Treasury Secretary Paulson drew the line at salvaging Lehman. Lehman Bros have filed for bankruptcy. There were no white knights. Merrill Lynch has been taken over by Bank of America. Is this the circuit breaker. Or is their more to come? American Insurance Group may well be next, as it hangs by a thread. Who next? What is needed to stabilize the financial markets?

Remember the de-coupling theory that any problems in the US real estate market would stay confined to the world's biggest economy. The rest of the world would happily steam on, driven by the strength of China and India. Australia had no worries.

Joseph Stiglitz in The Guardian says that:

The new low in the financial crisis...is the fruit of a pattern of dishonesty on the part of financial institutions, and incompetence on the part of policymakers...We had become accustomed to the hypocrisy. The banks reject any suggestion they should face regulation, rebuff any move towards anti-trust measures - yet when trouble strikes, all of a sudden they demand state intervention: they must be bailed out; they are too big, too important to be allowed to fail.

As the housing market turned toxic, the loans that Bear Stearns, Lehman Brothers, Fannie Mae et al, had cheerfully advanced, bought up, repackaged and insured, lost value. Stiglitz adds that:
It was all done in the name of innovation, and any regulatory initiative was fought away with claims that it would suppress that innovation. They were innovating, all right, but not in ways that made the economy stronger. Some of America's best and brightest were devoting their talents to getting around standards and regulations designed to ensure the efficiency of the economy and the safety of the banking system.

AIG is suffering from the shaky mortgages it holds, as well as the mortgage insurance contracts it has underwritten. Now it needs to borrow money on the financial markets on anything other than punitive terms – and this is the root cause of its problem.To raise funds AIG needs to show potential lenders what its assets are – and so is forced to put price tags on the swamp of mortgages and derivatives it is holding.

The New York Time reports that AIG has been valuing its mortgage junk bonds at far higher than the likes of Lehman Brothers, and so the hole in its accounts is bigger than expected. It has had its key credit ratings cut, potentially triggering billions of dollars of collateral payments on its many derivatives trades.

Update: 17 September
The Federal Reserve has agreed in principle to lend $US85bn to AIG in return for an 80% stake in the struggling company. The US Government has now become a major financier of the American financial system.

AIG has amassed huge liabilities by insuring financial investors against the risk of default on complex instruments including derivatives linked to subprime mortgages. A bridging loan gives it time to sell some of its sprawling collection of insurance businesses in order to bolster its finances.

Without that money, AIG would have defaulted on its obligations and the buyers of its insurance - such as banks and other financial companies - would have found themselves without protection against losses on the debt they hold. However, this morning AIG's shares traded at $US3.50, compared to the peak over the past year of more than $US70 a share. Its value at the close of trading was just over $US10 billion, but for all intents and purposes, it is now worthless.

| Posted by Gary Sauer-Thompson at 5:19 PM | | Comments (15)
Comments

Comments

Another day another crisis. So much for the financial markets saying that the crisis is at an end. They have said that after each collapse. They live in a cloud-cuckoo land where the reality of market failure never sets in.

Perhaps the Pentagon could bail out AIG!

Gary,
It's time for some economic navel gazing. This boom-bust situation is a natural consequence of organising an economy and a society on Friedmanite neoclassical underpinnings. the assumption of self-interested, rational agents has failed and brought on the sub-prime crisis. All the bank salesman had to do to collect a handsome bonus was sell a mortgage at unsustainable honeymoon rates to starry-eyed low incomers wanting a slice of the American dream. Once the paper was signed there was zero responsibility or accountablility - that is the crux of the problem. If you live life according to laissez faire philosophies, prepare to suffer the consequences.

Difficult to see this happening in central european style democracies. A. financial governance structures there would not allow it; and B. you wouldn't find people rapacious and greedy enough to condemn their fellow citizens to certain financial ruin.

The delicious ironically is that the US Gov has been bailing out insitutions and pouring liquidity into the markets. However, being massively in debt financing a war designed to secure their economic future it is thus unable to keep propping up the economy. All the neoliberal chickens are coming home to roost. - the US political economy is collapsing before our eyes. Time will tell if that innovation and entrepreneurial spirit we hear about ad nauseum from Albrechtsen et al will come to the rescue.

Robert
AIG is the big one. As Malcolm Maiden points out in the SMH:

It's facing losses of tens of billions of dollars on complicated derivatives that it created during the market boom after having its debt ratings downgraded on Monday night by the three main credit ratings agencies, and its boasts the debt crisis trifecta: awesome size, with assets of more than $US1 trillion ($1.3 billion) that have not been marked to market value (US insurance groups aren't required to, unlike the US banks); awesome complexity (it began diversifying away from vanilla life and general insurance in the mid-'60s and now has major exposure to two of the markets at the heart of this crisis, credit default swaps and mortgages); and a mainline connection into the arteries of the US economy.

He adds that there is next to no chance that it can survive in its present form; the challenge is to give it the time it needs to break itself up.

The US Treasury Secretary, Hank Paulson, has effectively declared that US taxpayer money will not be used to save AIG and the US Federal Reserve has rejected AIG's request for $US40 billion of bridging funding.

Vee,
yeah we are witnessing the decline of the shadow banking system in the US.

The implications of the present crisis for any company with high debt levels or a large derivatives exposure are unpalatable. These will be shorted by the hedge funds, again. There is now a "flight to quality". Until confidence is restored in the banking system, anything with the smell of high leverage will get roasted.

You can say goodbye to Babcock & Brown.

AIG, a global insurer, is struggling to survive. It's stock is down 95% this year and it is facing a severe cash crunch after ratings agencies cut the firm's credit ratings. This has forced the giant insurer to raise $14.5 bn to cover its obligations. If the insurer doesn't secure fresh funding it may have no choice but to opt for a bankruptcy-court filing.

The insurer has far more than that in assets that it could sell, but it could not get the cash quickly enough to satisfy the collateral demands. Thus the interest in obtaining a bridge loan to carry it through.

That collapse could pose a big danger to the financial system. It looks as the US government will provide a public subsidy, given the failure of the private sector to come up some funds---AIG's attempt to raise as much as $75 billion from private-sector banks failed. So much for the wonders of a self-correcting market so loved by the captains of finance now demanding the socializing of their losses caused by bad risk management.

Vee,
you may find this article on Hyman P. Minsky in the New Yorker of interest. Minsky's “financial-instability hypothesis,” held that bankers, traders, and other financiers periodically played the role of arsonists, setting the entire economy ablaze. Wall Street encouraged businesses and individuals to take on too much risk, he believed, generating ruinous boom-and-bust cycles. The only way to break this pattern was for the government to step in and regulate the moneymen. If neo-liberals stress the efficiency of markets, then Minsky puts the stress on their tendency toward excess and upheaval.

That hypothesis, as you suggest, is being borne out in the current financial crisis. If “apt intervention and institutional structures are necessary for market economies to be successful", then policymakers ought to be discussing how to reform the financial system so that it serves the rest of the economy, instead of feeding off it and destabilizing it.

In the context of the election this is being treated as the fault of greedy people on Wall St. The solution then, is to clear out the greedy people rather than introduce regulation.

Magically, there is nothing wrong with neo-liberalism but plenty wrong with the urban wealthy. How, then, would the needed regulation make its way through the political system?

Lyn,
During the Depression Congress separated commercial banks which take deposits and make loans from investment banks which underwrite and trade securities. In 1999 these depression era laws were repealed by Congress and the commercial banks began muscling in on Wall Street's turf. This competition whittled down profit margins so Wall Street used more of their capital and then lots of cheap debt to trade securities and create financial derivatives (eg., sub prime securities) to increase profits.Investment banks typically have 3% capital and gear more than 30 times their capital.

One option is to require the investment banks to develop a consumer deposit base. That would bring the remaining investment banks inside the regulatory system. It would provide what economists call counter-cyclical capital reserves.

Another obvious step is to regulate the supervision of the institutions so that they do not provide loans equal to 100 per cent of the barely appraised value to customers who cannot afford to repay the loans.

Wall Street would, of course oppose this restriction on their freedom to innovate and make a profit. Governments should not even pretend they can make the financial system stable.

In terms of the US presidential election the Democrats message is simple----the Bush administration failure to provide regulatory oversight over the financial markets has contributed to the crisis. Washington has been asleep at the wheel etc etc. McCain is saying that the fundmanentals of the economy are sound as was President Bush.


Anon, I'm struggling to understand a lot of this, but the deposit base is easy to grasp. If you have deposits you have actual money as opposed to non-existent products dreamed up by the financial special effects department.

Given my highly simplistic understanding, I'm thinking that regardless of what might be done, or what is done, the crisis won't be over until the special effects are reduced to their actual, proportionate value, which is getting lower all the time as the process which created their imaginary value also increased the imaginary value of concrete assets. Is this right?

Nouriel Roubini who predicted a lot of this financial crisis, argues that the last two investnment banks----Morgan Stanley and Goldmannn Sachs are next and may be unable to survive as independent entities.

What is feared is that is a situation of an institution selling its assets in bulk, leading to distressed prices, which forces other institutions to mark their assets to new market prices leading to losses and reductions of scarce equity.This leads to a scenario where no one accepts anyones credit and the market goes into meltdown.

This situation shows that what is needed is access to the lender of last resort support of the central bank.

There's a complete lack of trust in the US financial system. Fraud has been committed on a massive scale, never seen before in the history of international banking and finance, dating back to the 16th century.

Here's some humour dating back to the early days of the subprime fiasco in August 2007. Somehow things don't seem so amusing anymore.

NINJA loan - A special kind of housing loan for someone with No Income, No Job, no Assets.

Neutron loan - An ARM (Adjustable Rate Mortgage) housing loan that destroys the mortgagee but leaves the house standing.

ZOMBIE - Zoned Out Mortgagee; Bankrupt, Insolvent and over Extended.

The word zombie refers to the ‘living dead’. In US financial folklore zombies are portrayed as innocent victims who are transformed into a comatose trance by malevolent subprime mortgage brokers, and led to distant towns or estates where they are made to sign exorbitant mortgage contracts for homes they can't afford. Zombies are recognised by their docile nature, by their glassy empty eyes, and by the evident absence of will, memory, and emotion. Part of their souls may also be captured by the brokers. Zombies can only return to the world of the living upon the termination of their mortgages. Accounts are sometimes cited of actual people who have undergone this ordeal, were declared dead, and later after foreclosure have turned up at the homes of their relatives and friends in various degrees of health.

Hollywood cashes in on subprime.

Title: "Buy me a crackhouse, bitch!"

Plot: The plot is loosely based on an anecdote provided by a resident from the seedier side of the Bronx who claimed that he was once stopped in the street a young dude with a clipboard peddling no-doc, no-money-down, teaser mortgages. The next day on the way home from work, he swears that he saw the same clipboard guy in the street canvassing the neighbourhood crack dealer.

The over zealous broker makes the sale however is found out by his boss who fearing bad publicity order's the young broker to go back into the hood and convince the dealer to give up his newly acquired property. By this time the dealer has already transformed the property into a bonafide crackhouse and is unwilling to give it up. Shenanigans ensue when they cannot come to an agreement. Greed gets the better of the two and they decide to go into business together, using the dealer's extended distribution network to sell mortgages - "quarter ounce of coke, no problem, wanna $250,000 home loan with that?". The whole thing gets out of control when they start raking in more money from sale of mortgages than from cocaine. They also acquire a huge property portfolio from which they profit by flipping properties from one stressed mortgagee to another. Things start to get hairy as their burgeoning operations and new found wealth come under suspicion from the FBI who have the crackhouse under surveillance and the regulatory authorities who are on the trail of the dodgy property sales.

On the other side of town a 40 year old Wall Street Hedge fund manager who was awarded a $15 million bonus for is role in concocting CDO conduits has been fingered by his bosses to take the fall after the collapse of the CDO market leaving the fund holding $15 billion in CDOs it can't unload. Seeing no way out he goes AWOL, abandoning his $250,000 Maserati and $7 million Manhattan condo he decides to lie low in the Bronx until the whole thing blows over. Fate brings the three villains together and they decide to make a run for it to Acapulco with the FBI in hot pursuit. The movie ends with the three sharing a cell in Rikers Island.

Cast: Dave Chappelle stars as the crack dealer, Jack Black as the unscrupulous broker and Rob Schnider as the demented Wall Street financial alchemist. Special appearances by Bob Goldthwait as the jailer and Phillis Diller as the 92 year old pensioner who snares herself a 30 year mortgage.

Lyn
Max Hastings in The Age puts it well. He says:

Businesses such as Lehman Brothers and Merrill Lynch borrow stupendous sums in wholesale money markets, and use them to place bets in a fashion indistinguishable from punters at racecourses or in Las Vegas. Billions have been wagered on financial instruments of a complexity beyond the understanding of even those who invented them....The panic prevailing in London and New York is driven by the fact that, even now, none of those involved can figure out how bad things are for their own businesses, never mind for the system as a whole.

He adds that for decades, governments have deferred to the supposed wisdom and ruthless clout of bankers. Presidents and prime ministers have walked small in the company of those whose lightest word could move trillions.Now those same people are on their knees to their governments and central banks, trying to save their own skins.

The turmoil on Wall Street continues. US stocks plunged overnight led by insurer American International Group and the two remaining Wall Street giants, Morgan Stanley and Goldman Sachs.

Panic and fear is sweeping through the market. The fear gripping the markets reflects investors' concerns that AIG was unable to find a lifeline in the private sector and that Wall Street is now fretting about what other institutions could falter. The logic is that the price of protecting against defaults on debt rose sharply (ie.,the cost of insuring their debt), threatening their ability to finance themselves.The stock price plunged, and all that made it impossible for the institution to negotiate for a capital injection.

Morgan Stanley was holding preliminary merger talks with Wachovia, a troubled regional lender, and could approach other banks and look at other options in the coming days, people familiar with the situation said. Washington Mutual, another regional lender, has hired Goldman Sachs to contact potential buyers.


Steve,
witty. Another image is that of the financial Doomsday Machine for those modernists who see markets as a clockwork mechanism.

The machine is driven by a chain reaction of actions by stock market speculators, regulators, credit-rating agencies and accountants. The details of this mechanism are complex, but the gist is simple - if a bank's share price falls below a critical level, its credit is downgraded; it has to sell assets at fire-sale prices; this further weakens its capital, leading regulators to question its solvency; this drives down its share price and the vicious circle takes another turn.

The financial turmoil has shifted from New York to London - and the Lloyds takeover of HBOS.