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How The Mighty Fell

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Ten days that shook the world. as a movie title, perhaps not very original, but as a description of events over the past two weeks, it is very apt. It began with the takeover of the two largest mortgage lenders in the US, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation — fondly called Fannie Mae and Freddie Mac — and ended, at least temporarily, with the bankruptcy of Lehman Brothers.
“We are more worried than we were before,” says Nariman Behravesh, chief economist at Global Insights, an economic analysis and market intelligence firm. “The problem is now bigger, touching the upper end of our estimates. We are lurching from crisis to crisis, as a liquidity problem turned into a solvency crisis. The economy is more fragile now.”
The US government — through the US Treasury and the Federal Reserve — stepped in to save Fannie Mae and Freddie Mac, refused to do anything about Lehman, let Bank of America help Merrill Lynch save itself, and threw AIG a lifeline. Different strokes for different folks? Not exactly, because there’s method in this time of madness.
Fannie Mae and Freddie Mac account for almost half of the $12-trillion mortgage market. By law, they are not allowed to hold subprime mortgages, or refinance them. But they are listed companies, and when the market value of their capital base falls below mandated capital adequacy levels, how good the assets are is irrelevant.
As government sponsored enterprises (GSEs) many foreign central banks, including from Japan, China and possibly even India, have invested their reserves in the bonds of these agencies. So, it was very unlikely that the US government was going to let its own GSEs go bankrupt.

The Dominos Keep Falling
Lehman Brothers was negotiating a rescue deal with Barclays but that came to nought. Still, Barclays Bank was able to get what it wanted — Lehman’s ‘core assets’, which includes the investment banking business — for $1.75 billion late on 17 September. Merrill Lynch saw the writing on the wall once Lehman announced its bankruptcy filing. On 15 September, Bank of America’s chief Ken Lewis and Merrill’s boss John Thain announced the takeover of the country’s largest brokerage firm by the country’s largest bank. Commercial banks, long left out in the cold, are beginning to strut again.
“The whole model of independent investment banks seems to be broken,” says Anirvan Banerji, co-founder and director of research at the Economic Cycle Research Institute, in New York. “Merrill and Bank of America is a pretty powerful partnership.”
AIG was rescued — at least for now — by an $85-billion loan from the US Federal Reserve. Well, it’s not exactly a loan yet: it is an assurance that the money will be available to AIG at any time during the next 24 months should the largest insurance firm in the US need it. Then, it will be a bridge loan — a short-term one at the fairly steep price of about 8.5 per cent.
On the morning of 18 September, another massive rescue was announced across the Atlantic, in London, as Lloyd’s TSB announced the takeover of Halifax Bank of Scotland, the largest British mortgage firm. That will give the combined entity control over at least a third of all savings and mortgage accounts in the UK.

Morgan Stanley — with Goldman Sachs one of the two remaining independent investment banks — and Wachovia Banking Corporation are said to be in potential merger talks. Goldman Sachs has sought to reassure investors that it is no danger of going bust; but in the heightened atmosphere of fear that pervades Wall Street that is being treated with a pinch of salt.
The sharp decline in Goldman’s third quarter profits may have added to the scepticism. Washington Mutual (WaMu), the largest savings and loan bank in the US, is also under the gun, having asked Goldman Sachs (how ironic is that?) to advise it on finding the right buyer.
If WaMu fails to find a buyer, and goes bust, the Federal Deposit Insurance Corporation (FDIC) will have to step in to save WaMu’s depositors. But the FDIC is said to be running short on its insurance fund, after bailing out the depositors of 11 banks this year. At a time when the fund is at its lowest level since 2003 — now $45.2 billion — the number of troubled banks has been at its highest. And that’s a Pandora’s Box with no hope in it.


Add up all the funding the US Federal Reserve has provided and the exposures it has — and which may get added to — and you begin to wonder: can the Fed run out of cash for more rescues? When the Fed offers a loan, it does so in the form of securities: that is, it provides US Treasury securities of the committed amount, which the borrowing firm, say, AIG, can then sell in the open market.
While the Fed has a massive balance sheet, its reserves — in the form of marketable treasury securities — are estimated to be less than $200 billion today, down from $800 billion at the beginning of the year. So the US Treasury announced a new, temporary and separate auction of treasury bills — a Supplementary Financing Program for the US Federal Reserve — to assist the Fed to ‘better manage its balance sheet’.
The asset side of that balance sheet is loaded with exposures to the special purpose vehicle holding $30 billion of Bear Stearns’ ‘toxic assets’ as part of the deal with JP Morgan Chase. The Fed has also let investment banks use its discount window to borrow against collateral that is not exactly zero-risk. The Bank of England, the Bank of Japan and the European Central Bank may similarly hold illiquid assets. Mark to market, anyone?

Is It Over Yet?
Global losses emanating from the subprime mortgage market crisis are estimated to be about $650 billion, about $300 billion-475 billion of that being accounted for by the US financial system. “That’s 2 per cent-3.3 per cent of US GDP, and 20 per cent-40 per cent of total bank capital,” says Brian Bethune, chief US financial economist at Global Insights. “That’s a lot of capital to lose in one year.”
On 16 September, the US markets fell drastically by over 450 points or about 4 per cent. The next day, markets across Asia followed suit, all falling by 4 per cent or more, with Hong Kong’s Hang Seng Index falling by almost 7 per cent. This may be unrelated, but on 17 September, trading was suspended on Moscow’s stock exchange, as the market fell precipitously led by banking stocks. The Russian government pumped in $44 billion as capital into three largest Russian banks. By all accounts, the blood-letting both in the US and elsewhere in the world is not over yet.
Nouriel Roubini, professor of economics at New York University’s Stern School of Business, calls it the worst financial crisis since the Great Depression. And he paints a frightening picture: when the dust settles, credit losses will be close to $2 trillion — about two years worth of India’s GDP — and the failure of hundreds of small banks all over the US (by his estimate, 67 per cent of the assets on small banks’ books are housing loans).
Willem Buiter, professor of European political economy at the London School of Economics, raises another bogey in a paper written for the Centre for Economic Policy Research in May this year. He wonders if with this recent binge of liquidity support for banks and investment banks, central banks themselves could go broke (see ‘Can The Fed Go Broke?’).
Wall Street, goes an old sinister saying, is a street with the river at one end and a graveyard at the other. For investment banks, tombstones are going to take on a whole new meaning.
With inputs from P. Hari in San Francisco and Uttara Choudhury in New York
srikanth 'dot' srinivas 'at' abp 'dot' in
(Businessworld Issue 23-29 Sep 2008)

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