As US politicians argued over the $700 billion rescue plan, economists
asked: does it go far enough?
On June 6, 1889, an accident with a glue pot in a Seattle carpentry
shop led to a fire that destroyed the city’s business district,
its railway stations and much of the port. Out of the ashes came the
Washington National Building Loan and Investment Association, set up
to refinance a charred economy.
Washington Mutual or WaMu, as the bank became known, went on to
survive two world wars and the Great Depression to become the largest
savings and loan firm in America with 2,200 branches, 43,000 employees
and $188 billion on deposit.
But recent events have levelled many a financial giant. Last week WaMu
became the latest big institution to fall to the fire raging through
Wall Street. Shut down by the regulators, it was sold for a song to JP
Morgan, one of the few banks to emerge from this turmoil able to buy
anything.
WaMu’s collapse marked another defining event in the worst
financial crisis in a century, eclipsing what had long been
America’s largest bank bust on record, the 1984 failure of
Continental Illinois.
Even if the past week could not match the drama of the previous one –
when Lehman Brothers filed for bankruptcy, Merrill Lynch sold itself
to Bank of America, AIG was rescued and the US Treasury secretary,
Hank Paulson, proposed his $700 billion plan to “save” the
US economy – it was still high-octane stuff.
WaMu’s fall came as politicians wrangled over Paulson’s
Troubled Asset Relief Programme (Tarp), designed to put banks on a
more secure footing by taking bad assets off their balance sheets.
There were dire warnings from President George Bush about the
consequences of not reaching a deal. But economists were beginning to
ask another question. Is the Paulson package enough, or is it an
expensive piece of sticking plaster that will not tackle the
underlying problems of inadequate US bank capital, grim economic
prospects and falling house prices?
“Why have Paulson and his colleagues taken markets to the brink
and invited lawmakers and others to take a peek into the abyss?”
said Stephen Lewis of Monument Securities. “It may be that if
they could have come up with a better plan it would have sold itself,
and they wouldn’t have had to sound so alarmist.”
That alarmism, and fears that the package might get stalled by
political opposition, badly spooked the markets. As the world waited
to find out what shape Paulson’s bailout plan would take, all
bets were off. The billions that flow from one bank to another in the
normal course of business were stopped dead. Banks would not lend to
one another for more than a day, bringing the global financial system
to a halt.
The Libor interest rate – the London interbank offered rate, or the
interest rates banks charge each other for money – climbed to its
highest level since the credit crunch began. The rate to borrow money
for three months reached its highest spread above Bank rate since
September 16, 1992 – Black Wednesday, the day Britain crashed out of
the European exchange-rate mechanism.
Corporate Britain had lost faith in the banking system, having
witnessed the Lehman Brothers collapse, and the fall of HBOS into the
hands of Lloyds TSB. Those who can are keen to hoard their cash.
One senior banker said: “People keep saying that banks are
scared to lend to one another, but that’s not quite it. The
money we lend is not ours, but our customers’. With everything
going on in the markets, our corporate customers are only willing to
deposit it overnight. It’s a corporate equivalent of all our
personal customers moving their savings into their current accounts in
case they need the money.”
Uncertainty about Paulson’s plans was not the only factor in the
crisis – timing was playing a role. The end of September is the end of
the third quarter when banks begin to fret about what their balance
sheets will look like by the end of the year.
Money loaned last week on a three-month basis would still be on the
balance sheet when the banks close off their full-year accounts. Given
the speed at which established institutions have unravelled, that
seemed too big a risk to take.
The seizure in the money markets led to problems for the broader
credit markets. “The credit markets are now completely
frozen,” said one adviser to a British pension fund. “I
know we’ve said that before, but this week they have completely
ground to a halt.”
Bond prices were being hammered across the board, leading to huge
losses for investors. General Electric is one of the few industrial
companies in the world with an AAA credit rating – its bonds would
normally be considered as safe as government bonds. On Friday, as the
market reacted to a profit warning from the giant American
conglomerate, its 10-year senior debt was changing hands at 75 cents
in the dollar. Only a few weeks ago it was trading close to par value.
The broader debt markets were crippled by fears on Friday after the
sale of WaMu. Unlike other recent bank deals, this one saw senior
creditors wiped out alongside shareholders – an unexpected blow.
Between now and the end of the calendar year more than $300 billion of
bonds are due to mature, according to figures from Dealogic. In the
next 12 months almost $1.5 trillion of debt is due to roll over.
The wipeout of WaMu bonds is likely to make it much more difficult for
any struggling US bank to raise new finance. If bondholders can be
wiped out so easily, there is little point in extending debt to
struggling firms. The added uncertainty is likely to make it harder
for all companies to renew their debt facilities, and put a further
squeeze on the price.
FOR the Bank of England, this month’s crisis has had a familiar
ring to it. A year ago, the clearest signal of the severity of the
crisis’s first phase was a sharp rise in money-market interest
rates. Three-month Libor rose strongly, posing severe problems for
banks trying to borrow in the markets – most notably Northern Rock –
and for companies; 60% of business borrowing in Britain is linked to
Libor.
Last week the crisis in the money markets was even more severe than a
year ago. Three-month Libor, which earlier this month dropped to 5.7%,
leapt sharply to just under 6.3%. Though Bank rate stayed at 5%, it
looked increasingly irrelevant.
“Capital-market conditions had begun to look very scary, with
liquidity in a number of instruments almost nonexistent,” said
Philip Shaw, an economist at Investec.
So on Friday morning the Bank wheeled out the big guns to address what
it described as “the ongoing pressures in funding
markets”. Along with the Federal Reserve, European Central Bank
and Swiss National Bank, it announced measures to inject immediate
dollar liquidity into the markets, and ease the upward pressure on US
Libor rates.
More significantly, it said that from tomorrow it would hold weekly
operations, so-called long-term repo operations, to provide three-
month money to the system. Tomorrow’s auction will be for
£40 billion, allowing banks to obtain liquidity against
collateral, including mortgage securities, until January next year,
thus taking them beyond the critical year-end, when liquidity is
expected to get even tighter.
The banks, which had been privately pressing the Bank of England to
take action, welcomed the move. Stuart Gull-iver, chief executive of
global banking and markets at HSBC, said: “It’s what the
market was looking for. It shows a willingness to listen and will
alleviate stresses in the UK bank system right through the year-
end.”
But, warned others, the dramas of the past two weeks and the White
House’s desperation to get the rescue approved, underlined the
extent to which the debate had moved on.
Up to now, all the interventions in the market have been about short-
term solutions to boost liquidity in the system – cash in hand
to solve day-to-day funding problems. By addressing the toxic assets,
Paulson’s scheme has acknowledged that there are problems with
bank capital as well as liquidity. In other words, banks are likely to
face real losses. To get the system moving again, these prospective
losses need to be dealt with, as well as the short-term funding issue.
Despite this, the UK Treasury is not encouraging the idea that there
could be a British version of the Tarp, and analysts are also
sceptical. Britain’s banks, they say, are generally in better
shape than their American counterparts and some with operations in
America will benefit from Paulson’s scheme, if it is adopted.
“While we wouldn’t rule out the possibility that UK
policymakers may eventually need to establish some kind of state-
funded bailout akin to the Tarp, for the moment it seems they are
content with making regular cash injections and weighing up when to
start cutting interest rates,” said Paul Dales of Capital
Economics.
The Treasury will this week receive a report from Sir James Crosby
which could recommend ways of kick-starting Britain’s frozen
wholesale mortgage markets. Officials cautioned against any early
decision on his recommendations, pointing out that policymakers were
mainly engaged in fire-fighting a sharp deterioration in the global
financial climate.
This weekend world markets are watching Washington, where the angry
debate over the Tarp has exposed raw differences. Free-market thinkers
slammed the White House pressure to get a deal done as soon as
possible. Jagadeesh Gokhale, a former consultant to the US Treasury
and now an economist with the Cato Institute, said constant talk of an
imminent financial crisis was making a self-fulfilling prophecy.
“We have seen this before whenever a Treasury secretary says he
is not supporting the dollar, the market immediately reacts.
It’s the same with financial markets.” He said it was hard
to tell what was caused by fundamental problems in the economy and
what was the fault of scaremongering.
Gokhale said there were two main questions with the Bern-anke/Paulson
plan that remain unanswered. “First, is it at all necessary?
What is the evidence that there will be an effect on the real economy,
that agriculture, mining and so on will freeze up because of a lack of
credit?” He said there was some evidence that availability of
credit was slowing in the wider economy but where were the
government’s numbers?
“The second question is, what if $700 billion isn’t
enough? I’m concerned that they will just be back in a couple of
months asking for another trillion dollars.”
That would not be out of line with the cost of previous bank rescues.
In the 1990s, Sweden rescued its banking system, when the loan losses
of banks reached 12% of GDP. The equivalent for the US would be $1.7
trillion, a trillion more than the Paulson rescue package.
But Sweden handled things differently. All-party agreement was quickly
reached on a plan under which all bank creditors, but not
shareholders, were guaranteed protection against loss. Two commercial
banks were temporarily nationalised. Profits of the nationalised banks
and their eventual sale cut the cost to taxpayers to less than 2% of
GDP.
Paulson’s plan may in time emerge with similar success but it is
having to overcome the resistance of a culture that is much more
suspicious of government bailouts.
“This is a failed bailout of a failed bailout,” said Peter
Boockvar, equity strategist for the New York trading firm Miller
Tabak. “We have to let the economic cycle run its course. Every
time the government gets involved there are unintended
consequences,” he said.
After the dotcom bubble the then Fed chairman Alan Green-span slashed
interest rates and created the housing bubble. Subsequent government
interference helped to fuel the spike in commodity prices and the
market conditions that led to the collapse of Bear Stearns and Lehman
and nearly brought down Goldman Sachs and Morgan Stanley, said
Boockvar. “I don’t think this is a good idea.”
The Paulson bailout is now seen as necessary to avoid collapse, but
few economists believe it is sufficient to generate a sustained
recovery.
“It is enough on its own to make the banks willing to lend or
households and businesses willing to borrow,” said Tony Dolphin,
director of economics at Henderson Global Investors.
“Deleveraging is still the most likely outcome. America is not
Japan in the 1990s but the debt-to-GDP ratio will fall and that is
going to be painful.”
The extent of the pain is still a matter of debate. At a Reuters
conference on Friday, Simon Davies of Blackstone warned that more
European companies would go bust over the next few years than in the
early 1990s because debt levels are higher.
“The credit expansion phase was so large and so long that it has
created a much more difficult restructuring arena,” said Davies,
a vice-president in the private equity firm’s European corporate
advisory unit.
But David Stark of Deloitte, another restructuring expert, told the
same conference that business failures in Britain would be lower than
in the early 1990s, though corporate problems might take longer to
work through.
“As the restructuring community sees it, we don’t think it
will go completely mental – whereas in 1993 it went very, very
busy,” he said. “There hasn’t been the big wave of
LBO [leveraged buyout] restructurings we were expecting to see.”
Whether that happens depends partly on whether the banks themselves
see any light at the end of the tunnel.
Big companies are concerned their loan facilities could be pulled.
Most borrow working capital through large loans, syndicated between a
number of banks. If banks representing half the value of the loans
claim there has been a “market disruption” they can pull
out of the agreement.
“These are easily bad enough conditions for the banks to claim
that there has been a market disruption, but no bank wants to be the
first to put its hand up,” said one legal source. “The
first bank that does this fears being tarred with accusations that it
is in trouble.”
WHAT THEY SAID ABOUT THE RESCUE PLAN President George Bush If money
isn’t loosened up, this sucker could go down.
US Treasury secretary Hank Paulson I share the outrage that people
have . . . It’s embarrassing to look at this. I think it’s
embarrassing to the United States of America. There is a lot of blame
to go around.
I understand the view that I have heard from many of you on both sides
of the aisle, urging that the taxpayer should share in the benefits of
this plan to bail out our financial system.
Let me make clear: this entire proposal is about benefiting the
American people, because today’s fragile financial system puts
their economic well-being at risk.
Chairman of the Federal Reserve, Ben Bernanke The financial markets
are in quite fragile condition and I think, in the absence of a plan,
they will get worse.
The intensification of financial stress in recent weeks, which will
make lenders still more cautious about extending credit to households
and business, could prove a significant drag on growth.
Republican presidential candidate John McCain I’m an old navy
pilot, and I know when a crisis calls for all hands on deck.
Democratic presidential candidate Barack Obama The crisis is the final
verdict on eight years of failed economic policy promoted by George
Bush and supported by Senator McCain
Republican congressman Jeb Hensarling I can put a gun to my
neighbour’s head and take his college fund for his children and
place a bet on a roulette table in Las Vegas and maybe, maybe,
I’ll triple his money. But that’s not a risk that my
neighbour voluntarily undertook.
Republican congressman Ron Paul They want dictatorship, they want to
pass all the penalties and suffering on to the average person on Main
Street.
When they say that if we don’t do exactly as they say and turn
over more of our money and more of our liberties and exempt themselves
from any court in the whole nation, they’re trying to intimidate
us and lead us into doing the wrong thing.
William Smith, president of Smith Asset ManagementYou’re talking
about the largest failure in banking history, so there is going to be
a negative reaction, right?
What you are going to see is the strong stronger, and the weak are
going to die off.
James K Galbraith, University of Texas economist A nasty recession is
possible, but the bailout will not cure that. It will delay a
disaster, given that you only have three months left in this
administration. But it will not cure the problem in the financial
industry.
Vince Cable, Liberal Democrat Treasury spokesmanThe angry congressmen
are right to demand very tough conditions. Taxpayers must not be left
with the risk while the profitable upside is left to the banks
TV satirist Jon Stewart Before we hand these unelected officials 700
billion no-strings-attached dollars there is one thing you should
know; this financial guru never saw it coming.
James Crosby the great leader who led the strategy that HBoS to its
doom… Wasn’t Alan Greenspan another of Team GB’s bubble class
advisors?
Agree with Julian also Buy-outs work – bail-outs don’t The US has hit
the buffers and the new world order has started………………….
Yes I agree, the US Dollar is really on death row with this so-called
bailout. The 700 billion issued is simply based on nothing other than
more debt.. I’m pretty sure that central banks, the federal reserve
and others having been suppressing gold prices in order to make the
Dollar worh more.
Politicians around the world are huffing and puffing about who should
take the losses and take on the obligation to repay the debt. At the
end of the day the only one way for everyone, macro or micro to pay
off such massive liabilities, is for the ‘gurus’ to inflate the West’s
way out of trouble
There is no need for a bailout. Credit is available to all those who
want it but its price has gone up due to risk aversion. Eventually the
price will come down after the excesses have been washed out of the
system, and the economy in turn will be better off for it. Let’s give
credit a rest.
Julian Jordon, you are almost right . Dollar will crash to allow the
new Amero in. Look up North American Union. Swap dollars for silver
and gold.
So the US will print $700bn and in doing so devalue the $. Holders of
US$ switch to the Euro and further devalue the $ So the US will print
more Zimbabwean (sorry) US $’s and the whole cycle speeds up this
handcart to hell. Get it over with quickly; let the banks go to the
wall.
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