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 not 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.”
And that, after the events of this stormy September, is something no bank
wants to risk.
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 Management You’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 spokesman The 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.
