Wall fall down

Not since the invasion of Iraq have I been so completely absorbed by a news story.

I have been glued to the internet and, when I have to come up for air, switch to television. I even spent one night this week taking in information-overload incarnate, CNBC.

The story, of course, is the meltdown of the financial markets. It has unfolded in the past few days at a pace and scale that is breathtaking.

The story is hard to contextualise, but safe to say that the difference between 1929 and 2008 for Bear Stearns, Lehman Brothers and Merrill Lynch is that they survived 1929.

Zillions have been lost. Huge reputations smashed. It may well be the end of Wall Street as we know it, some commentators suggest, a kind of last symbolic unsuccessful roll of the dice as true market power moves to where it really resides, in the East.

Some see the all fall down, the sudden failures and the horrendous collapse of value as an indictment of capitalism itself.

But it has to be said that the rescue packages often look more like socialism — witness the nationalisation first of mortgage financiers Freddie Mac and Fannie Mae and then insurance giant American International Group (AIG).

If not socialism, then it is a peculiar form of taxpayer benevolence for other critics, as more than $900-billion has now been stumped up in a set of support measures for four or five companies.

The willingness of the authorities to take the toxic debt that emanates from the subprime mortgage market on to the government’s balance sheet has amazed some critics.

Two-thirds of all debt on the US Federal Reserve’s books is now non-treasury securities, raising questions as to when the Fed itself will need a bailout from the treasury.

So much loot has been sloshed into the system in tax cuts, liquidity pump-ins and bailouts that some commentators see huge problems for the next president, who will have to clean up the expensive mess before trying to make good on election promises.

The Fed allows Lehman Brothers to go to the wall in the biggest bankruptcy since 1990 because it does not bail out private companies, even after it has guaranteed a $29-billion rescue package for Bear Stearns, but two days later it is advancing $85-billion to AIG in exchange for taking control of the management of the company and 80% of its equity.

This could be thought of as a bargain buy for the taxpayer: an $85-billion loan buys 80% of a company with $1-trillion in assets and activities in 130 countries.

In the strange world of meltdown finance the taxpayer may end up not even paying a dime for this stake. The $85-billion facility has a high interest rate, meaning the company has a big disincentive to make use of the facility.

This can be seen as the sweetest kind of nationalisation. The state gets to own 80% of an insurance behemoth without spending any money.

AIG had to be rescued, the logic goes, because it is much bigger than Lehman. In terms of employees it has 106 000 compared with Lehman’s 25 000. It also has the added advantage of having insured a chunk of the toxic financial products, which are the cause of the problem in the first case. If it failed, the reasoning goes, it would have brought a 1930s-type recession with strings of company failures and job losses.

But with AIG shored up, who is next? Who will be allowed to fail and who will be considered so important that the taxpayers will be brought in with another rescue package?

One blog this week advised its readers that insurance coverage for funds held in banking accounts covers only $100 000 per bank. If you have more money than this as a cash deposit, the advice is, you should spread it to other banks. The equivalent amount in the United Kingdom is £35 000, but applies only to two bank accounts, my friendly neighbourhood coffee supplier tells me.

Let’s leave capitalism aside, at least for the moment, in deciding blame. Portfolio.com, a website, asked its readers to apportion blame.

Top of the list as a clear winner is former Fed chief Alan Greenspan. For endorsing financial deregulation, backing George Bush’s tax cuts and for keeping interest rates too low for too long. Greenspan, a former market God, is now the villain of the piece.

In second place comes the credit rating agencies, which are seen to have given investment grade ratings to doubtful subprime investments, with avaricious chief executives of investment banks close behind. Their greed, coupled with lust for leverage, is seen as fuelling the crisis.

Three of the top five investment banks are no more, having gone into bankruptcy or being taken over by other financial institutions. At the end of the crisis, the self-standing investment bank will be no more, according to some predictions.

These are not banks in the normal sense of the word as they are not deposit-taking institutions and so do not have their own funds. Rather they borrow money and lend it to others.

The two remaining independent majors, Morgan Stanley and Goldman Sachs, are likely to end up as part of larger institutions, according to some market experts.

Note that in the new environment of big is better, the bigger you are the more likely you are to get the taxpayer’s proxy, the Fed, to bail you out.

At this stage, thanks to the largesse of the American taxpayer, the fallout has been relatively contained. True, 25 000 jobs at Lehman Brothers are in jeopardy, but the Barclays deal will rescue 9 000 of these.

There also has been a tremendous loss of value to shareholders in the companies that have been making headlines in recent weeks.

But the cost to the real economy to date is limited. The Fed may even be able to trade the taxpayer out of the equation if recession is staved off, the housing market recovers and confidence returns.

But equally, the opposite may still happen. There may be more Bear Stearns, Fannie Maes, Freddie Macs, Lehman Brothers, Merrill Lynches and AIGs to come. Confidence may have been knocked so hard that funds are withdrawn and withheld. The mattress may return as the only safe haven.

The blame game has, not surprisingly, begun in earnest. A colleague says the real problem is that Americans live in debt.

Excessive executive pay is also seen as a key problem. Executives are overpaid and incentivised to play fast and loose with the company. The bigger the risk they take, the greater their reward. Oh, and if the company tanks, the CEO still, in most cases, gets to leave with a big cheque in the cardboard box with the rest of his things.

When markets work, investors are happy to leave them alone. But now there will be new demands for more regulation and more effective regulation.

It is not entirely clear what form this will take. The market is ultimately a wealth creation mechanism. Investors know that too much regulation could stifle innovation and new wealth creation.

It is also difficult if not impossible to know what will make the next bubble. Today’s dotcom is tomorrow’s subprime mortgage market.

The critics are right. Much has gone badly wrong. The system is incomprehensibly complex and probably impossible to regulate.

But I can’t help thinking that we are witnessing something you can’t plan for: the 100-year flood.

Crisis Timeline
Bear Stearns
Wall Street’s nightmares began in earnest with the bailout of Bear Stearns on March 14. In a deal struck between the Federal Reserve and competitor JP Morgan Chase that guaranteed $29-billion of Bear Stearns riskiest debt, the company was sold off to JP Morgan for $2,2-billion.

Fannie Mae and Freddie Mac
On September 7 the United States government takes temporary ownership of Fannie Mae and Freddie Mac to save the two mortgage lenders, which account for more than half of US mortgage debt, from collapse.

Lehman Brothers
Rumours abound that Lehman Brothers, Wall Street’s fourth-largest investment bank, will be the next big hit in the credit crisis. But the company reportedly dodges offers of buyouts as recently as August, when it refuses to sell off a 25% stake to the Korean Development Bank.

Merrill Lynch
On September 14, after negotiations, investment bank Merrill Lynch is sold to Bank of America.

Lehman Brothers
This is followed by the collapse of Lehman Brothers which files for bankruptcy protection a day later. Other institutions, such as insurance giant American International Group (AIG), start wobbling on the news of Lehman’s and Merrill’s demise.

American International Group
On September 16 former chief executive of AIG, Hank Greenberg, appeals to the Federal Reserve to save the company.

The Guardian quotes Greenberg as saying: ”No organisation around the world has the spread of risk that AIG does. It’s a company that opens markets — letting it go down would be a dramatic mistake.” The Fed answers with the bailout of AIG with an $85-billion loan, effectively buying 80% of the company.

Morgan Stanley CNBC reports on September 17 that Morgan Stanley is considering a merger with a deposits-taking bank to protect it from further fallout in the markets. The investment giant’s share price had seen a 49% year-on-year decline, as of Tuesday, according to Reuters.

Barclays Bank
British-based Barclays Bank issues a statement on September 17 in the UK saying it will buy Lehman Brothers’s core North American investment banking and capital markets business, saving about 10 000 Wall Street jobs.

Lynley Donnelly — with Reuters, Guardian and CNBC.com

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Kevin Davie

Kevin Davie is M&G's business editor. A journalist for more than 30 years, he has worked in senior positions at most major titles in the country. Davie is a Nieman Fellow (1995-1996) and cyberspace innovator, having co-founded SA's first online-only news portal, Woza, and the first online stockbroking operation. He is a lecturer at Wits Journalism. In his spare time he can be found riding a bicycle, usually somewhere remote.

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