All hands on deck as global economic crisis intensifies

BY MATT HUTCHINS

The White House, Capitol Hill, and the Federal Reserve have mobilized their full arsenal of intervention strategies to resolve the barriers impeding the free flow of credit in the global financial markets. This past Friday the House approved the $700 billion bail-out package which it had rejected that Monday. The measure, as enacted, extended federal insurance of bank deposits to $250,000 per account. Over the weekend the Federal Reserve extended its special lending facilities to an unprecedented $900 billion. Now the Treasury and the Fed are working together to establish a special credit vehicle to purchase corporate bonds, or “commercial paper” as it is known. On Wednesday, the Fed, in conjunction with the Bank of England and the European Central Bank, called for an emergency slash of the benchmark interest rate by a half percent to 1.5%. Any one of these moves would normally be sufficient to buoy markets and remove barriers to inter-bank lending, but taken together they embody an emergency call to arms aimed at bolstering the confidence of bankers and investors in the government’s willingness to ensure financial stability.

Despite the urgent measures taken by the government, the financial markets have continued their slide into chaos this week, with the most obvious sign of the continued slide being the roll-back of the Dow Jones stock-market odometer back below the 10,000 mark, closing at 9,258.10 on Wednesday. In Japan, the Nikkei average fell 9.4% on Wednesday, its third largest drop ever, and European markets fell more than 5%.

Within the troubled financial sector, even Bank of America and Citigroup, previously considered two of the most stable entities, are now wobbling. Bank of America announced an $8.4 billion settlement this week of claims against Countrywide, the mortgage lender it purchased this year, as well as a $4.7 billion agreement on Wednesday to buy back auction-rate securities it sold in February. To cope with its latest woes, Bank of America has raised $10 billion in additional capital this week, but its shares remain extremely volatile, trading at a massive volume of over 300 million shares.

While Bank of America digests the toxic remnants of Countrywide, Citigroup may be forced to abandon its claim to its recently acquired prey, Wachovia. Wells Fargo swept back into negotiations with Wachovia once it became clear that the bailout package would pass Congress, and their $15 billion offer for the whole company has enticed Wachovia to walk away from the government-brokered union with Citigroup it formed on Monday. Now there is talk that the two competing banks will split the holdings of Wachovia, potentially dividing up its deposits and branch locations. While Citigroup desperately needs the additional capital the Wachovia deposit base would provide, Wells Fargo remains financially secure. The case is being litigated ferociously in multiple courts, with injunctions flying and both sides claiming that they are acting within their rights. If the situation cannot be resolved quickly, Citigroup may falter before its claims can be vindicated.

Meanwhile, the other shoe is about to drop at AIG. The Fed has just announced that the $85 billion loan which was extended to allow the firm to sell off its branches and unwind financial positions has been extended by $37.8 billion dollars more, as the original loan has been completely exhausted. The colossal sum of $122.8 billion that they now owe to the Federal Government makes their $440,000 annual retreat seem like a drop in the bucket.

While the media criticized AIG for its reckless spending, the nation’s largest insurer has been brought to its knees not by swanky retreats but by its exposure to massive liabilities through its participation in credit-default swap (CDS) market during the past five years. This arcane credit derivative market originated in the 1990’s as a way of hedging risks in the bond markets, but since the year 2000 it has expanded from $900 billion in value to $64 trillion. Yes, that’s trillion with a “T”. For reference, the nation’s entire annual economic output is estimated to be about $14.3 trillion. How could a market grow so quickly? The most crucial factors were the total lack of regulation and the potential to speculate on the value of assets held by someone else.

Untangling the financial complexities of the CDS instruments is a difficult task, but essentially the contracts act as an insurance policy. The buyer receives a promise to pay the face value of a designated asset if a certain event occurs. The seller receives in return regular payments which resemble insurance premiums. The events which trigger a payment include defaults, interest rate resets, and other forms of debt restructuring. Unlike regular insurance, there is no requirement that the seller maintains a set level of assets to back up their commitments. Some estimates place the actual assets backing up the market at less than 3% of the face value of the outstanding commitments.

During the period of rapid growth in the market, bonds enjoyed historic stability and major financial brokerages and hedge funds made quick fortunes selling the contracts. Now, with the markets suffering from huge write-downs in the value of mortgage-backed securities and the housing crisis deepening as the credit markets implode, sellers of CDS instruments are faced with the reality that they may be required to deliver on the value of their holdings. Worse yet, the ability to hedge against declines in the value of bonds has created a powerful tool for speculators who see the faltering economy and inter-bank lending fear creating a freeze in the commercial paper market. With money fund managers having pulled out more than $200 billion from the commercial paper market since the Lehman failure in September, some fear that the critical corporate bonds market could freeze up, preventing companies from acquiring the funds needed to meet their payroll. If these bonds were to fail, the CDS contracts triggered by those failures could spiral into astronomical losses for companies like AIG and JP Morgan that have huge exposure to the market.

The grim reality is that the complex derivatives markets which were so profitable during a time of stability could create perverse incentives to take short positions across the board and hope the system crashes. If this mentality takes control of the markets, we will witness a financial meltdown unlike any witnessed in the history of the modern free market system. The ultimate question is whether the emergency maneuvers by the governments of the world will be adequate to restore confidence and resolve the short-term volatility of the markets long enough to resolve the systemic instability which is currently threatening our entire financial system.

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