Core financial institutions backed by international action

BY MATT HUTCHINS

At the ringing of the closing bell on Friday, world markets were collapsed in the corner, still bleeding from the worst week of trading in modern history. In early trading that morning, the Dow Jones Industrial Average had sunk more than 600 points to 7957.77, but by the end of the day the loss had eased to only 117.48. At the Friday close of 8451.19, the blue-chip index had fallen 2688 points over two weeks for a drop of 24%. With the global economy in the midst of a historic crash, the finance ministers of the G20 gathered in Washington over the weekend to design the next international strategy for restoring confidence in the global financial markets. Coordinated action was needed to avoid the potential for instability resulting from hodgepodge bail-outs and bank deposit guarantees. What resulted was a plan to recapitalize the core financial institutions of Europe and America with direct investments and provide central bank support for inter-bank lending.

The news of decisive government action buoyed markets on Monday, reversing a significant portion of the previous weeks losses with an 11% rise of 925 points, the largest single-day gain ever. The U.S. markets were also boosted by news that Mitsubishi UFJ purchased a $9 billion stake in Morgan Stanley, which had become dangerously low on vital liquidity during the market crash. The vote of confidence was exactly what pessimistic traders needed to reverse the sell-offs of the past ten trading days. Tuesday’s trading remained relatively flat, but on Wednesday the increasingly numerous signs of a general recession reignited the anxiety of investors.

The leading industrialized nations of the world have now taken drastic, direct action to clearly express their confidence in the core stability of the global financial system, and details are emerging on how the infusion of capital will be executed. The United States will commit at least $250 billion of the bail-out package passed by Congress to the recapitalization of the nation’s nine largest financial institutions through the purchase of preferred stock. European nations announced similar measures, with investments by the governments of the United Kingdom of $65 billion, by France of $55 billion, and by Germany of $109 billion. Another $1.8 trillion will be set aside by European governments to allow their central banks to insure inter-bank lending. In the United States, the targeted banks will be J.P. Morgan Chase & Co., Citigroup, Bank of America/Merrill Lynch & Co, Morgan Stanley, Goldman Sachs, State Street, and Bank of New York Mellon Corp. The purchased securities will have dividends of 5% per year the first three years and 9% per year after that.

The drastic steps which have been taken thus far can reassure investors that all available means will be devoted to the resolution of the current crisis. World leaders are deploying an unprecedented arsenal of financial strategies to resolve the liquidity crisis and restore confidence in inter-bank lending. The sheer magnitude of the wager being put on the table by world leaders has signaled confidence to the markets that they will not allow another insolvency like Lehman Brothers. While world leaders may hope that the enormous sums being injected into the economy will stimulate lending, the continually worsening situation in the markets indicates that this capital will mainly be used to cover positions that are already overextended.

Indeed, it is doubtful that governments truly expect bail-out payments to stimulate commercial lending. Until a more detailed accounting of the current state of the major banking institutions can be had, the aftermath of the Lehman Brothers collapse remains a hidden stain on the balance sheets of many institutions. With only 8.625 cents on the dollar being covered by Lehman’s assets, the issuers of credit default swaps on the company’s debt could end up paying as much as $365 billion to settle outstanding contracts. Since these derivatives are not traded on an open market, no one knows for sure where the losses will appear when the dust settles. The infusion of billions more in capital will hopefully prevent the losses circulating in the market from pulling another critical financial institutions into insolvency, as this could potentially launch a cascading series of losses which would quickly become too wide in scope for any government action to contain.

Now that major governments have come together to say that no more major institutions will be allowed to fail, the chain of dominoes may have been broken, but as the losses mount at firms like AIG that have massive exposure to the derivatives markets, the price tag of a stable financial system continues to grow more expensive. What’s more, casualties continue to mount around the perimeter, with Iceland’s entire economy entering a nose dive and GM pursuing a union with Chrysler through its parent, Cerberus Capital. There is a sense that the number of spinning plates, each of which must be carefully balanced to prevent a disaster, is reaching the limits of global leaders to manage. Losses will most likely be pushed onto those institutions which will suffer the most compartmentalized collapse. For now, and to the rue of very few outside of Manhattan, this seems to be the hedge fund managers who prospered so excessively during the bull market. The leveraged and hedged positions of many sophisticated investors became frozen when Lehman shut its doors, and they have been forced to watch helplessly as the value of their portfolio has collapsed over the past month. However, if the bail-out funds fail to unfreeze credit markets and corporations cannot receive vital short-term financing, traders might lose confidence again, triggering another wave of sell-offs a new phase in the crisis. It is for this reason that the Fed is planning to enter the commercial bond market. Any major default right now could trigger derivative contract liabilities that would once again rock the core of the banking system.

By one account, the plan to recapitalize banks could be just the reset which was needed to restore ordinary business activities and allow the shocks which have hit markets recently to dissipate. The other side of the coin is that with trillions of dollars of exposure to the banking markets, a catastrophic failure would drag the Dollar and the Euro out to sea with the riptide of insolvency. Given the potential that there could be another major crisis event, one begins to wonder how much it would cost to let the financial system fail. Is it even a fathomable proposition to say that we should freeze the entire system and just ask everyone to settle their accounts? Could the government simply proclaim that only FDIC insured accounts would be protected? In reality, the answer is no. No matter how bad the crisis gets, the value of every individual’s savings across the entire banking system depends on the ability of the industry to continue operation as a going concern. A complete meltdown of credit markets would imperil the operation of every business in the nation. No matter how painful it becomes, the government must continue to pump dollars into the markets to create as much liquidity as is needed to clear the day’s transactions and keep the doors open in the nation’s financial centers.

This does not, however, mean that should abstain from collectively taking our pound of flesh from those businesses that fail to remain independently viable. I believe that the nationalization of failed financial institutions like AIG, while unattractive in many ways, presents a unique opportunity to reorganize the core of our economy. In the recent past, each time Wall Street has failed we patched it together just good enough to get it working again, like an old jalopy which keeps breaking down. Nationalization during a time of crisis would allow us to melt down the broken parts of our national economic machine and re-forge them to be more reliable and transparent. We should start considering what changes need t
o be made to prevent the next crisis before the current one has passed and we once again sink into the complacency of allowing those same people who have lost our fortunes before to fool us into believing that there is no risk of systemic failure.

Fed chief Ben Bernanke said today that the restructuring of the financial sector will need to address excessive leveraging and the too-big-to-fail problem, stating that there are “too many firms that are in some sense systemically critical.” We can hope that this new skepticism will endure and result in a plan for reform in a sector which is critical to future stability.

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