"I’m standing outside Lehman Brothers headquarters on 7th Avenue and 50th Street in New York City watching Lehman Brothers die," writes Fortune Magazine‘s managing editor, Andrew Serwer. "Employees, some in suits, others in casual clothes, are filing out with all they can carry as time runs out."
It’s a crisis that began in slow motion but is now unfolding on the pavements of the world’s most famous financial district. The New York Times and Fortune have published photographs of people carrying out boxes from the marbled foyer of Lehman Brothers’ Times Square headquarters. The Wall Street Journal reports "the US financial system was shaken to its core". CNBC calls it "Bloody Sunday" and a "financial tsunami".
Yesterday the US stock market suffered its worst daily plunge since the September 11, 2001, terrorist attacks, with the Dow dropping 500 points.
One of Wall Street’s biggest and oldest merchant banks, Lehman Brothers, has gone bust. The company filed for bankruptcy on Monday morning, New York time, under chapter 11 of the Bankruptcy Code.
Lehman is just part of a spreading disaster on Wall Street. Another famous merchant bank, Merrill Lynch, sold out to the Bank of America over the weekend in a last-ditch ploy to avoid the same fate. A major US savings bank, Washington Mutual, is also in trouble, as is a huge insurer, the American Insurance Group.
A year ago, Wall Street had five major merchant banks. Now only two are left.
The crisis reached boiling point on Friday evening, New York time, when US Treasury officials – including Treasury Secretary Henry Paulson and Chairman of the Federal Reserve, Ben Bernanke – briefed senior Wall Street executives that there would be no government bailout of Lehman.
"There is no political will for a federal bailout," said Bernanke’s top New York official, Timothy Geithner, according to reports in the Wall Street Journal. "Come back in the morning and be prepared to do something." So began a frantic weekend in which Lehman Brothers CEO Richard Fuld tried to find a willing suitor to buy the troubled bank. None were found. With Lehman Brothers shares falling 94 per cent since the start of 2008, the company was out of cash and out of time.
In response, the US Federal Reserve has announced yet another rescue package of soft loans and relaxed collateral provisions to try and keep Wall Street from imploding – the latest in a long line of attempted bailouts since the sub-prime crisis first emerged in August 2007. Like those earlier announcements, this latest statement seems unlikely to stem the onrushing tide. In a separate development, other Wall Street firms rolled out a $70 billion program of emergency loans.
How did it happen?
As I explained in March this year, the sub-prime crisis emerged unexpectedly in a financial industry enjoying a four-year boom. The risks of dubious mortgages were thought to have been tamed, owing to the clever packaging and on-selling of that debt to a cascade of secondary lenders through elaborate financial instruments like "collaterised debt obligations" and "credit-default swaps".
But that was before the US housing crisis, in which a speculative bubble in home lending burst spectacularly. Many mortgagees defaulted on loans that banks thought were secure, and lenders could no longer sell on that debt – or even insure it. Some heavily indebted householders destroyed their properties or simply stopped paying their mortgages, forcing lenders to take costly and time-consuming court action to repossess homes. And some housing markets (for instance, parts of California and Florida) are so depressed that buyers cannot be found. The resulting liquidity crunch has savaged the bottom lines of scores of US financial institutions.
UQ Professor of Economics John Quiggin has called the sub-prime crisis "the end of neoliberalism". What he means is that the massive nationalisation of the mortgage companies Fannie Mae and Freddie Mac "marks the failure of the central claim of the neoliberal program, namely that private capital markets, free from intrusive government regulation, can enable individuals and households to handle the risks they face more flexibly and efficiently than a social-democratic welfare state".
Unfortunately for the rest of us, Quiggin is probably engaging in wishful thinking here, if only because the die-hard proponents of neoliberalism live in a cloud-cuckoo land where the reality of market failure never sets in. Even so, the sub-prime crisis and subsequent Wall Street panic is the gravest instance of market failure in two generations. The bankruptcy of Lehman will place severe pressure on other banks, which will now have to unwind any positions they held with Lehman as a counter-party – probably at a loss. This poses a whole range of further problems to the stability of a vulnerable and inter-connected financial system.
As I asked in my March article on the forced sale of Bear Sterns, "why do banks fail so regularly?" The reason is that they are inherently unstable: all banks lend out much more than they hold in assets. If confidence in a bank dries up, the result is a panic like the one we saw on the weekend. Customers rush to pull their money out – this is called a "run" – and the institution collapses. We’ve already seen two of these so far in this crisis: the UK’s Northern Rock and IndyMac in the US.
In other words, banks and other companies that lend money are dangerous institutions, and need to be regulated carefully. One of the things the sub-prime crisis has clearly demonstrated is that the banking and finance industries don’t necessarily understand the way their industry is interconnected. But because of the money that could be made in a housing asset boom, legislators were persuaded by aggressive lobbying to relax lending standards. Further, under Alan Greenspan, US fiscal policy was kept purposely lax, which only made the bubble worse.
If enough financial institutions fail, the turmoil can spread to the rest of the economy. There must now be a significant risk of this in the US and European economies. In the Great Depression, thousands of American banks failed and millions of ordinary citizens lost their savings. The result won’t be as bad this time. But the long-term effects of the Panic of 2008 will undoubtedly affect the world economy. More US companies will fail before this crisis abates.
There are also lessons here for Australia. Although our financial regulations are much more stringent than those in the US, our housing sector is similarly over-valued. The housing sector is already stalling in NSW and may be about to turn in other states. If Australia suffers a housing bust on the scale of the US, UK or Spain, Australian banks will eventually come under the same sort of pressure that has destroyed Bear Sterns, Merrill Lynch and Lehman Brothers.
At that point, Reserve Bank chief Glenn Stevens will really be earning his money.
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