18th September 2008
News Category: Business Finance
The credit crunch is now causing some of the world's largest financial institutions to fail under the collapse of investor confidence. The past week has seen the worst financial crisis in decades with the nationalisation of AIG, the collapse of Lehman's investment bank, the rescue of HBOS by Lloyds TSB. Today, the Federal reserve pumped an astonishing $180 billion in loans into the capital markets in order to provide liquidity for struggling wholesale banks, in a desperate effort to restore confidence in the markets. Meanwhile, the Bank of England lent £22 billion as part of its international bail out a scheme set up early last year. However, it appears that that's banks remain fearful of using existing or additional funds to lend to each other. As a result, the libor interest rates remain at a 15 year high. President Bush appeared on television, yet again today, reassuring the American public that his administration was taking proactive action to restore stability and market confidence.
Major events started on Monday of this week, when Merrill Lynch decided to save itself from bankruptcy by selling itself to the Bank of America for a massively reduced market price. Then in an equally dramatic move, on Tuesday Lehman's investment bank collapsed, filing for bankruptcy. This represents the largest corporate insolvency in US history. The US Government decided that it would not bail out Lehman's with taxpayers dollars, sending a clear message to banks around the world that it was prepared to allow the market to correct itself naturally, (rather than artificially prop up failing albeit large institutions). Lehman's credit rating was downgraded as its exposure to US sub prime mortgages became evidently worse than originally forecast. Goldman's have been appointed to take over the administration process. Then, on Wednesday, it was announced that Barclays bank were to buy the trading arm of Lehman's, making it the third largest investment bank in the world. The collapse raised the question as to whether a government should intervene and save an massive financial institution where the broader economic concerns affect millions of ordinary people's lives.
Stock markets in New York, Tokyo and London have collapsed, as investors short sell high profile banking organisations that reported to be in financial difficulty. Tonight, the media attention focuses on Morgan Stanley, who like many other high profile casualties have borrowed heavily from the wholesale money markets in order to finance their activities over the last decade. The bank is now in talks with a US regional bank Wachovia and a Chinese state run investment fund called the China Investment Corporation (CIC). CIC already has a 9.9% shareholding in Morgan Stanley.
On Wednesday, the UK giant HBOS bank saw its share price go into meltdown, collapsing 40% on the back of short of selling by speculators and city rumours that the bank was heavily exposed to sub prime debt. Ordinary savers queued outside HBOS branches in an attempt to frantically withdraw their savings, (reminiscent of the Northern Rock fiasco just over one year ago). As the day went on, media reports emerged that Lloyds TSB were in advanced takeover talks with HBOS. Today, it was announced that a takeover rescue plan had been agreed making Lloyds TSB the largest bank in the UK. It will control approximately one third of UK mortgages and savings accounts. Behind-the-scenes negotiations with the Prime Minister and Chancellor have seen competition laws swept away in the interests of national stability for the UK economy. The deal will inevitably face a rocky ride through Parliament, as Lloyds TSB's competitors may oppose the takeover on legal grounds. The acquisition is likely to be completed early next year and will create one of the largest financial companies in Europe. The inevitable integration process may lead to mass redundancies, as duplication is eliminated from two very large retail banking institutions.
Across the Atlantic an even larger crisis had hit traders screens with reports that the global giant insurer, the American International group (AIG), may collapse. Its share price halved in value in one day. The company had a $440 billion position in credit default swaps by writing credit insurance for most of the world banks. In effect, it has underwritten most of the world's potential bad debt, by behaving more like a bank than a traditional insurer. Therefore, in exchange for an $85 billion loan, the US government took a 80% stake in the company. In effect, the organisation has been nationalised by the US government in order to save it from bankruptcy. The impact of a failure of global insurer of this magnitude, in these turbulent few days, would have been incalculable. The government made a policy decision to restore order in an extremely fragile financial market.
Tonight the FSA banned speculators from short selling stocks and shares in a response to the HBOS fiasco. Short selling has been accelerating the pain felt by many institutions rumoured to be in financial difficulty. Short selling is a type of betting, where hedge funds and other institutions seek to make a profit on a falling share price. The financial process has been linked with illegally spreading false rumours regarding a business that may be in in financial difficulty. Some economists argue that the process is beneficial to accelerate the uncertainty and turbulence of business failure. HBOS was fundamentally overstretching itself by borrowing heavily using a risky strategy. In other words, without short selling, it is likely that HBOS and Lehman's would have run into severe difficulties or failed anyway. Short sellers accurately forecasted business failure and have profited accordingly. Hector Sants, the chief executive of the FSA, said: "While we still regard short-selling as a legitimate investment technique in normal market conditions, the current extreme circumstances have given rise to disorderly markets.
Tonight, rumours are circulating markets that the US government is setting up an agency to buy up all toxic debt from banks, in an attempt to calm nerves and restore stability. It would be a change of policy to remedy the cause of the problem, rather than the symptoms of a liquidity crisis. The hundreds of billions that have already been pumped into the system appeared to have been to no avail. The report that Treasury Secretary Henry Paulson is considering the formation of a vehicle like the Resolution Trust (that was set up during the savings and loan crisis of the late 1980s) has caused shares to bounce back in late trading today. The United States Treasury eventually has confirmed it is setting up a rescue package to save struggling financial institutions by providing a safe haven for toxic across the US economy. The programme will cost hundreds of billions of dollars and enable confidence and stability to the restored to troubled markets three aim of the rescue plan is to allow banks to remove identifiable elements of debt affecting their credit rating and their ability to borrow money from other financial institutions. The plan is similar to that of the Savings and Loan rescue plan initiated in the 1980s, where investors lost confidence in the sector of the US economy. Shares around the world rallied up on the news. Major UK institutions share price shot up by 30% or more.
These events in the financial news are happening so fast that government policies and regulators are struggling to keep up. The blame game has begun as to who caused the credit crunch. Financial services employees fearing redundancy are blaming high flying, well-paid city traders. Meanwhile, economists are blaming governments policies for allowing a relaxed regulatory regime, that has in turn allowed banks to lend liberally to people who clearly could not afford to repay mortgages. No one is blaming individuals (who are categorised as the sub prime mortgage market), who collectively have borrowed far more than they could reasonably expect to repay their lifetimes. In addition, the shareholders both large and small, who enjoyed a decade of handsome dividends are not easily identifiable. So who is to blame for a liquidity crisis that is having a knock-on effect on real people's jobs, career prospects and small business survival?....