BT: The perfect financial storm (16 Sep 2008)

The perfect financial storm

EVEN though it wasn't an official working day, Sunday September 14, 2008 will go down as one of the most dramatic and scary in the history of Wall Street. After marathon emergency discussions that lasted through the weekend, the US Federal Reserve and the US Treasury drew a line in the sand, refusing to subsidise the rescue of Lehman Brothers, a 158 year old firm that was, until last week, the world's fourth largest investment bank. Lehman will now file for bankruptcy, the latest victim of the worst financial storm since the 1930s, which has already consumed another major investment bank, Bear Stearns, and several smaller institutions.

Also on Sunday, the giant insurance company AIG - believed to be in danger as well - was reported to have approached the Fed for some US$40 billion in short term financing to shore up its capital. Another large bank, Washington Mutual, was rumoured to be in deep trouble. The saving grace of the day was the announcement that Merrill Lynch - the world's largest brokerage, in which Singapore's Temasek Holdings has a substantial stake - would be taken over by the Bank of America. As a leading member of the so-called shadow banking system, Merrill was believed to be next in line after Lehman, and vulnerable to the same fate. The Fed and the Treasury have sent a clear signal that they will not keep on bailing out financial firms. Both banks and broker-dealers will have to find their own 'white knights.'

In taking this position, the US authorities have taken a gamble; if the Lehman bankruptcy does not cause massive systemic damage, they will be vindicated. Also, the absence of an automatic safety net will increase the urgency for troubled banks and brokerages to find rescuers; Lehman had enough time to do so, but drove too hard a bargain - or perhaps bet, wrongly, on a bailout. But the Fed/Treasury move is also risky. Lehman's positions have to be unwound under pressure; it is one of the 10 largest counterparties in the market for credit-default swaps. It also owns some US$33 billion of commercial real-estate assets and US$13 billion of residential mortgages - all of which will have to be liquidated in a difficult market. The potential for collateral damage is thus very much there - which may help explain why Asian and European markets went into a swoon yesterday, as did the US dollar.

In an attempt to limit the contagion, the Fed has significantly relaxed the terms under which it lends to investment banks under its Primary Dealer Credit Facility. Dealers will now be able to pledge as collateral a wider range of assets. including equities and sub-investment grade debt. The European Central Bank has also taken steps to relax borrowing terms. In addition, all major central banks and regulators have said they will remain in close contact and monitor events as they unfold - which suggests that, if there is need for further emergency action - like a rate cut - it will be taken. The financial storm is still raging. It will settle eventually. But meanwhile, financial authorities will be tested, as perhaps never before, in their ability to avert systemic risks.

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