Sep 25, 2008

Overview of the Financial Crisis

reposted from the Maoist discussion blog Kasama

Posted by John Steele on September 22, 2008

Following are articles and excerpts from some news stories and analysis on the financial crisis over the past week, including recent developments. This is a very serious crisis which is still developing, as is apparent in these articles, which are all from mainstream sources.

Dow Jones Index

Dow Jones Index

Big Financiers Start Lobbying for Wider Aid
New York Times – Sept. 22, 2008

Even as policy makers worked on details of a $700 billion bailout of the financial industry, Wall Street began looking for ways to profit from it.

Financial firms were lobbying to have all manner of troubled investments covered, not just those related to mortgages.

At the same time, investment firms were jockeying to oversee all the assets that Treasury plans to take off the books of financial institutions, a role that could earn them hundreds of millions of dollars a year in fees.

Nobody wants to be left out of Treasury’s proposal to buy up bad assets of financial institutions.

“The definition of Financial Institution should be as broad as possible,” the Financial Services Roundtable, which represents big financial services companies, wrote in an e-mail message to members on Sunday.

The group said a wide variety of institutions as varied as mortgage lenders and insurance companies should be able to take advantage of the bailout, and that these companies should be able to sell off any investments linked to mortgages.

The scope of the bailout grew over the weekend. As recently as Saturday morning, the Bush administration’s proposal called for Treasury to buy residential or commercial mortgages and related securities. By that evening, the proposal was broadened to give Treasury discretion to buy “any other financial instrument.”

The lobbying became particularly intense because Congress plans to approve a package within just two weeks, without the traditional hearings and committee process.

* * * * *

Each part of the financial industry is pursuing its own interests.

Small banks, for example, are pushing the government to buy loans they made to home builders and commercial developers. Wall Street banks are lobbying to temporarily suspend certain accounting rules to avoid taking big losses on the assets they sell to Treasury, which would weaken them further.

Over the weekend, the Securities Industry and Financial Markets Association, Wall Street’s main trade and lobbying group, held conference calls to discuss “your firms’ views and priorities related to Treasury’s proposal,” according to an e-mail message sent to members.

There were signs of the industry’s fingerprints on drafts of the legislation released over the weekend. While an earlier draft said that only firms with headquarters in the United States could sell assets to the government under the program, a later version said sellers could include any financial institution. Securities firms were initially excluded but were included in a version released Sunday afternoon.

* * * * *

Perhaps the biggest question about the Treasury’s acquisition plan is how the government will decide how much it is willing to pay for the loans and securities it acquires. Will the government drive a hard bargain and acquire assets for the lowest possible price to protect taxpayers against losses? Or will the Treasury Department, in the interest of jumpstarting the credit market, try to bolster large financial institutions like Citigroup and Washington Mutual by paying a slight premium to the markets’ valuation of these troubled assets? Over the weekend, Treasury said it might use “reverse” auctions in which financial institutions rather than the Treasury — as buyer — would submit bids.

“The trick for the Treasury and American people is to make sure that the price exacts enough of a toll on the originators and holders of these securities, but not enough to destroy lending,” said Mr. Gross of Pimco, who has argued in recent weeks that the government must buy distressed debt to deal with a “financial tsunami.”

Global banks expect to fall under U. S. bailout umbrella
By Nelson D. Schwartz and Carter Dougherty
International Herald Tribune - September 21, 2008

PARIS: After initial signs they might be left out in the cold, most European and international banks holding substantial amounts of troubled U.S. mortgage debt now expect to be eligible for the $700 billion bailout plan ironed out in Washington over the weekend.

The initial draft released Saturday limited participation to U.S. banks, but after a round of lobbying and intense questions from bankers around the world, a subsequent version on Sunday promised it would also include institutions with substantial operations in the United States.

While that is sure to please foreign bankers and reassure global markets, it also is expected to stoke some opposition among lawmakers in Congress who are already skeptical of what could ultimately turn out to be a trillion-dollar bailout for Wall Street.

Defaults will test a fair-weather construction
By Wolfgang M√ľnchau
Financial Times [London] September 21 2008

The good news is that the bail-out of Wall Street will probably save us from an imminent collapse of the financial system. But it raises disturbing questions. To what extent will it transform financial sector default risk into sovereign risk? What are the long-term implications for economic growth? How will foreign investors react if the gamble does not pay off? And what effect will it have on structure and incentives in the financial sector?

Under the proposed scheme, the US government will buy up any private sector debt securities from distressed US-based financial companies at a discount, with the intention of selling them later. Theoretically, the government could make a profit and rescue the financial sector at the same time.

But that would be a triumph of hope over logic. It would imply that the irrational event is the crisis itself, which has produced the current low valuations of risky assets, rather than the bubble that preceded it.
Any estimate of the financial damage of this crisis is prone to huge margins of error. There is, however, no doubt that the taxpayer faces a clear and present danger of a large loss. I would not be surprised if we ended up counting the costs of this joyride in thousands of billions.
This mother of all bail-outs has shifted the burden of risk from the few to the many. But the ultimate outcome of this financial crisis is as open today as it was a week ago.

In turmoil, capitalism in U.S. sets new course
By David Wessel, Wall Street Journal, September 20, 2008

This past week marks a decisive turn in the evolution of American capitalism.

Black September, the biggest financial shock since the Great Depression, is prompting a Republican Treasury secretary and Federal Reserve chairman to devise the most muscular government intervention in the economy since the Great Depression in an effort to prevent the economic devastation of the Great Depression.

Abandoning its one-rescue-at-a-time strategy of recent months, the government suddenly has shifted to a broad attack on what Treasury Secretary Henry Paulson calls “the root cause of our financial system’s stresses,” the rot on the balance sheets of America’s financial system.
As recently as Spring 2007, Mr. Paulson, among others, was arguing that onerous regulations were crippling American finance in intensifying global competition. Those cries are silenced.
In March, the Federal Reserve shattered a half-century of tradition in which it had lent money only to banks whose deposits were insured by the government. Declaring circumstances to be “unusual and exigent,” as required by a little-used statute, it lent to investment bank Bear Stearns and eventually risked $29 billion of taxpayer money to induce J.P. Morgan Chase to buy Bear. It seemed a very big deal at the time.

But in the past two weeks, the U.S. government, keeper of the flame of free markets and private enterprise, has:

– nationalized the two engines of the U.S. mortgage industry, Fannie Mae and Freddie Mac, and flooded the mortgage market with taxpayer funds to keep it going;

– crafted a deal to seize the nation’s largest insurer, American International Group Inc., fired its chief executive and moved to sell it off in pieces.

– extended government insurance beyond bank deposits to $3.4 trillion in money-market mutual funds for a year;

– banned, for 799 financial stocks, a practice at the heart of stock trading, the short-selling in which investors seek to profit from falling stock prices.

– allowed or encouraged the collapse or sale of two of the four remaining, free-standing investment banks, Lehman Brothers and Merrill Lynch;

– asked Congress by next week to agree to stick taxpayers with hundreds of billions of dollars of illiquid assets from financial institutions so those institutions can raise capital and resume lending.

It was less than a week ago that Mr. Paulson appeared to draw a line at government bailouts, rebuffing Lehman’s plea for a Bear Stearns-like rescue and allowing the investment bank to collapse into bankruptcy. “The national commitment to the free market lasted one day,” Barney Frank, the Massachusetts Democrat who chairs the House Financial Services Committee, quipped earlier this week. That one day was Monday, Sept. 15. The day before the government rejected Lehman’s cry for help; the day after it seized AIG.

The shift in strategy reflects the realization by Mr. Paulson and Federal Reserve Chairman Ben Bernanke that the financial crisis was intensifying in recent days, endangering the entire economy. Confidence deteriorated markedly. Distrust spread. Credit markets weren’t functioning and lending dried up. Normal business wasn’t getting done. The two remaining free-standing investment banks were under severe pressure. The panic was spreading to ordinary Americans, who were beginning to pull money out of money-market mutual funds.
It is too early to say whether Mr. Bernanke and Mr. Paulson have made the right call and will bring the crisis to a close, despite global stock markets’ ebullient reaction Friday. If the fear does subside, then talk will turn to writing new rules for a financial system that has changed more in the past six months than in the previous decade. The government has bailed out financial institutions — and particularly their creditors — and taxpayers will pick up the tab for many of the institutions’ bad decisions. That could encourage bad behavior in the future. So, the government needs to craft a new regulatory regime to reduce those incentives.

The fruit of hypocrisy
Dishonesty in the finance sector dragged us here, and Washington looks ill-equipped to guide us out
Joseph Stiglitz
The Guardian [UK] - September 16 2008

Houses of cards, chickens coming home to roost - pick your cliche. The new low in the financial crisis, which has prompted comparisons with the 1929 Wall Street crash, is the fruit of a pattern of dishonesty on the part of financial institutions, and incompetence on the part of policymakers.

We had become accustomed to the hypocrisy. The banks reject any suggestion they should face regulation, rebuff any move towards anti-trust measures - yet when trouble strikes, all of a sudden they demand state intervention: they must be bailed out; they are too big, too important to be allowed to fail.
The present financial crisis springs from a catastrophic collapse in confidence. The banks were laying huge bets with each other over loans and assets. Complex transactions were designed to move risk and disguise the sliding value of assets. In this game there are winners and losers. And it’s not a zero-sum game, it’s a negative-sum game: as people wake up to the smoke and mirrors in the financial system, as people grow averse to risk, losses occur; the market as a whole plummets and everyone loses.

Financial markets hinge on trust, and that trust has eroded. Lehman’s collapse marks at the very least a powerful symbol of a new low in confidence, and the reverberations will continue.

The crisis in trust extends beyond banks. In the global context, there is dwindling confidence in US policymakers. At July’s G8 meeting in Hokkaido the US delivered assurances that things were turning around at last. The weeks since have done nothing but confirm any global mistrust of government experts.

How seriously, then, should we take comparisons with the crash of 1929? Most economists believe we have the monetary and fiscal instruments and understanding to avoid collapse on that scale. And yet the IMF and the US treasury, together with central banks and finance ministers from many other countries, are capable of supporting the sort of “rescue” policies that led Indonesia to economic disaster in 1998. Moreover, it is difficult to have faith in the policy wherewithal of a government that oversaw the utter mismanagement of the war in Iraq and the response to Hurricane Katrina. If any administration can turn this crisis into another depression, it is the Bush administration.
· Joseph E Stiglitz is university professor at Columbia University and recipient of the 2001 Nobel prize in economics

Going for Broke
Barrons Financial Weekly – Sept. 22, 2008

BABY, IT’S COLD OUT THERE. So let’s toss another billion on the fire.

What’s that make it? Well, let’s see: $29 billion for Bear Stearns, somewhere between $1 billion and $100 billion each for Fannie and Freddie (a nice narrow range), $85 billion for AIG, a couple of hundred billion to keep stray banks, brokers and their errant kin from asphyxiating themselves by swallowing toxic paper. And then there’s the proposed reincarnation of the Resolution Trust Corp., which all by itself may mean shelling out $800 billion, perhaps even as much as $1 trillion.

While we’re at it, we might as well include the $400 billion with which the Paulson-Bernanke grand plan envisages endowing the Federal Deposit Insurance Corp. so it can insure money-market funds.

But, please, understand those mind-boggling sums in no way, shape or form are to be construed as designed to aid and abet a bailout. Instead, they are merely the essential ingredients of an “intervention,” or, if you prefer, a “rescue” — just about anything, in other words, that’s semantically sweeter than bailout, with its ugly connotation of a sinking ship.

Besides, we have it on the best authority that none of this largess will cost the taxpayer a cent over the long run, which, if nothing else, speaks volumes about what constitutes the best authority these days. The reasoning is simple (or perhaps simple-minded is more accurate), namely that deep-pockets Uncle Sam can sell off the assets of the foundering companies on which he has bestowed that bounty and come out whole.

Surely, they jest. For a heap of those so-called assets might easily be confused with liabilities since even those that can be sold will likely fetch a feeble fraction of what their possessors now claim they’re worth.

This is not to say that until the powers-that-be pounded the panic button last week, the billions they had already thrown at the problem as well as taking a big step further and making the wretched companies soaking up those billion de facto vassals of the government were completely in vain. They undeniably had an instant impact. Unfortunately, an instant was about as long as the impact lasted, and it failed miserably to becalm the frantic credit markets or rekindle investor confidence.

The sad truth is that just about every one of Messrs. Paulson and Bernanke’s previous brainstorms — and they seemed to come with increasing frequency as Hank and Ben’s agitation mounted — touched off a brief spasm of exhilaration among investors, only to evaporate in very short order as the credit crisis resolutely morphed into a credit calamity. Or, to change the metaphor, what had been a slow-motion train wreck picked up demonic speed.
WILL THE GRAND PLAN WORK? Will piling on all those billions on billions atop a budget deficit that’s already a cinch to shoot up to over half a trillion next fiscal year allow the badly winded economy to start a sustainable recovery?

Ben, remember, vowed to use helicopters to drop money from the sky, but now he seems to be gearing up to use 747s. Can the Fed run its printing machine full-time to churn out all those billions without a substantial infusion from increasingly pinched taxpayers? And won’t priming the pump like mad drive the dollar back into the pits and force interest rates higher?

The plan, in all its extravagance, seems to have been thrown together on the fly, and once Congress gets a whack at it in the waning days before the lawmakers scurry off to the hustings, it may bear only passing resemblance, for better but probably for worse, to Paulson and Bernanke’s handiwork.

Obviously, the unknowns greatly outweigh the knowns, which make those and myriad other questions tough or downright impossible to answer.

We’re willing to concede that some forceful action was necessary, if only so the Fed can pay penance for its critical part in creating the incredible credit-cum-housing disaster.

As Merrill Lynch’s David Rosenberg observes, the fact that the government is suddenly so aggressive in coming to grips with an epic credit collapse is eloquent testimony to how the Fed and the Treasury “have consistently underestimated the severity of that collapse from the get-go.”

He reminds us, moreover, that the original Resolution Trust Corp. was strictly about buying bad mortgages. So he wonders whether the new incarnation will also undertake the purchase of Level 3 assets, whose value is extremely problematic and, in any case, more than a little difficult to gauge, and which are a sizable and not particularly desirable presence in many banks’ portfolios. And will the new RTC also buy credit-card debt, commercial real estate, leveraged loans “or the other mountains of bad debts out there?”

David cautions that the entire credit collapse to date has “reflected the unwind of the largest bubble of all time — residential real estate. Meanwhile, a consumer-led recession is taking hold this very quarter for the first time in 17 years, and every consumer recession in the past was followed by a negative credit cycle of its own.”