Like what you've read?

On Line Opinion is the only Australian site where you get all sides of the story. We don't
charge, but we need your support. Here�s how you can help.

  • Advertise

    We have a monthly audience of 70,000 and advertising packages from $200 a month.

  • Volunteer

    We always need commissioning editors and sub-editors.

  • Contribute

    Got something to say? Submit an essay.


 The National Forum   Donate   Your Account   On Line Opinion   Forum   Blogs   Polling   About   
On Line Opinion logo ON LINE OPINION - Australia's e-journal of social and political debate

Subscribe!
Subscribe





On Line Opinion is a not-for-profit publication and relies on the generosity of its sponsors, editors and contributors. If you would like to help, contact us.
___________

Syndicate
RSS/XML


RSS 2.0

Wall Street dodges a bullet, how about the next one?

By David Dapice - posted Friday, 19 September 2008


On September 17, 2008, the US once more became the lender of last resort for its banks and industries battered by the subprime crisis, extending an $85 billion bridge loan to global insurer AIG. Immediate danger averted, the American banking system is now in uncharted territory with bigger problems lurking ahead.

The AIG rescue came in a year that had seen the US Treasury and the Federal Reserve negotiate and orchestrate a series of costly rescues, each centring on the sub-prime crisis: Bear Stearns, Fannie Mae and Freddie Mac, and now AIG. Only Lehman Brothers was allowed to fail. The unorthodox US action, presented as designed to protect the world economy, may not close the curtain on the subprime fiasco and could prove to be the opening act of a different crisis.

Easy credit allowed housing prices to bubble, and investors assumed that mortgages were safe havens for their savings. A pattern has emerged of undercapitalised companies holding notes associated with the housing market and federal officials coming to the rescue of several banks and companies, designating them as too big to fail. But in the process, the Federal Reserve could be encouraging companies to take risks and recklessly expand, sending signals that the US will come to rescue of anything “too big to fail”.

Advertisement

First, investment banks Bear Stearns and Lehman Brothers got into trouble. Bear had entered into derivative contracts for more than $13 trillion and had assets of more than $350 billion with net equity capital, excluding hard-to-value assets, of $12 billion. As it quickly sank, the Federal Reserve used billions of Bear’s risky mortgages and securities as collateral to arrange a takeover by JP Morgan for a fraction of Bear’s former value and prevent a market meltdown.

Lehman had bought a lot of highly leveraged real estate and mortgage debt. As values of these assets sank, their 3 per cent worth of capital was wiped out. With only $600 billion in total assets and fewer derivative contracts, the Fed and Treasury decided that a failure would be manageable and did not commit federal funds. Lehman filed for bankruptcy. A third investment bank, Merrill-Lynch agreed to be taken over by Bank of America, a huge commercial bank, in a share exchange initially valued at $50 billion - though BOA’s share price fell after the deal was announced.

Fannie Mae and Freddie Mac are government-sponsored private firms created to promote a liquid market in mortgages and mortgage securities for homeowners. They owned or backed more than $5,000 billion of these securities with a capital ratio of under 3 per cent. Because home prices were falling and other players withdrew, these two firms accounted for most mortgages written and sold in 2008. When it became clear that their assets might be worth much less than their debts, the costs of borrowing rose and the Treasury moved in and put them into receivership. It’s unclear how much it will cost to ensure their debt is honoured. The shareholders and preferred shareholders will lose most of their investments.

AIG is one of the largest insurance companies in the world with assets of more than $1,000 billion. It misjudged the risk on insurance for derivative contracts and these losses impinged on their capital base of 8 to 9 per cent. The New York state and federal authorities have discussed what kind of loans, by whom and on what terms, might be made to keep AIG operating. Because they have more capital, a profitable business and deep connections to other financial players, the Federal Reserve decided to arrange for up to $85 billion in loans to keep the firm afloat and will acquire four-fifths of the company! Because the AIG insurance covered trillions of dollars of debt instruments, the Fed and Treasury judged that its bankruptcy would cause chaos in world financial markets and cause more damage than the dangers raised by the bailout.

Financial institutions around the world connected with AIG might heave a sigh of relief, but those not working on Wall Street have reason to worry.

First of all, when banks lose capital they lose their ability to lend. Most commercial banks lend $10 for each $1 of capital. For investment banks, the amounts invested or lent can be $20 or $30 per dollar of capital. The International Monetary Fund estimates that total losses of financial firms could amount to $1 trillion, with perhaps half of that total already observed.

Advertisement

To the extent that these losses fall on financial firms rather than on funds held by those firms and to the extent that new investors do not make up the capital losses, the world economy can expect a credit crunch. That is, lending will shrink by trillions of dollars. This means that new investment, new jobs and income growth will be much less than previously projected. Many borrowers - even with good credit records - will not be able to get a loan at all. Growth around the world will slow and may reverse.

Unless a lot of investors are found to increase the capital of banks, it will take time to build up new capital and lending. The Treasury implored banks to buy preferred shares - lower return but supposedly safer - of Fannie and Freddie in the last year and then imposed losses on them. Few investors want to repeat that experience! The Fed will try to help by keeping short-term rates low and long-term rates higher, but that is in effect a tax on savers at a time when there’s too little overall savings in the US, especially given the high level of federal deficits. It will not be easy to get out of these difficulties quickly.

Second, there’s the question of what Wall Street will look like after the dust settles. It’s clear that many banks were over-leveraged and under-regulated, or at least not well regulated. There will be fewer investment banks, less leverage and more regulation in return for more access to Federal Reserve borrowing.

  1. Pages:
  2. Page 1
  3. 2
  4. All

Reprinted with permission from YaleGlobal Online - www.yaleglobal.yale.edu - (c) 2008 Yale Center for the Study of Globalization.



Discuss in our Forums

See what other readers are saying about this article!

Click here to read & post comments.

13 posts so far.

Share this:
reddit this reddit thisbookmark with del.icio.us Del.icio.usdigg thisseed newsvineSeed NewsvineStumbleUpon StumbleUponsubmit to propellerkwoff it

About the Author

David Dapice is associate professor of economics at Tufts University and the economist of the Vietnam Program at Harvard University's Kennedy School of Government.

Other articles by this Author

All articles by David Dapice

Creative Commons LicenseThis work is licensed under a Creative Commons License.

Article Tools
Comment 13 comments
Print Printable version
Subscribe Subscribe
Email Email a friend
Advertisement

About Us Search Discuss Feedback Legals Privacy