In the end, the financial markets did not stand a chance against voter antipathy, partisanship and election year politics.
The defeat of the extraordinary $US700 billion ($860 billion) financial rescue package represented a perfect collision of the forces of modern politics - a fast-moving internet campaign, vulnerable incumbents, a weakened and unpopular president, and a roiling presidential campaign - all working against the so-called Masters of the Universe.
Polls showed widespread public opposition to the plan - the biggest federal intervention in financial markets since the Great Depression of the 1930s - and many Republicans saw such an enormous set-aside of taxpayer money as an unnecessary intrusion into free markets. Of the 19 most-endangered House incumbents, 13 voted no.
"This is one of those scenarios where nobody really wanted to do it," said House Republican Whip Roy Blunt of Missouri, who played a leading role in the final negotiations.
Such a roaring confluence of opposition could only have been overcome with strong party discipline and presidential power. But a weakened and unpopular President George Bush and lawmakers forced to weigh the vote against their political careers conspired against success.
Outside Congress, however, furious pressure built up against the bill in email campaigns and on websites.
The Club for Growth, a conservative free-market oriented group, warned lawmakers that it would count a vote in favour of the legislation against lawmakers seeking the group's support.
The Club for Growth is viewed with apprehension by many Republicans because it has been known to support challengers running against party incumbents in primary contests.
Longtime conservative activist Richard Viguerie warned that lawmakers who voted for the rescue package would be targeted for defeat.
"Republicans and Democrats alike who support this monstrosity will face the wrath of the voters if they stand side-by-side with predatory politicians and bureaucrats and their greedy friends who got us in this mess," he said.
The opposition on the House floor came from an unlikely coalition of conservatives and liberals. The progressive grassroots group MoveOn.org aired an ad blaming the financial crisis on John McCain and his allies.
All those forces worked against powerful special interests. The US Chamber of Commerce and a diverse group of industry lobbying organisations ranging from the National Association of Realtors to the American Hotel and Lodging Association pressed Congress to back the bill, pointedly noting that they too would consider this a key vote when ranking members.
The vote also represented an extraordinary rejection of Bush, who personally called wavering lawmakers and delivered a last-ditch public appeal this morning, as well as Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke.
"Despite days of negotiating, this is still the same bailout bill, written by a Wall Street guy with a Wall Street solution to a problem created on Wall Street," said Mike Rogers, a Michigan Republican. "This bill was still a blank cheque to Henry Paulson."
The vote also did nothing for the presidential contenders, Democrat Barack Obama and Republican John McCain. Both stepped into the fray last week and boasted of exercising leadership in the negotiations.
Not only did a majority of McCain's Republican colleagues vote against it, so did all his fellow Arizona lawmakers. Obama was unable to sway many House liberals, including a majority of the Congressional Black Caucus.
House Republican leader John Boehner of Ohio, in a crowded Capitol corridor after the vote, accused House Speaker Nancy Pelosi of delivering a partisan pre-vote speech that caused some Republicans to refuse to back the proposal.
Blunt said the speech could have cost the bill about 12 Republican votes. He did not identify those lawmakers
Pelosi earlier had delivered a tough attack on Bush economic policies and a "right-wing ideology of anything goes, no supervision, no discipline, no regulation" of financial markets - a pointed critique not much different than what she has been saying for days.
But Boehner said Pelosi's speech "poisoned our conference, caused a number of members that we thought we could get, to go south".
House Banking Committee Chairman Barney Frank, a Massachusetts Democrat who is known for his quick, often acerbic wit, said the Republican leaders' complaints meant that some Republicans "decided to punish the country" because their feelings were hurt.
"Give me the names of those 12 people and I'll go talk uncharacteristically nice to them," he said.
Monday, September 29, 2008
Thursday, September 25, 2008
Warren Buffett and Goldman Sachs
Warren Buffett’s return to Wall Street raises hopes
AP
Buffett lunchIN 1998 Goldman Sachs was looking for help in bailing out Long-Term Capital Management, a sickly hedge fund to which it was exposed. It sought a contribution from Warren Buffett. But the Oracle of Omaha was on holiday (with Bill Gates, of course) and as the deadline approached his boat drifted out of mobile-phone range. This time there were no communication problems. Mr Buffett has answered Goldman’s latest call with a $5 billion infusion from his cash pile.
Goldman could not have wished for a more credible vote of confidence, albeit at a steep price: Mr Buffett’s holding company will receive $500m a year in dividend payments on its preferred stock. Mr Buffett knows from experience that it pays to negotiate hard with investment bankers. His only previous foray on Wall Street, a $700m bet on Salomon Brothers, went badly awry, though it eventually turned a profit.
He is, he says, betting “on brains”—and, implicitly, that Goldman’s profits will not be hit too hard by becoming a regulated bank. Some also see the move as a vote of confidence in financial firms, which Mr Buffett has thus far avoided in this crisis, preferring the relative calm of energy, railroads and chewing gum.
That may be hoping for too much. Mr Buffett made clear that he considers Goldman’s management a cut above. And he drew a contrast between its cautious valuation of illiquid assets and more “fanciful” marks at some other firms. Moreover, for all his hardheadedness he has a soft spot for Goldman, having befriended its one-time boss, Sidney Weinberg, as a young man and stayed close to the firm ever since
In any case, Mr Buffett’s skill lies more in picking undervalued stocks with strong brands than in timing market bottoms—indeed, he bought into Salomon only weeks before the 1987 crash. Even when it comes to individual holdings, he is not flawless. He held Moody’s, a rating agency, for too long.
Still, it is heartening that such a shrewd investor is beginning to spy opportunities in the rubble of a crisis he has dubbed “an economic Pearl Harbour.” He confirmed this week what must already have been obvious: that he has been approached by almost every big financial institution in recent months. After Goldman, he can expect the phone to ring off the hook.
AP
Buffett lunchIN 1998 Goldman Sachs was looking for help in bailing out Long-Term Capital Management, a sickly hedge fund to which it was exposed. It sought a contribution from Warren Buffett. But the Oracle of Omaha was on holiday (with Bill Gates, of course) and as the deadline approached his boat drifted out of mobile-phone range. This time there were no communication problems. Mr Buffett has answered Goldman’s latest call with a $5 billion infusion from his cash pile.
Goldman could not have wished for a more credible vote of confidence, albeit at a steep price: Mr Buffett’s holding company will receive $500m a year in dividend payments on its preferred stock. Mr Buffett knows from experience that it pays to negotiate hard with investment bankers. His only previous foray on Wall Street, a $700m bet on Salomon Brothers, went badly awry, though it eventually turned a profit.
He is, he says, betting “on brains”—and, implicitly, that Goldman’s profits will not be hit too hard by becoming a regulated bank. Some also see the move as a vote of confidence in financial firms, which Mr Buffett has thus far avoided in this crisis, preferring the relative calm of energy, railroads and chewing gum.
That may be hoping for too much. Mr Buffett made clear that he considers Goldman’s management a cut above. And he drew a contrast between its cautious valuation of illiquid assets and more “fanciful” marks at some other firms. Moreover, for all his hardheadedness he has a soft spot for Goldman, having befriended its one-time boss, Sidney Weinberg, as a young man and stayed close to the firm ever since
In any case, Mr Buffett’s skill lies more in picking undervalued stocks with strong brands than in timing market bottoms—indeed, he bought into Salomon only weeks before the 1987 crash. Even when it comes to individual holdings, he is not flawless. He held Moody’s, a rating agency, for too long.
Still, it is heartening that such a shrewd investor is beginning to spy opportunities in the rubble of a crisis he has dubbed “an economic Pearl Harbour.” He confirmed this week what must already have been obvious: that he has been approached by almost every big financial institution in recent months. After Goldman, he can expect the phone to ring off the hook.
Saving Wall Street - the last resort
Sep 18th 2008 | WASHINGTON, DC
From The Economist print edition
The American government’s bail-outs are less arbitrary than they appear
SIX months after the American government supported the sale of Bear Stearns to JPMorgan Chase, leading to the end of one of Wall Street’s “Big Five”, it tried to make it clear last weekend that there would be no further bail-outs, and let Lehman Brothers fail. Two days later, that line in the sand had all but blown away.
The Treasury’s decision on September 16th to take over American International Group (AIG), one of the world’s biggest insurers, in exchange for an $85 billion credit line from the Federal Reserve, was momentous. More so than allowing Lehman Brothers, which was even bigger than Bear Stearns, to go bust the day before; more so, even, than the takeover of Fannie Mae and Freddie Mac, the big mortgage agencies, just over a week before. With AIG, the stakes were higher for both the financial system and the authorities’ credibility.
Fannie and Freddie always had implicit federal backing, so when they tottered, the federal government had little choice but to make that support explicit. Bear Stearns was a regulated investment bank whose demise was so sudden that its collapse could have caused a maelstrom.
AIG is an insurer, not a bank, and as such had neither federal backing nor much federal oversight. Yet it quietly built itself into a juggernaut in the global financial system by using derivatives to insure hundreds of billions of dollars of corporate loans, mortgages and other debt. Holders of these assets ranged from the world’s biggest banks to retired people’s money-market funds. Allowing AIG to fail could have panicked small investors, forced banks to take steep write-downs, and introduced a terrifying new phase to the financial crisis.
To some, the institution-by-institution approach to bail-outs seems haphazard. “Mr Secretary...you’re picking and choosing. You have to have a set policy,” Richard Shelby, the leading Republican on the Senate banking panel, complained to Hank Paulson, the treasury secretary.
In fact, back in July Mr Paulson had argued in favour of a formal mechanism to take over and wind down non-banks, such as investment banks and insurers, in an orderly way, much as already exists for retail banks. But Congress was only prepared to consider that as part of a bigger regulatory overhaul under the next president. That forced Mr Paulson, Ben Bernanke, the Fed’s chairman, and Timothy Geithner, the president of the New York Fed (the three are virtually joined at the hip) to pursue rescues ad hoc. Yet a certain logic has governed their actions.
It is possible to detect a pattern of sorts emerging in Mr Paulson’s interventions. First, establish if a firm is so large or so entangled within the financial system that its unexpected failure could be catastrophic. If the answer is “no”, as the authorities concluded it was in Lehman’s case, encourage a private sale but commit no public money. If the answer is “yes”, as with Bear, Fannie and Freddie, and AIG, then make sure that taxpayers get first claim on the assets, common and preferred shareholders pay a steep price, and management is replaced. Mr Paulson argues that the approach combines pragmatism with an intense focus on moral hazard, or letting people pay for failure. “I don’t believe in raw capitalism without regulation. There’s got to be a balance between market discipline, allowing people to take losses, and protecting the system,” he says.
Assuming the markets eventually right themselves, the bail-outs may hasten healthy consolidation. American economic growth has been heavily dependent on borrowing and leverage for the last decade. AIG had used its unregulated status to supply cheap credit protection to regulated entities. But that business thrived in a period of easy credit and low defaults. When those conditions ended, it produced enough losses to nearly bankrupt AIG.
Lehman’s bankruptcy and AIG’s failure suggest Wall Street has too much leverage and too much capital devoted to products of questionable economic utility. The bail-outs will facilitate a deleveraging. The Fed expects AIG to repay its loan by selling off its healthy businesses, while winding down its derivatives book. Mr Paulson wants Fannie and Freddie to reduce much of their mortgage portfolios.
“The necessary shrinking of the financial system is taking place in real time,” says Kenneth Rogoff of Harvard University. It could go too far. If the cycle of falling asset prices, insolvency and credit constriction is excessive, the government may have to step in and buy up bad assets en masse, as has often occurred in other financial meltdowns (see article).
Even without such drastic action, the economy and the financial system are becoming dependent on the taxpayer. Bank of America was in a position to buy Merrill Lynch in part because the Federal Deposit Insurance Corporation, which guarantees deposits, insulates a large share of the bank’s funding from crises of confidence.
With federal backing comes federal oversight. Even the most free-market policymakers will be reluctant ever to see another company get as large and interconnected as AIG without tougher regulation. Just as the Fed insisted on more oversight of investment banks when it agreed to lend to them in March, it will now have the authority to inspect the books of AIG any time it chooses.
This poses risks to the Fed. Thrust to the fore during the crisis, its role in the financial system has expanded. It has so far balanced these responsibilities with its attention to inflation. On September 16th it defied market hopes for lower interest rates and kept its short-term target at 2%. It judged that for now, expanding its loans to banks and securities dealers, and broadening the collateral it accepts from banks, addresses the crisis better than looser monetary policy would, though it may yet decide further rate cuts are necessary.
Still, the Fed has lent so heavily to the most beleaguered financial firms that it is running out of bonds. The government has promised to help with a special issuance of Treasury bills which, through the machinations of reserve management, will result in a larger Fed balance sheet but no impact on interest rates.
The Fed needs to be sure it does not become a crutch for insolvent financial firms, distorting credit allocation and risk taking. For the time being, though, that concern is far less important to it than keeping the financial system intact.
From The Economist print edition
The American government’s bail-outs are less arbitrary than they appear
SIX months after the American government supported the sale of Bear Stearns to JPMorgan Chase, leading to the end of one of Wall Street’s “Big Five”, it tried to make it clear last weekend that there would be no further bail-outs, and let Lehman Brothers fail. Two days later, that line in the sand had all but blown away.
The Treasury’s decision on September 16th to take over American International Group (AIG), one of the world’s biggest insurers, in exchange for an $85 billion credit line from the Federal Reserve, was momentous. More so than allowing Lehman Brothers, which was even bigger than Bear Stearns, to go bust the day before; more so, even, than the takeover of Fannie Mae and Freddie Mac, the big mortgage agencies, just over a week before. With AIG, the stakes were higher for both the financial system and the authorities’ credibility.
Fannie and Freddie always had implicit federal backing, so when they tottered, the federal government had little choice but to make that support explicit. Bear Stearns was a regulated investment bank whose demise was so sudden that its collapse could have caused a maelstrom.
AIG is an insurer, not a bank, and as such had neither federal backing nor much federal oversight. Yet it quietly built itself into a juggernaut in the global financial system by using derivatives to insure hundreds of billions of dollars of corporate loans, mortgages and other debt. Holders of these assets ranged from the world’s biggest banks to retired people’s money-market funds. Allowing AIG to fail could have panicked small investors, forced banks to take steep write-downs, and introduced a terrifying new phase to the financial crisis.
To some, the institution-by-institution approach to bail-outs seems haphazard. “Mr Secretary...you’re picking and choosing. You have to have a set policy,” Richard Shelby, the leading Republican on the Senate banking panel, complained to Hank Paulson, the treasury secretary.
In fact, back in July Mr Paulson had argued in favour of a formal mechanism to take over and wind down non-banks, such as investment banks and insurers, in an orderly way, much as already exists for retail banks. But Congress was only prepared to consider that as part of a bigger regulatory overhaul under the next president. That forced Mr Paulson, Ben Bernanke, the Fed’s chairman, and Timothy Geithner, the president of the New York Fed (the three are virtually joined at the hip) to pursue rescues ad hoc. Yet a certain logic has governed their actions.
It is possible to detect a pattern of sorts emerging in Mr Paulson’s interventions. First, establish if a firm is so large or so entangled within the financial system that its unexpected failure could be catastrophic. If the answer is “no”, as the authorities concluded it was in Lehman’s case, encourage a private sale but commit no public money. If the answer is “yes”, as with Bear, Fannie and Freddie, and AIG, then make sure that taxpayers get first claim on the assets, common and preferred shareholders pay a steep price, and management is replaced. Mr Paulson argues that the approach combines pragmatism with an intense focus on moral hazard, or letting people pay for failure. “I don’t believe in raw capitalism without regulation. There’s got to be a balance between market discipline, allowing people to take losses, and protecting the system,” he says.
Assuming the markets eventually right themselves, the bail-outs may hasten healthy consolidation. American economic growth has been heavily dependent on borrowing and leverage for the last decade. AIG had used its unregulated status to supply cheap credit protection to regulated entities. But that business thrived in a period of easy credit and low defaults. When those conditions ended, it produced enough losses to nearly bankrupt AIG.
Lehman’s bankruptcy and AIG’s failure suggest Wall Street has too much leverage and too much capital devoted to products of questionable economic utility. The bail-outs will facilitate a deleveraging. The Fed expects AIG to repay its loan by selling off its healthy businesses, while winding down its derivatives book. Mr Paulson wants Fannie and Freddie to reduce much of their mortgage portfolios.
“The necessary shrinking of the financial system is taking place in real time,” says Kenneth Rogoff of Harvard University. It could go too far. If the cycle of falling asset prices, insolvency and credit constriction is excessive, the government may have to step in and buy up bad assets en masse, as has often occurred in other financial meltdowns (see article).
Even without such drastic action, the economy and the financial system are becoming dependent on the taxpayer. Bank of America was in a position to buy Merrill Lynch in part because the Federal Deposit Insurance Corporation, which guarantees deposits, insulates a large share of the bank’s funding from crises of confidence.
With federal backing comes federal oversight. Even the most free-market policymakers will be reluctant ever to see another company get as large and interconnected as AIG without tougher regulation. Just as the Fed insisted on more oversight of investment banks when it agreed to lend to them in March, it will now have the authority to inspect the books of AIG any time it chooses.
This poses risks to the Fed. Thrust to the fore during the crisis, its role in the financial system has expanded. It has so far balanced these responsibilities with its attention to inflation. On September 16th it defied market hopes for lower interest rates and kept its short-term target at 2%. It judged that for now, expanding its loans to banks and securities dealers, and broadening the collateral it accepts from banks, addresses the crisis better than looser monetary policy would, though it may yet decide further rate cuts are necessary.
Still, the Fed has lent so heavily to the most beleaguered financial firms that it is running out of bonds. The government has promised to help with a special issuance of Treasury bills which, through the machinations of reserve management, will result in a larger Fed balance sheet but no impact on interest rates.
The Fed needs to be sure it does not become a crutch for insolvent financial firms, distorting credit allocation and risk taking. For the time being, though, that concern is far less important to it than keeping the financial system intact.
Collapse of Wall St. - And then there were none
Sep 25th 2008 | NEW YORK
From The Economist print edition
What the death of the investment bank means for Wall Street
THE radical overhaul of the City of London in 1986 was dubbed the Big Bang. The brutal reshaping of Wall Street might be better described as the Big Implosion. The “bulge-bracket” brokerage model—the envy of moneymen everywhere before the crunch—has collapsed in on itself. Even more humiliating for the Green Berets of the markets, the new force in finance is the government.
The last remaining investment banks, Goldman Sachs and Morgan Stanley, sought safety by becoming bank holding companies after last week’s run on the industry, which sent Wall Street scrambling for loans from the central bank (see chart). After Lehman Brothers collapsed, the markets could no longer stomach their mix of illiquid assets and unstable wholesale liabilities. Both will now start gathering deposits, a more stable form of funding. Signing up strong partners should also help. Mitsubishi UFJ Financial Group (MUFG), a giant Japanese bank, will buy up to 20% of Morgan (see article). Goldman has gone one better, coaxing $5 billion from Warren Buffett (see article).
Mr Buffett, no idle flatterer, describes Goldman as “exceptional”. But some doubt that it will be able to adapt and thrive. As a bank, it faces more supervision from the Federal Reserve, tougher capital requirements and restrictions on investing. Universal banks, such as Citigroup and Bank of America, long dismissed as stodgy, argue that their vast balance sheets and wide range of businesses, from credit cards to capital markets, give them an edge in trying times. The head of one bank suggests that the golden years of risk-taking enjoyed by investment banks in 2003-06 were an “aberration”, fuelled by the global liquidity glut.
Private-equity firms and hedge funds spy opportunity, too. Blackstone’s Stephen Schwarzman is keen to take advantage of Wall Street’s disarray. Kohlberg Kravis Roberts, a rival, has ambitions to create a financial “ecosystem”. The buy-out barons got good news this week, when the Fed relaxed its rules on their ownership of banks. One of them, Christopher Flowers, bought a small lender in Missouri, which he may use to hoover up other troubled financial firms. Citadel, a hedge-fund group that is already an options marketmaker, is reportedly mulling a move into the advisory business. Hedge funds have stepped up their financing of mid-tier firms that cannot get loans from Wall Street.
These investors are also going after the “talent” in investment banks. Morale there is not high. One executive admits that becoming a bank “does little for our cachet”. Hedge funds will be particularly keen to get their hands on cutting-edge risk-takers, particularly the Goldman crowd who used to thrive on leverage.
Power may shift in two other directions: abroad and, to a lesser extent, to boutique investment banks. MUFG will be joined by others. After a brief wrangle in the bankruptcy courts, Britain’s Barclays has taken over Lehman’s American operations and quickly put its logo on the fallen firm’s headquarters. “Global financial power is becoming more diffuse,” says Andrew Schwedel of Bain & Company, a consultancy. Merger boutiques, such as Lazard and Greenhill, will emphasise their stability to pick up business. Their shares have done relatively well this year.
But all is not lost for the former investment banks. For one thing, they may not have to cut leverage by as much as feared. Though their overall leverage ratios are high, their risk-adjusted capital ratios under the Basel 2 rules are stronger than those of most commercial banks. They acknowledge, however, that they may have to raise these even higher for a while to assuage market concerns about hard-to-sell assets.
Brad Hintz of Sanford Bernstein, an asset manager and research firm, reckons regulatory shackles will cut Goldman’s return on equity by four percentage points over the cycle. The bank disputes this. Either way, even if it is forced to tone down its in-house proprietary trading it can make up for this by, for instance, launching more hedge funds. And it faces no immediate pressure to sell its large private-equity or commodities holdings. It will continue to co-invest in projects alongside clients, a key Goldman strategy.
Moreover, there are some advantages to becoming a bank. Goldman and Morgan should be able to amass deposits cheaply and easily, because dozens of regional lenders are expected to fail. Almost one-fifth have less capital than regulators consider a safe minimum. However, the new banks will be under scrutiny to ensure they do not put those deposits at great risk.
As sharp distressed-debt investors, they will also be looking to buy assets from the government’s giant loan-buying entity when it gets going. This is likely to be more helpful to them than to commercial banks, which have marked down their mortgage assets less and will not benefit as much when clearing prices are set.
Given the acute stress that remains in money markets, however, the accent for the time being is still on survival. Morgan Stanley’s debt with a maturity of four months was trading to yield as much as 37.5%. Maybe it should consider using credit cards instead.
Financial firms fear further fallout from the recent, potentially catastrophic run on money-market funds, after several of the supposedly ultra-safe vehicles saw their net asset values slip below the sacrosanct $1 level at which investors break even. Only when the government stepped in to guarantee that no more funds would “break the buck” did a semblance of calm return. But “prime” money funds, which are big buyers of corporate debt, are still pulling away from anything deemed risky. This is a big problem for banks, since some $1.3 trillion of their short-term debt is held by such funds, and they may have to turn to longer-term (and dearer) sources.
You might just miss us
Once markets stabilise, Wall Street will start to wonder if it is better or worse off without its stand-alone investment banks. Some think they were no more worth saving than Detroit, another once-iconic industry caught up in its own battle for a public rescue. Perhaps even less so: the securities Wall Street packaged were the financial equivalent of slick-looking cars with no brakes. But they may leave a hole. As broker-dealers, regulated more lightly by the Securities and Exchange Commission, they were free to put large dollops of capital to work, providing liquidity, making markets and assuming risk. As banks, they may find the Fed takes a more restrictive view.
It seems implausible that the investment bank will make a comeback, given the speed with which it has unravelled. Yet, 75 years after the legal separation of commercial and investment banking, America has made a full return to the one-stop-shop model practised by John Pierpont Morgan. Another black swan in 2083, and who knows?
The financial crisis - What next?
Sep 18th 2008
From The Economist print edition
Global finance is being torn apart; it can be put back together again
Illustration by Oliver BurstonFINANCE houses set out to be monuments of stone and steel. In the widening gyre the greatest of them have splintered into matchwood. Ten short days saw the nationalisation, failure or rescue of what was once the world’s biggest insurer, with assets of $1 trillion, two of the world’s biggest investment banks, with combined assets of another $1.5 trillion, and two giants of America’s mortgage markets, with assets of $1.8 trillion. The government of the world’s leading capitalist nation has been sucked deep into the maelstrom of its most capitalist industry. And it looks overwhelmed.
The bankruptcy of Lehman Brothers and Merrill Lynch’s rapid sale to Bank of America were shocking enough. But the government rescue of American International Group (AIG), through an $85 billion loan at punitive interest rates thrown together on the evening of September 16th, marked a new low in an already catastrophic year. AIG is mostly a safe, well-run insurer. But its financial-products division, which accounted for just a fraction of its revenues, wrote enough derivatives contracts to destroy the firm and shake the world. It helps explain one of the mysteries of recent years: who was taking on the risk that banks and investors were shedding? Now we know.
Yet AIG’s rescue has done little to banish the naked fear that has the markets in its grip. Pick your measure—the interest rates banks charge to lend to each other, the extra costs of borrowing and of insuring corporate debt, the flight to safety in Treasury bonds, gold, financial stocks: all register contagion. On September 17th HBOS, Britain’s largest mortgage lender, fell into the arms of Lloyds TSB for a mere £12 billion ($22 billion), after its shares pitched into the abyss that had swallowed Lehman and AIG. Other banks, including Morgan Stanley and Washington Mutual, looked as if they would suffer the same fate. Russia said it would lend its three biggest banks 1.12 trillion roubles ($44 billion). An American money-market fund, supposedly the safest of safe investments, this week became the first since 1994 to report a loss. If investors flee the money markets for Treasuries, banks will lose funding and the contagion will suck in hedge funds and companies. A brave man would see catharsis in all this misery; a wise man would not be so hasty.
The blood-dimmed tide
Some will argue that the Federal Reserve and the Treasury, nationalising the economy faster than you can say Hugo Chávez, should have left AIG to oblivion. Amid this contagion that would have been reckless. Its contracts—almost $450 billion-worth in the credit-default swaps market alone—underpin the health of the world’s banks and investment funds. The collapse of its insurance arm would hit ordinary policyholders. At the weekend the Fed and the Treasury watched Lehman Brothers go bankrupt sooner than save it. In principle that was admirable—capitalism requires people to pay for their mistakes. But AIG was bigger and the bankruptcy of Lehman had set off vortices and currents that may have contributed to its downfall. With the markets reeling, pragmatism trumped principle. Even though it undermined their own authority, the Fed and the Treasury rightly felt they could not say no again.
What happens next depends on three questions. Why has the crisis lurched onto a new, destructive path? How vulnerable are the financial system and the economy? And what can be done to put finance right? It is no hyperbole to say that for an inkling of what is at stake, you have only to study the 1930s.
Shorn of all its complexity, the finance industry is caught between two brutally simple forces. It needs capital, because assets like houses and promises to pay debts are worth less than most people thought. Even if some gain from falling asset prices, lenders and insurers have to book losses, which leaves them needing money. Finance also needs to shrink. The credit boom not only inflated asset prices, it also inflated finance itself. The financial-services industry’s share of total American corporate profits rose from 10% in the early 1980s to 40% at its peak last year. By one calculation, profits in the past decade amounted to $1.2 trillion more than you would have expected.
This industry will not be able to make money after the boom unless it is far smaller—and it will be hard to make money while it shrinks. No wonder investors are scarce. The brave few, such as sovereign-wealth funds, who put money into weak banks have lost a lot. Better to pick over their carcasses than to take on their toxic assets—just as Britain’s Barclays walked away from Lehman as a going concern, only to swoop on its North American business after it failed.
The centre cannot hold
Governments will thus often be the only buyers around. If necessary, they may create a special fund to manage and wind down troubled assets. Yet do not underestimate the cost of rescues, even necessary ones. Nobody would buy Lehman unless the government offered them the sort of help it had provided JPMorgan Chase when it saved Bear Stearns. The nationalisation that, for good reason, wiped out Fannie’s and Freddie’s shareholders has made it riskier for others to put fresh equity into ailing banks. The only wise recapitalisation just now is an outright purchase, preferably by a retail bank backed by deposits insured by the government—as with Bank of America and Merrill Lynch, Lloyds and HBOS and, possibly, Wachovia with Morgan Stanley. The bigger the bank, the harder that is. Most of all, each rescue discourages investors from worrying about the creditworthiness of those they trade with—and thus encourages the next excess.
For all the costs of a rescue, the cost of failure to the economy would sometimes be higher. As finance shrinks, credit will be sucked out of the economy and without credit, people cannot buy houses, run businesses or as easily invest in the future. So far the American economy has held up. The hope is that the housing bust is nearing its bottom and that countries like China and India will continue to thrive. Recent falls in the price of oil and other commodities give central banks scope to cut interest rates—as China showed this week.
But there is a darker side, too. Unemployment in America rose to 6.1% in August and is likely to climb further. Industrial production fell by 1.1% last month; and the annual change in retail sales is at its weakest since the aftermath of the 2001 recession. Output is shrinking in Japan, Germany, Spain and Britain, and is barely positive in many other countries. On a quarterly basis, prices are falling in half of the 20 countries in The Economist’s house-price index. Emerging economies’ stocks, bonds and currencies have been battered as investors fret that they will no longer be “decoupled” from the rich countries.
Unless policymakers blunder unforgivably—by letting “systemic” institutions fail or by keeping monetary policy too tight—there is no need for today’s misery to turn into a new Depression. A longer-term worry is the inevitable urge to regulate modern finance into submission. Though understandable, that desire is wrong and dangerous—and the colossal success of commerce in the emerging world (see article) shows how much there is to lose. Finance is the brain of the economy. For all its excesses, it allocates resources to where they are productive better than any central planner ever could.
Regulation is necessary, and much must now be done to improve the laws of finance. But it must be the right regulation: an end to America’s fragmented system of oversight; more transparency; capital requirements that lean against booms and flex with busts; supervision of giants, like AIG, that are too big and too interconnected to fail; accounting that values risks better and that everyone accepts; clearing houses and exchanges to make derivatives safer and less opaque.
All that would count as progress. But naive faith in regulators’ powers creates ruinous false security. Financiers know more than regulators and their voices carry more weight in a boom. Banks can exploit the regulations’ inevitable blind spots: assets hidden off their balance sheets, or insurance (such as that provided by AIG) which enables them to profit by sliding out of the capital requirements the regulators set. It is no accident that both schemes were at the heart of the crisis.
This is a black week. Those of us who have supported financial capitalism are open to the charge that the system we championed has merely enabled a few spivs to get rich. But it helped produce healthy economic growth and low inflation for a generation. It would take a very big recession indeed to wipe out those gains. Do not forget that in the debate ahead.
From The Economist print edition
Global finance is being torn apart; it can be put back together again
Illustration by Oliver BurstonFINANCE houses set out to be monuments of stone and steel. In the widening gyre the greatest of them have splintered into matchwood. Ten short days saw the nationalisation, failure or rescue of what was once the world’s biggest insurer, with assets of $1 trillion, two of the world’s biggest investment banks, with combined assets of another $1.5 trillion, and two giants of America’s mortgage markets, with assets of $1.8 trillion. The government of the world’s leading capitalist nation has been sucked deep into the maelstrom of its most capitalist industry. And it looks overwhelmed.
The bankruptcy of Lehman Brothers and Merrill Lynch’s rapid sale to Bank of America were shocking enough. But the government rescue of American International Group (AIG), through an $85 billion loan at punitive interest rates thrown together on the evening of September 16th, marked a new low in an already catastrophic year. AIG is mostly a safe, well-run insurer. But its financial-products division, which accounted for just a fraction of its revenues, wrote enough derivatives contracts to destroy the firm and shake the world. It helps explain one of the mysteries of recent years: who was taking on the risk that banks and investors were shedding? Now we know.
Yet AIG’s rescue has done little to banish the naked fear that has the markets in its grip. Pick your measure—the interest rates banks charge to lend to each other, the extra costs of borrowing and of insuring corporate debt, the flight to safety in Treasury bonds, gold, financial stocks: all register contagion. On September 17th HBOS, Britain’s largest mortgage lender, fell into the arms of Lloyds TSB for a mere £12 billion ($22 billion), after its shares pitched into the abyss that had swallowed Lehman and AIG. Other banks, including Morgan Stanley and Washington Mutual, looked as if they would suffer the same fate. Russia said it would lend its three biggest banks 1.12 trillion roubles ($44 billion). An American money-market fund, supposedly the safest of safe investments, this week became the first since 1994 to report a loss. If investors flee the money markets for Treasuries, banks will lose funding and the contagion will suck in hedge funds and companies. A brave man would see catharsis in all this misery; a wise man would not be so hasty.
The blood-dimmed tide
Some will argue that the Federal Reserve and the Treasury, nationalising the economy faster than you can say Hugo Chávez, should have left AIG to oblivion. Amid this contagion that would have been reckless. Its contracts—almost $450 billion-worth in the credit-default swaps market alone—underpin the health of the world’s banks and investment funds. The collapse of its insurance arm would hit ordinary policyholders. At the weekend the Fed and the Treasury watched Lehman Brothers go bankrupt sooner than save it. In principle that was admirable—capitalism requires people to pay for their mistakes. But AIG was bigger and the bankruptcy of Lehman had set off vortices and currents that may have contributed to its downfall. With the markets reeling, pragmatism trumped principle. Even though it undermined their own authority, the Fed and the Treasury rightly felt they could not say no again.
What happens next depends on three questions. Why has the crisis lurched onto a new, destructive path? How vulnerable are the financial system and the economy? And what can be done to put finance right? It is no hyperbole to say that for an inkling of what is at stake, you have only to study the 1930s.
Shorn of all its complexity, the finance industry is caught between two brutally simple forces. It needs capital, because assets like houses and promises to pay debts are worth less than most people thought. Even if some gain from falling asset prices, lenders and insurers have to book losses, which leaves them needing money. Finance also needs to shrink. The credit boom not only inflated asset prices, it also inflated finance itself. The financial-services industry’s share of total American corporate profits rose from 10% in the early 1980s to 40% at its peak last year. By one calculation, profits in the past decade amounted to $1.2 trillion more than you would have expected.
This industry will not be able to make money after the boom unless it is far smaller—and it will be hard to make money while it shrinks. No wonder investors are scarce. The brave few, such as sovereign-wealth funds, who put money into weak banks have lost a lot. Better to pick over their carcasses than to take on their toxic assets—just as Britain’s Barclays walked away from Lehman as a going concern, only to swoop on its North American business after it failed.
The centre cannot hold
Governments will thus often be the only buyers around. If necessary, they may create a special fund to manage and wind down troubled assets. Yet do not underestimate the cost of rescues, even necessary ones. Nobody would buy Lehman unless the government offered them the sort of help it had provided JPMorgan Chase when it saved Bear Stearns. The nationalisation that, for good reason, wiped out Fannie’s and Freddie’s shareholders has made it riskier for others to put fresh equity into ailing banks. The only wise recapitalisation just now is an outright purchase, preferably by a retail bank backed by deposits insured by the government—as with Bank of America and Merrill Lynch, Lloyds and HBOS and, possibly, Wachovia with Morgan Stanley. The bigger the bank, the harder that is. Most of all, each rescue discourages investors from worrying about the creditworthiness of those they trade with—and thus encourages the next excess.
For all the costs of a rescue, the cost of failure to the economy would sometimes be higher. As finance shrinks, credit will be sucked out of the economy and without credit, people cannot buy houses, run businesses or as easily invest in the future. So far the American economy has held up. The hope is that the housing bust is nearing its bottom and that countries like China and India will continue to thrive. Recent falls in the price of oil and other commodities give central banks scope to cut interest rates—as China showed this week.
But there is a darker side, too. Unemployment in America rose to 6.1% in August and is likely to climb further. Industrial production fell by 1.1% last month; and the annual change in retail sales is at its weakest since the aftermath of the 2001 recession. Output is shrinking in Japan, Germany, Spain and Britain, and is barely positive in many other countries. On a quarterly basis, prices are falling in half of the 20 countries in The Economist’s house-price index. Emerging economies’ stocks, bonds and currencies have been battered as investors fret that they will no longer be “decoupled” from the rich countries.
Unless policymakers blunder unforgivably—by letting “systemic” institutions fail or by keeping monetary policy too tight—there is no need for today’s misery to turn into a new Depression. A longer-term worry is the inevitable urge to regulate modern finance into submission. Though understandable, that desire is wrong and dangerous—and the colossal success of commerce in the emerging world (see article) shows how much there is to lose. Finance is the brain of the economy. For all its excesses, it allocates resources to where they are productive better than any central planner ever could.
Regulation is necessary, and much must now be done to improve the laws of finance. But it must be the right regulation: an end to America’s fragmented system of oversight; more transparency; capital requirements that lean against booms and flex with busts; supervision of giants, like AIG, that are too big and too interconnected to fail; accounting that values risks better and that everyone accepts; clearing houses and exchanges to make derivatives safer and less opaque.
All that would count as progress. But naive faith in regulators’ powers creates ruinous false security. Financiers know more than regulators and their voices carry more weight in a boom. Banks can exploit the regulations’ inevitable blind spots: assets hidden off their balance sheets, or insurance (such as that provided by AIG) which enables them to profit by sliding out of the capital requirements the regulators set. It is no accident that both schemes were at the heart of the crisis.
This is a black week. Those of us who have supported financial capitalism are open to the charge that the system we championed has merely enabled a few spivs to get rich. But it helped produce healthy economic growth and low inflation for a generation. It would take a very big recession indeed to wipe out those gains. Do not forget that in the debate ahead.
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