FINANCIAL AFFAIRS: by Peter WestmoreNews Weekly
Why Wall Street imploded
, September 27, 2008
Financial deregulation, pushed by over-zealous free-market ideologues, has much to answer for. Peter Westmore reports.Last week's collapse of two of Wall Street's largest financial houses, Lehman Brothers and Merrill Lynch, is a symptom of what former US Federal Reserve chairman, Alan Greenspan, described as the worst financial crisis for the past 50, perhaps 100, years - in other words, at least as bad as the Great Depression of the 1930s which only ended with World War II.
The original cause of the crisis was the collapse of the sub-prime mortgage market in the United States. The immediate crisis has been caused by the involvement of the Wall Street powerhouses with collateralised debt obligations (CDOs), the financial instruments which were created to "sell" sub-prime mortgages to mainstream financial institutions throughout the world.
When the sub-prime crisis hit in August 2007, CDOs became almost worthless, leaving the holders of CDOs short of billions of dollars. Earlier victims of the sub-prime crisis included Bear Stearns, Fannie Mae and Freddie Mac, Northern Rock, a large UK banking group, and a string of regional US banks which have become insolvent over the past 12 months.
Even Australian banks, which had purchased CDOs as part of their international investment portfolios, have lost hundreds of millions of dollars.Market failure
The cause of the collapse is clear: a market failure characterised by the total lack of supervision of the derivatives market in the US, as former Treasurer, Peter Costello, pointed out in his address to the National Press Club last week.
He echoed the observations of others, including Anatole Kaletsky, who described the collapse as "the complete failure of the biggest, most dynamic, most innovative and competitive markets that have existed in the history of capitalism - the Wall Street stockmarket and the market for US bonds". (The Times
, London, September 12, 2008).
Kaletsky recently added, "Since the early 1990s, regulatory changes, inspired by an over-zealous belief in free-market economics, have intensified boom-bust cycles. These regulatory distortions have rested on the naïve belief that 'the market is always right'.
"The greatest irony is that the last adherents of this free market dogma are the financial regulators whose raison d'être is to guard against situations when the markets are dangerously wrong, but who still insist, for example, that energy prices are never manipulated by speculation or that governments must draw black and white distinctions between shareholders and creditors of troubled banks." (The Times
, September 15).
Paul Krugman, the highly respected American economist, drew parallels with the collapse of the 1930s. He said that new technology had produced a new version of runs on the banks.
"These don't look like the old-fashioned version: with few exceptions, we're not talking about mobs of angry depositors pounding on closed bank doors. Instead, we're talking about frantic phone calls and mouse clicks, as financial players pull credit lines and try to unwind counter-party risk.
"But the economic effects - a freezing up of credit, a downward spiral in asset values - are the same as those of the great bank runs of the 1930s."
Krugman said that the answer to the current problems "would have been to take preventive action before we reached this point. When Bear [Stearns] went under, many people talked about the need for a mechanism for orderly liquidation of failing investment banks.
"Well, that was six months ago. Where's the mechanism?" he asked.
If anyone had predicted a year ago that three of America's six largest merchant banks would have been liquidated or forced into a fire-sale, they would have been either laughed at or ignored. What makes the present situation even more dangerous is that nobody knows which other financial institutions are vulnerable.
Now, not only have Bear Stearns, Lehman Brothers and Merrill Lynch been effectively wound up, but then the American insurance giant AIG was in the firing line. A week before the collapse of Lehman Brothers, AIG stock lost 45 per cent of their value on the stock exchange, and the company was forced to seek to borrow $40 billion from the US Federal Reserve. AIG was effectively re-capitalised by the US Government with an injection of $106 billion.
America's sixth largest bank, Washington Mutual, lost more than a third of its market value in the same week.Emergency borrowing
A short time later, 10 of America's top banks agreed to contribute a total of $90 billion to an emergency borrowing facility that any of the banks can tap if they run into a credit crisis similar to the one faced by Lehman. However reassuring that may seem, a run on any one of these banks could put all 10 of them at risk.
The unknown question is whether the US Treasury Secretary, Henry Paulson, and chairman of the US Federal Reserve, Ben Bernanke, will then stand behind the banks.
The Fed engineered the takeover of Bear Stearns by JP Morgan six months ago and, last month, bailed out the mortgage giants Fannie Mae and Freddie Mac with a $250 billion line of credit, but drew the line at rescuing Lehman Brothers and Merrill Lynch.
The impact of the crisis is being seen in rising unemployment in the US, a collapsed housing market which has spread to Western Europe and Australia, and mounting concerns that the credit crunch is bound to depress economic output. No one knows where it will end.- Peter Westmore