TWN Info Service on Finance and Development (Oct08/01)
8 October 2008
Third World Network

Finance: Crisis takes dramatic turn for the worse, despite US bailout deal
Published in SUNS #6562 dated 7 October 2008

Geneva, 6 Oct (Martin Khor) -- Despite last Friday's passage of the $700 billion bailout scheme through the US Congress, the global financial crisis has worsened. It has spread to Europe, and it has moved from finance to the real economy.

The banking crisis has spread to Europe, with many financial institutions having to be rescued in the past week, and more banks facing default and requiring multi-billion euro bailouts. Key European leaders met over the weekend but failed to decide to move from national ad hoc measures to a regional and more system-wide approach.

The result was a panic fear by policymakers by Monday that depositors may be on the verge of effecting a run and perhaps a general run on the banks.

Meanwhile, new data show that the crisis has spread from the financial sector to the "real economy", with reports of job losses and declines in GNP in various countries. The recession has arrived and the downturn will be significant.

On Monday, due to fears of recession and Europe's problems, the stock markets in Japan, Korea and Hong Kong closed 4 to 5 per cent lower. Russia had to suspend the Moscow stock market. The stock market in the UK, Germany and France opened 5% down. Iceland suspended trade in financial stocks.

Last Friday, the $700 billion bailout plan was finally approved by the United States' House of Representatives and signed into law by President George W Bush.

This was after much drama. The bill was originally rejected by the House because of intense pressure from the public who are outraged that the banking "fat cats" are being bailed out by taxpayers while house buyers are not and many are losing their homes through mortgage defaults.

After a minor touch up, both the Senate and the House passed the bill, because they were told that the US economy would totally collapse if the bailout did not take place. Under the scheme, the government can buy up to $700 billion of "toxic securities" from the banks, so that their balance sheets can improve and they can lend again.

The debate is continuing on the plan's ethical or unethical underpinning, the extent to which it will stem the crisis, and on how it will actually operate, including the conflict of interest of bank officials being hired by the Treasury to assess the prices at which to buy the toxic assets.

Despite the adoption of the US bailout plan, the crisis of the Western economies has worsened in recent days.

Firstly, more data are showing that the "real economy" is sinking. There were 159,000 jobs lost in the US in September, a five-year high. Major European economies, the latest being France, have slipped into recession. An international survey of manufacturers reported on 1 October a bleak situation, with indices showing that manufacturing output and orders seem to have fallen in September in the US, Europe and Japan.

Secondly, while most media attention has been on the US bailout, it is in Europe that the crisis has deepened, and it is now rivaling the US as the epicentre of the financial earthquake.

European countries have had to rescue six banks, some of them household names, in the space of a week. Probably the biggest shock was the failure of the giant Hypo Real Estate in Germany, necessitating a revised and bigger bailout plan on 5 October involving almost $70 billion.

Other rescued institutions (involving loans, equity or nationalization) were Bradford & Bingley (of the UK), Fortis (the Dutch-Belgian bank which owns parts of ABN AMRO), Dexia (a French-Belgian bank) and Glitnir (Iceland). This was in addition to the forced sale of two American banks, Washington Mutual and Wachovia.

Several other banks are in a precarious situation. Most prominent among these is Iceland's biggest bank, Kaupthing. Indeed, Iceland's economy is in a state of crisis and potential collapse. It suspended trading in finance-sector shares on Monday.

Unlike the US, there has been no region-wide systemic approach to stem the crisis. There is no "bailout package" offering to buy toxic assets or inject equity in a systemic level. An attempt by France for a regional approach, such as creating a European common fund to bail out financial institutions, was opposed by Germany and the European Central Bank, among others.

A finance-crisis summit on 4 October in Paris of four major European countries (France, Germany, United Kingdom, and Italy) and European institutions ended with only pledges to cooperate, but no concrete plan.

Indeed, the divergence of policies among European countries has emerged in recent days, driven by fears in each country that there will be a run on particular banks or even a general run on banks by depositors fearing not only that particular banks, but also the financial system, are facing collapse.

Depositors have become jittery as they are not sure if the banks keeping their savings are safe and whether the government will guarantee their savings (or to what extent) in the event of a failure. In the UK, for example, depositors have been "fleeing to safety" as they move their savings to banks that are owned by or fully guaranteed by the government.

When the Irish government announced that it is giving unlimited guarantee for deposits in its six domestic banks, this caused a storm in other countries, especially the UK as savers began shifting their funds to Irish banks, at the expense of other banks. Greece also announced a similar move.

The Paris summit failed to produce a common policy on guarantees for deposits. Then, Germany on 5 October, fearing a run on banks, announced a government guarantee on banks' private deposits, causing a shock in other European countries, with analysts decrying the go-it-alone policy and the lamentable absence of a common approach. Germany responded that this was only a political statement, but it is clear that behind it is a commitment to guarantee savers' funds. Denmark has also given a guarantee, and more countries are sure to follow.

Thirdly, the "credit crunch" has really worsened, in that banks and companies are now largely unable to get loans from the money markets. This in turn means that the banks are reducing loans to consumers and businesses, while companies could face financial problems as well as cut their investments.

The impact on the real economy will be devastating, as "effective demand" (made up of consumer spending and investment of companies) will significantly fall.

The credit crunch is taking place in various financial markets. The "money market", in which banks lend to one another, has been largely frozen as the banks fear that other banks may be having problems. Inter-bank loans for 3, 6 or 12 months are not available at all, forcing the banks to depend on overnight money, and to keep hunting for funds on a daily basis, an unsettling situation.

As a result, the cost of borrowing has shot up to record levels. The normal inter-bank rate is 0.08 percentage point above official interest rates. But on 30 September, the inter-bank rate was 4 percentage points higher. Although the central banks have pumped hundreds of billions of euros of loans to banks to make up for the scarcity in the money market, many banks are still short of funds.

The inability to borrow funds has contributed to the insolvency of the banks that had to be rescued.

Then there are the "money market funds," which provide short-term loans in the form of "commercial paper" to companies. There is now a virtual freeze in this market, with even top companies like General Electric and AT&T unable to tap it. In three weeks, $200 billion was taken out of the commercial paper market, and last week alone the amount lent to companies fell by $95 billion.

A turning point in the reluctance of the money market funds to lend was the experience of Reserve Primary Fund. It had lost money from its loans to Lehman Brothers, which are frozen after Lehman's bankruptcy. Reserve Primary's net asset value fell below $1.

This so-called "breaking the buck" had been virtually unheard of, as money market funds are reputed to be super-safe, and the fall of Reserve Primary made investors and funds nervous about extending more loans, even to well-known companies.

A market strategist was quoted by the Financial Times as saying that there is no area in the credit markets or banking system where companies are raising money, an "unbelievable" situation. This is problematic as the commercial paper market is where companies go to raise working capital to produce goods and services.

The crisis in money markets was added by the total collapse of the so-called $400 billion "shadow banking system", made up of "structured investment vehicles" (SIVs) which operated outside the rules of traditional banking. On 1 October, its biggest and last surviving institution, Sigma Finance, closed down.

The SIVs funded themselves with short-term debt carrying low interest rates and placed the funds in long-term investment instruments with high profits. They were thus vulnerable to the freeze in short-term funding and could not access central bank rescue funds as they were outside the official system. Banks had made use of these SIVs as their credit to them could be placed outside their balance sheets.

Fourthly, more problems are on the near horizon. For example, the $54,000 billion credit derivatives market is facing a big test this month as contracts of defaulted derivatives on failed companies like Fannie Mae, Freddie Mac and Lehman Brothers are due for settlement.

This could result in billions of dollars of losses for insurance companies and banks that offered credit insurance, according to a Financial Times article.

For example, Lehman's bonds have been trading at 15 to 19 cents on the dollar. Thus, investors who gave out protection (insuring that Lehman would not default) will have to pay out 81 to 85 cents on the dollar.

The credit derivatives market is not only huge in value but also complex in inter-relationships between institutions and counter-parties. A problem there could have wide repercussions.

Another forthcoming problem is an expected shake-up of the hedge funds. There are 10,000 hedge funds with total assets of $2 trillion. Some investors in these funds are demanding their money back, forcing a few funds to be liquidated.

According to a report in the London-based Sunday Times (5 October), the firestorm is expected to be quick and violent. Events of the past three weeks, including the collapse of Lehman Brothers (which froze billions of dollars of hedge-fund trades), a ban on short-selling stocks, volatile markets and the evaporation of credit, have created a deadly climate, said the article.

It also quotes a broker as saying that "small firms are bleeding, assets are being sold off, investors are redeeming money and the managers are scuttling off to work somewhere else."

Fifthly, the prices of oil and many commodities have fallen sharply, due to speculative forces and the fear that recession would cause a fall in demand, heralding the end of the commodities boom. A benchmark measure of commodities prices, the S&P GSCI commodity index, fell by 28.6% in the third quarter of this year, and was 5% below compared to its 1 January level.

Leading the commodity declines was oil, whose price has fallen from $140 per barrel to about $90-95. Prices of many metals and agricultural products have also been falling.

Although the lowering of commodity prices is seen as positive news for importing countries, especially developed countries, whose input prices will drop, it poses a problem for many developing counties that are commodity exporters and will be adversely affected through reduced export earnings.

Finally, the crisis has so far been focused on the developed countries, but some developing countries are being affected financially from the crisis' effects. Moreover, the weakening of the US and European economies will affect the exports of the developing world, as the fall in commodity prices already show.

The above are only some of the crucial areas in which the global economy is going off the rails. They show that the architects of the US bailout package may have hoped to resolve the financial crisis, at least in the US, at its root and once and for all, but that it is unable to prevent the multiple crises that are exploding in many places and in many aspects.

This is likely to be still the beginning stage of the crisis, and as it continues to unfold, there will be more shocks and many problems ahead. +