Service on Finance and Development (Oct08/01)
Crisis takes dramatic turn for the worse, despite
banking crisis has spread to
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.
Monday, due to fears of recession and Europe's problems, the stock markets
Friday, the $700 billion bailout plan was finally approved by the
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.
a minor touch up, both the Senate and the House passed the bill, because
they were told that the
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.
the adoption of the
more data are showing that the "real economy" is sinking.
There were 159,000 jobs lost in the
while most media attention has been on the
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
rescued institutions (involving loans, equity or nationalization) were
Bradford & Bingley (of the
other banks are in a precarious situation. Most prominent among these
finance-crisis summit on 4 October in
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.
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
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
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.
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
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
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. +