Global Trends by Martin Khor

Monday 22 Sept 2008

The week global finance almost collapsed

At astonishing pace, one iconic financial institution after another was collapsing in a week the system almost fell apart, with speculators being blamed.  A U.S. rescue package emerged to save the situation, but will it work?


What a tumultuous week for the global financial markets!   It saw an astounding series of shocks, with one giant financial institution after another facing collapse.

The system itself was like a car racing to a cliff.  But just as it was about to fall to total disaster, the United States financial authorities announced the setting up of a government vehicle (“bad bank” in the current term) to buy up the “toxic mortgages” from banks and also inject fresh capital into banks facing capital shortfall, a move that will cost US$700 billion.

This solution sounds a lot like the Danaharta and Danamodal agencies that Malaysia established during the financial crisis a decade ago.  The first took over the banks’ non-performing loans and the second recapitalised some insolvent banks. 

These moves helped revive the troubled local banks and enabled them to lend again, thereby contributing to Malaysia’s economic recovery.

The U.S. announcement last Friday led to a euphoric boost to stock markets around the world.

And so the global markets live to fight another day, after a ghastly week during which one Wall Street bank (Lehman Brothers) collapsed, another bank (Merrill Lynch) had to undergo emergency sale to prevent failure, the world’s largest insurance company AIG

was taken over by the US authorities through a US$85 billion funds injection, and the U.K. bank HBOS was taken over by Lloyds  to avoid collapse.

Three of the five big Wall Street investment banks had closed, and the two remaining ones, Morgan Stanley and Goldman Sachs, were also facing a crisis as their share values were falling sharply.   

The crisis spread to other areas, including the freezing of the money market (in which banks lend to one another) and the fast increases of risks in the credit default swap market.

The western financial system was unravelling.  What had been considered its strengths were now proving to be its Archilles Heel.

The deregulation of financial services had led to the expansion of risks.  The introduction of one exotic and complex financial instrument after another decreased the quality of loans while increasing the risks of default and the spreading of these high risks to a widening range of financial institutions.  The cheap credit policy also led to bubbles in property and stock markets.

The sub-prime mortgage crisis was the spark that set off the fires that destroyed several iconic companies and now threaten to engulf the whole system.

The crisis was also fuelled by “short selling”, a favourite practice of hedge funds and other speculators to make quick profits by targeting vulnerable companies and institutions.

They use short selling not only to bet on a trend that the share prices of the companies would decline, but also to influence and even determine that trend.

On 19 September, short selling in financial companies was temporarily banned by the U.S. Securities and Exchange Commission.  This followed a similar ban by the U.K. Financial Services Authority a day earlier.

The SEC chair Christopher Cox said the commission is “committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets.”  Earlier he said the rules are needed “to ensure that hidden manipulation, illegal naked short selling or illegitimate trading tactics do not drive market behaviour and undermine confidence.”

Short selling is now pin-pointed as the major cause of the dramatic falls in the share prices of huge financial companies and banks including Lehman Brothers (which collapsed last Sunday), Merrill Lynch, HBOS, Morgan Stanley and Goldman Sachs.

The fall in their equity prices caused the market value of these firms to drop sharply, threatening their viability.     

Short selling is a practice in which the speculator borrows the shares of a company and then sells them at the current price in the expectation that the share price will drop.  The speculator then purchases the shares at the reduced price to deliver, and makes a profit.

In “naked short selling”, shares are not even borrowed by the speculator, who sells shares that he neither owns nor has borrowed.

In selling large quantities of the shares of the targeted companies, the speculator in fact influences the prices of the shares to go down.  Short selling can force share prices to fall below what is justifiable by economic fundamentals.  This destroys market and public confidence in a company which then faces collapse.  Without the short selling activity it may have survived. 

During the present crisis, as the shares of one big company after another have been targeted and fallen, the U.S. and U.K. regulators finally recognised the manipulation involved and banned the practice as applied to financial firms.

However, short selling is still allowed in other sectors.  It is also so ingrained in the financial culture and system that the authorities were careful to stress that the ban is only temporary.

During the Asian financial crisis a decade ago, the affected Asian governments blamed currency speculators (operating through hedge funds or through the currency operations of commercial banks and other financial institutions) for attacking their currencies through short selling and in doing so bringing the rates of the local currencies far below their real economic levels.

At that time, Western governments and the IMF dismissed the claims of the Asian governments, arguing that their financial crisis was due to economic mismanagement and denying that speculation and the short-selling of currencies played any significant role.

Short-selling has continued and expanded as a routine and legitimate method of financial operation in the stock, commodity and currency markets.  

As the global financial centres in London and New York take action, the developing countries should take note and quickly consider regulation and restraints on short-selling, as it is also very prevalent in these countries’ financial markets, where the practice has already wreaked havoc in the past.

According to the Guardian (London), short sellers betting on a drop in the Lehman Brothers share price made a windfall profit of over $3 billion when the investment bank filed for bankruptcy protection on 15 September.  Even bigger gains were made by short sellers when Bear Stearns collapsed in March.

The Financial Times commented the smashing of the world’s largest insurer and the world’s most prestigious investment banks were supposedly done by short sellers. 

“They short a bank stock, the price falls, the bank’s credit is downgraded, forcing it to sell assets at firesale prices.  This weakens its capital, the stock falls further, and so on.  In practice short-sellers are short anything with leverage.  Yet by doing this they ultimately short themselves.”      

With the two worst hit countries (the US and UK) taking action, it remains to be seen whether regulators in other countries, developed and developing, will also take similar action against short selling, including bans and disclosure requirements.