Global Trends by Martin Khor

Monday 6 October 2008

US bailout passed, but crisis worsens

After high drama, the US Congress finally passed a bailout package aimed at preventing an economic disaster.  But the financial and economic crisis actually worsened last week.


Last Thursday the US$700 billion bailout plan was finally approved by the United States’ House of Representatives and signed into law by President George 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 tax payers 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 be vapourised if the bailout did not take place.  Under the scheme, the government can buy up to US$700 billion of “toxic securities” from the banks, so that their balance sheets can improve and they can lend again.

Despite the adoption of the US bailout plan, the crisis of the Western economies worsened last week.

Firstly, more data showed the “real economy” is sinking.  The loss of jobs hit a five-year high in the US, while more major European economies have slipped into recession, which will deepen in future. A survey of manufacturers showed falling orders throughout the developed world.

Secondly, the prices of oil and many commodities have fallen sharply, due to speculative forces and the fall in demand, heralding the end of the commodities boom.  Developing countries like Malaysia will be affected through reduced export earnings.

Thirdly, while most media attention was on the US bailout, it is in Europe that the crisis has really deepened last week.

European countries have had to rescue six banks, some of them household names, such as Bradford & Bingley (of the U.K.), Fortis (the Dutch-Belgian bank which owns parts of ABN AMRO), and Dexia, a French-Belgian bank.

Several other banks are in a precarious situation.  But unlike the US, there is no “bailout package” in Europe.  French President Nicolas Sarkozy proposed a European common fund to bail out financial institutions, but this was opposed by Germany and the European Central Bank among others.

A finance-crisis summit of four major European countries ended last Saturday with only pledges to cooperate, but no concrete plan. 

On the ground, depositors have become jittery.  They are “fleeing to safety” in the U.K. as they move their savings from their banks to other banks that are fully guaranteed by the government. 

And when the Irish government announced it is guaranteeing deposits in its six domestic banks, this caused a storm in other countries, as people are shifting their funds to Irish banks, at the expense of other banks.

Fourthly, 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 (thus worsening the recession) while companies could face financial problems as well as cut their investments.

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.

As a result, the cost of borrowing has shot up to record levels.  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.   We can expect more banks going under in Europe.

Then there are the “money market funds,” which provide short-term loans known as “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, US$200 billion was taken out of CP, a type of short-term debt, and last week alone the amount lent to companies fell US$95 billion.

A market strategist was quoted by 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.

Fifthly, more problems are on the near horizon.  For example, the US$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 the Financial Times. 

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.

Finally, the crisis has so far been focused on the developed countries, but some developing countries like Brazil are already reporting that they are being affected financially.  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 US bailout package may help restore some confidence in the markets for a short while, but as the crisis continues to unfold, there will be more shocks and many problems ahead.