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US Financial Market Meltdown
Friday, 26 September, 2008
SAY good-bye to Wall Street as we knew it, said The Wall Street Journal (WSJ) in an editorial. In a flash, five giant investment banks have "ceased to exist," -- transforming themselves into, or being absorbed by, conventional big banks.
"This has been the worst financial crisis since the Great Depression. There is no question about it," said New York University economist Mark Gertler.
What really has happened with Wall Street? It has been a near earth-shattering -- even historic -- week for US and world financial markets. The 158 year old US investment bank, Lehman Brothers, collapsed and the Bank of America bought Merrill Lynch -- another Wall Street icon --in a $50 billion deal.
Markets were seriously shaken as the American International Group (AIG) -- the largest insurance company in the world -- was stressed to secure a $40 billion bridge loan (an interim financing for an individual or business until permanent financing is guaranteed) from the Federal Reserve (the US Central Bank, in short, the Fed) ahead of a possible downgrading of its credit worthiness.
What really set-off the meltdown, and why this matter to the average citizen appears mind boggling - very intricate, if you will? Almost every expert agrees that much of the debacle is rooted in too much greed-driven risk taken by the CEOs of these and many other firms. Assets -- real or financial -- were over-assessed, loan worthiness of borrowers was over inflated, and credit cards charging maxed out. People were living well beyond what their income and wealth could support.
The crisis originated from the unbridled growth in sub prime mortgage -- a loan that didn't meet the legal requirement.
Fannie Mae -- the Federal National Mortgage Association -- was created in the 1930s to facilitate homeownership in the US by buying mortgages from banks, freeing up cash that could be used to make new loans. Fannie and Freddie (FAF), which does pretty much the same thing, now finances most of the home loans being made in America.
Although FAF is private companies with stockholders, they're "government-sponsored enterprises" established by federal law. As a result, FAF enjoys special privileges -- the most important is the belief of investors that if FAF is threatened with failure, the government will come to their rescue, because they enjoy implicit government loan guarantee.
In that case, one wonders, how did they get into this mess? The answer is the sheer scale of the housing bubble and the magnitude of the unabated price declines that caused the bubble to burst. The result is an alarmingly rising rate of delinquency.
FAF drove the explosion of the sub prime housing market by buying up literally hundreds of billions of dollars in substandard loans.
By passing up all the old rules, FAF gobbled up the mortgage market. Using unusual leverage, they ended up holding 90% of the secondary market mortgages. That raised their total portfolio of loans to $5.4 trillion -- nearly half of all US mortgage lending. They borrowed $1.5 trillion from US capital markets with an "implicit" government guarantee of the debts.
No real market can have such an accelerated growth for that long without being fixed. And that's just what FAF was -- fixed. They essentially became a government-run, privately owned, home finance monopoly.
In the near-term, adverse effects for both developed and emerging markets are unavoidable. Experts predict that the market meltdown has triggered cascading effects:
- Asset prices have fallen in financial markets around the world.
- The threat to global economic growth has increased.
- Volatility in currency markets has surged.
- Banks will take heightened risk aversion stance, which will restrain banks' access to capital and thus slow down lending.
- Consumer credit will become more restrictive, making projected global growth of 5%-6% unattainable.
Because of credit tightening everywhere, tanking stock markets are sinking corporate valuations, and there are fewer investment bankers operating these days.
Financial firms unaffected by the market predicament will be much more cautious in extending credit to normal firms and individuals. So, even for people and firms whose credit standings have not changed much, their cost of the credit is also going to rise.
In their September 18 WSJ article, Senrath, Serena, and Paletta said that the Fed and US Treasury have diagnosed the market virus -- over-leveraged financing (debt financing) - and also found the cure - which is de-leveraging, that is, unwinding (undoing) of debt.
During the credit boom, financial institutions and American households went on a spree of borrowing. Between 2002 and 2006, household borrowing grew at an average annual rate of 11% -- by far outpacing the overall economic growth. Financial institutions' borrowings grew by a 10% annualized rate. A multitude of loan defaults - aggravated by the crumbling housing prices - made the home value fall below mortgage loan, culminating in foreclosure.
To deliberate the process to an end at least three things need to be done, and they're not easy to accomplish all at once.
- Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money.
- They need to pay off debt.
- Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets.
On September 20, U.S. Treasury Secretary Henry Paulson with the Fed Chairman Ben Bernanke on board proposed a $700 billion market bailout plan -- the largest intervention in the history of the U.S. financial system aimed at supporting the private sector.
While presenting the bailout plan to Congress, Paulson warned that the nation's still-frozen credit markets were very fragile and Congress must act swiftly to pass the package to halt further proliferation of the market meltdown.
But no done deal came through as of Saturday, September 24. Debates about bailout recipients, who would in fact benefit from the anti-crisis measures, erupted in the Congress. President George Bush finished his address to the nation explaining the origin of the crisis and urging a bipartisan passage of the package. Some form of the deal is expected to pass before the market opens on Monday to avert market instability and a potential total collapse of the banking operation in the US.
Source: http://www.thedailystar.net/