Tuesday, October 14, 2008

Financial crisis: If you thought the worst was over think again

The roar was visceral: a gutsy grunt of defiance. For a few heady minutes on Friday afternoon, traders on the floor of the New York Stock Exchange cheered aloud as they briefly heaved the stock market into positive territory.

The effort was Herculean: a dwindling band of optimists pouring billions of dollars into a few selected shares in the hope of encouraging others to rally round. Twice they succeeded, only to see the forces of panic overwhelm them each time.

Finally, New York closed for the weekend, once again in the red: bringing temporary relief to a global rout that has reduced the value of most international markets by a fifth in just five brutal days.

Listening to the animal language of the trading pit, it is easy to forget that securities trading is just a mathematical invention – nothing but the abstract agglomeration of pricing data.

The sober Reuters wire service wrote on Friday of investors being “castrated”. Scandinavian bank Enskilda warned clients that markets were “at riot point”. “It’s like someone cancelled gravity yesterday,” added one London trader.

Goldman Sachs boss and Wall Street cheerleader Lloyd Blankfein spoke of “unlimited pessimism”. Surely no mere human construct can behave so uncontrollably?

The sense that humanity is instead grappling with a monster – a marauding Godzilla leaping from Tokyo to London then Wall Street, in single bounds – is compounded by the apparent failure of both national and international rescue attempts.

It feels an age since the US and UK governments each committed £400,000,000,000 of our money to bailing out the markets: the euphoria that followed lasted barely hours.

Hopes that the G7, IMF or EU will do much better this weekend are almost as low as the markets themselves. Our biggest guns are bouncing harmlessly off this force of nature.

For many bystanders, the drama is compelling. Newspapers and TV channels report the crisis much as they did Hurricane Katrina or the Indonesian tsunami: a mixture of shock, awe and lots of computer-generated graphics. We know in our hearts that this will hurt us all, but the lingering feeling that the world has changed for ever in just 30 days leaves us giddy.

The anxiety is also contagious. No matter how secure one’s personal finances, it is impossible not to feel a frisson of panic at the thought that bank ATM machines might run out of cash, or pay-cheques might vanish into the ether: both very real prospects until the Government stepped in to underwrite the bank clearing system on Tuesday. Even now, there are scenarios so destabilising they are barely mentioned.

Our fear explains why Friday’s sell-off was so brutal. This delayed reaction to a month of almost unbelievably bad news in the credit markets was driven primarily by ordinary investors – Mr & Mrs Average finally deciding to cash in their pension nest egg for fear it might be cracked beyond repair by Monday.

All round the world, fund managers reported a huge surge in customers demanding their money back. The professionals panicked long ago.

Ironically, the worst of the financial crisis may, just possibly, have passed. Friday also exhibited many of the hallmarks of what market historians call “capitulation” – the moment when even the optimists lose hope.

The sad lesson of past stock-market crashes is that the point when ordinary punters finally realise it is time to get out usually marks the point when it is time for the smart money to get back in again.

But the difference now may be in what happens beyond the financial markets. Usually, a banking crisis follows some form of economic crisis: lenders are hit by wave after wave of customer bankruptcies until they themselves cannot take any more and topple over. This time, the banking collapse has preceded the recession.

Although the crisis started with the default of some sub-prime mortgages in the US, the scale of the global market losses (and government bail-outs) long ago exceeded the size of the initial defaults.

Instead, last week’s stock market rout marked the point when the usual direction of cause and effect was reversed: now it is the real economy that is expected to take its cue from the markets.

Countries could be next to see their solvency questioned. Iceland is already seeing its currency under attack. Difficult places such as Pakistan, Ukraine and Kazakhstan are looking vulnerable – with devastating consequences for political stability.

Even Britain and the US are seeing the price of credit protection soar as investors worry whether they can afford to bail out the banking system.

Then there is the commodity boom. A bubble in the market for oil is coming to an equally abrupt end, as the slowing world economy reverses the imbalance of supply and demand that drove crude to such giddying prices only a few months ago.

Mining companies were also among the biggest casualties of last week’s stock-market collapse because investors expect China to cease its breakneck industrial growth.

General Motors, once the world’s largest carmaker, is one of several colossal companies on the verge of bankruptcy. It has already temporarily shut down its European factories to preserve its precious cash reserves.

The knock-on effects on the rest of the manufacturing world are rippling out rapidly. Companies bought by private-equity investors are especially vulnerable because they typically rely on a ready supply of debt.

In Britain, there is particular weakness in the property, construction and retail industries. Quite apart from more systemic problems in the banking industry, the loss of thousands of highly-paid financial jobs in the City will deal a devastating blow to London’s economy. Job losses will further impact consumer spending – leading to yet more job losses.

Scary as it may sound, in many ways this is more familiar territory than the pure financial crisis of recent weeks. Economic recessions come and go every few years and we know that the downward spiral cannot continue forever.

This downturn may last longer than that of the early 1990s, but anyone who remembers the horrors of the 1970s knows we are still a long way from three-day weeks and the lights going out.

The real mystery is how the negative feedback loop in the financial markets became so devastating. How could this domino effect happen so quickly?

How could we lose control of something we designed to serve us? One answer is that this is what happens when we allow debt to get out of hand. This is not a natural disaster, but a man-made calamity caused by excessive leverage.

To see the multiplying effects of leverage in action, just look at the behaviour of our big banks in recent days. The reason they have stopped lending cash to each other is not just because they fear for the survival of others, but because they desperately need whatever cash they have to meet mounting obligations of their own.

Last month’s collapse of Lehman Brothers, for example, caused a delayed stampede for cash on Friday because the banks who had offered insurance against a Lehman bankruptcy were forced to pay out. Similarly, the big banks are facing huge calls from some of their big business customers.

These customers long ago arranged emergency overdraft facilities in case other means of finance became temporarily unavailable. Suddenly, everyone wants money out of the banks at the same time.

All the while, the banks’ ability to raise fresh money is being crippled by the fall in the value of their own share prices. Watching these pillars of the financial community lose 25 per cent or more in value during a single day is a huge deterrent to anyone thinking of putting money on deposit , let alone invest directly in new bank shares. For this reason, even the Government rescue plan is looking more problematic by the day.

The plan, outlined by Gordon Brown and Alistair Darling on Tuesday, envisaged banks first turning to their own shareholders for more funds, and then asking the taxpayer to top up any shortfall.

Yet the subsequent fall in the share prices of Royal Bank of Scotland and HBOS has made the numbers harder to square. Ultimately, if the sum of money injected by the Government exceeds the market value of the bank, it becomes hard to describe the process as anything other than nationalisation.

So far, the Government has avoided using the 'n’ word at all costs – not least as it tries to encourage other governments to inject money directly into their banks, too.

Prime Minister Brown has drawn a clear distinction between what happened to Northern Rock and Bradford & Bingley – which were taken fully into public ownership – and what he expects to see at HBOS, RBS and others – which will be more akin to a temporary investment.

But the vexed question this weekend is why the price of shares in these companies has continued to tumble since the Government announcement. Surely if investors believed the public stood four-square behind them, they would stop panicking?

Unfortunately, they haven’t. Worse still, investors may well be behaving perfectly rationally in continuing to dump bank shares. Given the colossal demands on bank cash both now and for the foreseeable future, and given the growing gap between these demands and the cash available, it is quite possible that several of our biggest banks are literally worthless. In this case, nationalisation becomes the only alternative.

The implications for the future of the banking industry hardly bear thinking about. Running two big mortgage lenders (Northern Rock and B&B) is quite enough for the Treasury already, but being placed in charge of a major clearing bank like RBS could require the type of Whitehall intervention in the economy not seen for a generation.

The politics of it all are not pretty, either. Taxpayers might be able to afford it (just) but they are not going to like it. Bonuses are also set to become a toxic political issue just as they proved a toxic financial issue.

It is easy to say that the bankers directly involved should lose their bonuses – or their jobs – but what about others who have made money, or the sought-after professionals necessary to pick up the pieces?

Wall Street legal fees for handling the Lehman bankruptcy are estimated to cost more than $900 million (£530m) – with some lawyers charging $950 an hour each. How will that go down in Britain when compared with typical public-sector salaries?

Meanwhile, those who work in the City can only look on with horror. Some remain frantically busy. An unlucky few have already been made redundant. Most are simply staring, like the rest of us, in slack-jawed horror at the screens in front of them.

Until this passes, all normal rules of business, such as seeking to maximise the return on investment, are suspended. “It’s not the return on our money we’re worried about any more,” said one banker last week. “It’s the return of our money.”

By Dan Roberts

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