What the government's done

Friday, October 10

The level of government intervention resulting from the financial crisis has no recent US precedent. The sum of the liabilities assumed by federal authorities during the past six months -- from transactions involving mortgage giants Fannie Mae and Freddie Mac, the insurer AIG, investment bank Bear Stearns and eleven failed regional banks -- now exceeds 50% of GDP. Treasury Secretary Henry Paulson's 700 billion dollar financial sector rescue plan, which was finally approved by Congress on October 3, could push the fiscal deficit in 2009 up to 1.5 trillion. However, the eventual scale of government intervention is likely to be much larger.

Market conditions continue to deteriorate rapidly. Nevertheless, there are several conclusions that can be drawn about the likely course of events:

Beyond liquidity.

Access to the Fed's discount window, or its newer 'term-auction facility' does not guarantee that an investment bank can escape bankruptcy. When the Fed opened its window after Bear Stearns's involuntary merger with JP Morgan Chase, Wall Street generally believed that it would protect Lehman Brothers from the sort of liquidity shocks that overwhelmed Bear. Lehman took advantage of this optimism to raise several billion dollars of new capital during the second quarter. However, this confidence was misplaced.

Derivatives challenges.

The Lehman bankruptcy has been far more destabilising than federal authorities believed, due to its status as a prime broker and its role as counterparty in a huge number of over-the-counter (OTC) derivatives contracts. The fact that Barclays will purchase Lehman's brokerage operation may help to contain some of the damage done by the bankruptcy of the parent company. However, as Lehman had assets of 691 billion dollars (compared, for example, to 103 billion dollars for WorldCom and 63 billion dollars for Enron), there will be further casualties. The forced sale of approximately 60 billion dollars of assets on Lehman's balance sheet could further depress the value of some securities, and associated derivatives.

Piecemeal intervention fails.

The authorities' piecemeal, largely reactive approach to the crisis has not worked:

• The Securities and Exchange Commission (SEC) has banned short sales on more than 800 financial stocks.

• The Treasury has announced it will use 50 billion dollars from the Exchange Stabilization Fund to back money market funds whose asset value falls below 1.00 dollar per share.

There was clearly an attack on Bear and Lehman from hedge funds and other financial players who hoped to profit from their demise. The government has not had time fully to investigate the activities of the hedge funds or formulate a strategy for controlling them, but recent events are certain to provoke an ongoing debate about their potential to disrupt markets. Short-selling is a key trading tool and hedging device, and often helps to stabilise markets -- but the political backlash will pose major challenges for the hedge funds industry.

De-leveraging beyond Wall Street.

The major reduction in leverage now occurring on Wall Street is rapidly spreading to Main Street. The assets of US investment banks increased from 5% of GDP during the late 1970s to 25% of GDP in 2003. This has recently shrunk to 23%, and will plunge in the year ahead. Meanwhile, the debt of the household sector has increased from 60% of GDP during the early 1990s to almost 100% last year. Household borrowing is still positive, but the growth rate has plunged from nearly 1.2 trillion dollars per annum three years ago to just 500 billion dollars; consumer borrowing actually dropped in September for the first time since 1998. Corporate debt also increased from 53% of GDP during the mid-1990s to over 70%. All of this leverage is likely to be significantly wound down in the year ahead.

The current US de-leveraging spiral is more than a mere liquidity crisis: it is systemic, and thus the piecemeal government intervention generally pursued thus far has failed. Using the 700 billion dollar bailout package to recapitalise banks by taking direct equity stakes is a start, but arresting economy-wide de-leveraging will require more major fiscal policy and regulatory responses.