Another week of turmoil in the Western financial system

Interesting article on the ‘Sick’ financial system in the WestTongue out 

Monday March 24, 2008

GLOBAL TRENDS
BY MARTIN KHOR

After the Bear Stearns collapse and takeover, rumours caused another big bank to tremble last week. As trust erodes in the financial system, governments in Europe and the United States are considering more radical meas

LAST week, Britain’s largest mortgage lender and fifth-largest bank, HBOS, came under massive speculative attack and might have collapsed in similar fashion as the Wall Street investment bank Bear Stearns but for quick action by the British financial authorities to scorch rumours that the bank was in trouble.

HBOS lost a quarter of its share value last Wednesday after rumours swept London that it had sought emergency funding from the Bank of England. The bank was facing a potential run from depositors, which could have had disastrous effects on the whole financial system.

The Bank of England quickly rang up news organisations to deny the rumours, said to be caused by short-sellers who profited from the sudden fall in HBOS shares. The London financial authorities then announced it was investigating market manipulation. By the end of the day the bank’s share was only 7% down.

On Thursday the Governor of the Bank of England held crisis talks with the chiefs of Britain’s five biggest banks. Central bankers in Britain and Europe made available billions of dollars of liquidity in the financial markets.

As one British newspaper said, the markets “stumbled into the long Easter weekend ? as the turbulence of the week finally proved the breadth and depth of the financial crisis.”

As shown in the cases of the Britain’s Northern Rock bank (which fell when there was a run by depositors on the bank) and Bear Stearns (where investors pulled out their funds), the loss of confidence in a financial institution can cause it to collapse, and suddenly too. Bear Stearns fell and was then taken over in only a few days.

The biggest problem is that trust has been eroded in the West in financial institutions, and there is also a lack of openness in the real standing of these institutions, thereby making them susceptible to rumours that threaten to be self-fulfilling.

Two weeks ago the rumours hit Bear Stearns (which didn’t survive), last week the rumours hit HBOS as well as Lehman Brothers (another Wall Street investment bank) and both survived. Many are wondering who else the rumours will hit tomorrow.

With the situation so serious, now that public trust has been affected, the central banks of Britain, Europe and the United States are reported in the past few days to be considering radical measures to arrange for the purchase of mortgage-backed securities from financial institutions holding them, as a means to stem the spiralling credit crisis.

This would be considered a major break from the policy of non-intervention by the state, and would risk the taxpayers having to subsidise billions of dollars of losses racked up by the banks, hedge funds and other institutions.

The Western financial authorities are still only “considering” this option, which was “unthinkable” until very recently. But the fact that they are even doing so shows how desperate the situation has become.

Many economists and news analysts are now commonly talking about “vicious cycles”, for example, how the crises facing banks lead to a squeeze in credit they give out which in turn causes problems for borrowers like housebuyers and companies, which in turn worsens the banks’ problems as well as the real economy.

Lawrence Summers, former US Treasury secretary, told a seminar earlier this month that “we are facing “the most serious combination of macroeconomic and financial stresses that the US has faced in a generation, and possibly much longer than that.”

A Financial Times article on March 13 quotes Summers as describing three vicious cycles going on simultaneously:

> A liquidity vicious cycle, in which asset prices fall, people sell and therefore prices fall more;

> A “Keynesian vicious cycle”, where people’s incomes go down, so they spend less, so other people’s income falls and they spend less; and

> A “credit accelerator”, where economic losses cause financial problems that cause more real economy problems.

Meanwhile, estimates of the losses suffered by the banking institutions from the mortgage crisis are mounting.

The official estimate is US$400bil (RM1.3bil), but Summers calls that “substantially optimistic.” The economist Nouriel Roubini envisages loan losses could total US$1tril (RM3.2tril).

But the impact of these losses on the real economy will be multiple times greater.

This was illustrated by the chief economist of Goldman Sachs, Jan Hatzius, who was reported by Financial Times on March 19 as showing a chart to clients recently that predicted major banks and brokers would suffer US$200bil (RM636bil) subprime-linked losses, but the impact on bank lending would be much greater.

In the calculations, the US$200bil loss would cut bank capital by 12%. If banks shrank their balance sheets by 12% the implied reduction in overall lending would total US$2.3tril (RM7.3tril).

This estimation is in line with the “financial accelerator” concept of the Federal Reserve chairman Ben Bernanke (when he was an academic), that losses to banks and declines in the value of their loan collateral cause banks to reduce their lending and thus magnify the scale of an economic downturn, according to the Financial Times article.

Each week brings new twists and turns in the financial crisis saga of the Western countries. Fortunately the effects of the crisis have not yet been much felt in Asia. But it is a matter of time. The big question is how bad or mild these effects will be.

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About kchew

an occasional culturalist
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