The cavalry rode to the rescue of the global financial system last week. We hope this unprecedented bailout works, because nothing else has since a worldwide credit crunch tied to U.S. "subprime" mortgages began in August.
The U.S. Federal Reserve Board has cut its key federal funds rate three straight times, or a full percentage point. Henry Paulson, the U.S. treasury secretary, is trying to cobble together a superfund to quarantine the big banks' soured loans, and last week unveiled a bailout plan for homeowners who can't make their mortgage payments. Retiring Bank of Canada governor David Dodge has been trying to repair a troubled financial sector – non-bank asset-backed commercial paper (ABCP) in a deal Canadian banks completed Friday. And so-called "sovereign funds," owned by state governments hailing from Dubai and Singapore, have injected capital into ailing Citigroup Inc. and Swiss banking giant UBS AG.
That's not sound and fury signifying nothing, but it might as well be. Restorative efforts to date have failed to arrest the low-grade panic on Wall Street and in other global financial centres, where expectations of further massive losses run high. Banks, brokerages and other major financial institutions bracing for an estimated $400 billion (U.S.) in subprime mortgage losses are so gun-shy they've even stopped lending to each other, and are turning away credit-worthy prospective consumer and commercial borrowers in order to shore up their balance sheets. A sustained credit freeze of this magnitude could steer the U.S. and Canada into a recession, perhaps a severe one, by the first half of next year if the financiers' confidence in their own system isn't promptly restored. Apart from the financial wreckage, an estimated 2 million Americans risk losing their homes in the next year.
"What we are witnessing is essentially the breakdown of our modern-day banking system," Bill Gross, managing director at Pacific Investment Management Co. LLC (Pimco), writes in his latest client note. Pimco manages close to $1 trillion, and the investing acumen of Gross rivals that of Warren Buffett. His latest commentary only added to fears on Wall Street that the worst of the bad-loan reporting isn't over, even after staggering writedowns declared by blue-chip financial houses including UBS, Citigroup and Merrill Lynch & Co. Inc. Last week, Bank of America Corp. and Wachovia Corp., the No. 5 U.S. bank, declared or warned of large subprime-related losses. Canadian banks have so far taken a $1.3 billion hit.
"Credit contraction, with its inevitable companion of asset destruction," Gross writes, "is spreading with the speed of an infectious disease."
To halt the contagion, five central banks – the U.S. Fed, the Bank of Canada, the Bank of England, the European Central Bank (ECB) and the Swiss National Bank – joined Wednesday to inject as much as $64 billion of liquidity into the world financial system.
The funds will be distributed in four auctions, beginning tomorrow and stretching into January. Twenty-four billion dollars of the amount represents greenbacks the Fed is making available to the ECB and the Swiss National Bank for European clients who've coped most of this year with a scarcity of U.S. dollars. It's the biggest central-bank intervention in the global system since the aftermath of the attacks of Sept. 11, 2001, and is described by one U.S. analyst as "revolutionary" for the impressive degree of co-operation among the central banks.
"As always with central banking, the most important message is in the signal that central banks are sending," Bruce Kasman, an analyst at JPMorgan Chase & Co. wrote in his blog Wednesday. "They are telling us they are now prepared to take an aggressive and co-ordinated approach to dealing with this issue."
To get the banks lending again, the U.S. Fed-led initiative will lend money to banks at discount rates and, in an unorthodox move, accept as collateral a wide range of assets including securities not backed by government entities. "More than lowering rates in the economy, just having this banking system liquefied will make a huge difference," Wachovia CEO Ken Thompson said in a Wednesday conference. Financiers "are still fearful of each other, and everybody is worried about counter-party risk and so [banks] are hoarding their balance sheets, and this will help that."
Financiers have had ample grounds for fear. Write-down announcements by the world's biggest financial institutions have been a bad penny for months. UBS has alarmed the market more than once with fresh revelations of soured mortgage-related loans on its books. Banks thought to be free of the contagion, including London-based giant HSBC Holding PLC, have dismayed rivals with news of subprime-infected balance sheets. Canadian Imperial Bank of Commerce stunned Bay Street on Dec. 7 by revealing its $9.8 billion exposure to the U.S. subprime market.
The deep-seated problem is that no one knows exactly where the debt is, in what amount, and in what state of repair. Since the U.S. housing bubble began to inflate in 2004, something like $2 trillion worth of mortgages have been granted, in many cases to "ninjas" (no income, no job, no assets). In the case of low-income borrowers with spotty credit histories, mortgages were sold at "teaser" rates as low as 7 per cent that would eventually "reset" at as much as 13 per cent.
Foreclosures are now mounting, as the dubious mortgages begin to reset. The toxic loans, which should have been labeled "junk mortgages" yet inexplicably bore Triple-A ratings from credulous credit-rating agencies, were bundled into packages of $100 million or more and labeled ABCP and "collateralized debt obligations" (CBOs). They were then swapped and re-swapped among global banks, brokerages, hedge funds and other investors who each garnered a fee as the hot potatoes made their way around the globe.
The outcome has been one of the biggest fiascos in the financial system in modern times. "What is happening in credit markets today is a huge blow to the credibility of the Anglo-Saxon model of transactions-oriented financial capitalism," veteran money-market observer Martin Wolf wrote last week in the U.K. Financial Times. "A mixture of crony capitalism and gross incompetence has been on display in the core financial markets of New York and London."
The system itself appears long ago to have grasped the enormity of its troubles, and thus failed to react positively to the remedial actions preceding last week's dramatic central-banks bailout scheme. As recently as the day it was announced, Wall Street initially jumped for joy, pushing the Dow Jones Industrial Average up 270 points, before coming to its senses and closing the day up just 41 points, or 0.3 per cent.
The jolt has had some salutary effects, in the realm of central-bank practices. The stigma of the Fed's "discount window" has kept banks from borrowing there for fear of appearing desperate. Under last week's bailout scheme, banks are encouraged to borrow at discount rates knowing their identities won't be revealed.
Regional lenders far smaller than the New York-based "money-centre" banks will be urged to deal directly with the Fed for the first time, bypassing intermediaries. A humbled Fed is adopting tools used by the European Central Bank and the Reserve Bank of Australia, which include lending to a much wider variety of institutions and accepting a more diverse range of collateral.
Both the Fed and the Bank of Canada have hinted strongly that assistance will continue beyond January if necessary. That's not enough to satisfy Gross, who says a federal funds rate cut to 3 per cent from the current 4.25 per cent is required to head off a recession. And when the system is able finally to exhale, there will be a need to debate regulatory and other reforms – including more transparency about the quality of assets on bankers' books.
The current calamity arises from a systemic failure over, of all things, home mortgages – one of the most dead-simple financial transactions in existence. When the housing bubble was gaining altitude, lenders, regulators, debt-rating agencies, buyers of bundled mortgages and central bankers couldn't imagine that questionable loans to Sacramento trailer-home buyers could someday trigger a global credit crisis.
Even those relatively few optimists about last week's dramatic bailout efforts are counseling patience about recovering from a catastrophic blunder that has come close to crippling the global financial system.
"The big, big picture is that a bunch of people basically accepted much more debt than their balance sheets could afford," Jeff Bronchick, chief investment officer at Reed Conner Birdwell, a Los Angeles money management firm, told the Wall Street Journal last week.
"That has to be cured and it can only be cured with time."
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