Though it has been more than a year since the sub-prime
crisis in the US mortgage sector came to light, the
meltdown in global financial markets, especially its
Wall Street frontage, persists. Just days after the
Treasury and the Federal chose to nationalise Fannie
Mae and Freddie Mac and pump in as much a $200 billion
to keep them solvent, troubled Lehman Brothers Holdings
Inc., the fourth largest investment bank on Wall Street
came to the table with requests for support. This was
to be expected, not just because of the nationalisation
of the government sponsored enterprises (GSEs) in the
mortgage market, but because of the role that the Federal
Reserve and the Treasury had taken on to inject liquidity
into the market and support and part finance the merger
of Bear Stearns with J.P. Morgan Chase. Even when the
Treasury Secretary declared that the government was
unwilling to bail out Lehman, and tried arm twisting
the big banks to buy into the company, the effort failed
because it was not willing to underwrite the process
with tax payers’ money.
What followed is the beginning of a tale still being
told. The 158-year old Lehman filed for bankruptcy and
Merrill Lynch, one more Wall Street icon, chose to pre-empt
a similar fate befalling it by deciding to sell out
to Bank of America in a $50 billion all stock deal.
That may appear a good price relative to its then prevalent
market capitalisation of $26 billion, but was way below
the $80 billion high it had reached during the previous
52 weeks. Meanwhile, the insurance and investment management
major AIG (American International Group) has been struck
by a major ratings downgrade and is in Fed mediated
talks to secure a $75 billion line of credit that would
help cover the additional collateral it would have to
provide it derivatives trading partners because of that
downgrade. If that line of credit does not materialise
(or perhaps even if it does) AIG too is heading towards
What accounts for the recent spate of problems? All
of them are related to the now-not-so-new sub-prime
crisis and the unwillingness of both the institutions
concerned and the regulators to properly assess the
effects of that crisis on their financial viability.
On the contrary, they have been strenuously engaged
in concealing those effects. Consider for example Fannie
Mae and Freddie Mac which acquire mortgages from banks,
housing finance companies or other financial institutions,
so as to keep lending for housing acquisitions going.
According to reports, just before they were placed under
conservatorship, they together held or backed $5.3 trillion
in mortgages. What is more with the mortgage markets
facing a credit squeeze over the last year, they were
providing 70-80 per cent of new mortgage loans. To undertake
these activities, these firms were indebted to a range
of creditors, credit from many of whom would freeze
up if these GSEs defaulted on their commitments. Any
effort on the part of these creditors to sell their
debt would result in a decline in value that would threaten
the financial viability of many of them.
Thus, there were two important reasons, among many,
why these institutions could not be allowed to close.
First, mortgage credit would dry up resulting in a collapse
of the already declining prices in the housing market.
Second, the fall out for the viability of other financial
firms and the stability of financial markets could be
dire. An implication was that institutions such as these
should exercise caution in their operations and be subject
to stringent supervision, neither of which seems to
have been the case. Managers who paid themselves fat
salaries and bonuses backed suspect mortgage loans and
bought into suspect mortgage-backed securities on the
presumption that defaults would be low. And regulators
not merely turned a blind eye to such activities but
missed the use of accounting practices, which though
not in violation of rules, overestimated the capital
resources and financial strength of these firms. At
the time of the nationalisation, losses on mortgage
related securities were estimated at $34.3 billion in
the case of Freddie and $11.2 billion in the case of
Fannie, both of which were kept out of calculations
of regulatory capital by treating them as temporary
losses. On the other hand, these losses were used to
generate deferred tax assets on their balance sheets
on the assumption that they would make large enough
profits in future, so that these losses can be offset
against the tax to be paid on those profits. The fact
of the matter, however, was that these firms were on
the verge of insolvency, and ended up needing huge taxpayer-financed,
bail-out packages to survive.
The Fannie and Freddie experience illustrated a larger
feature of the increasingly deregulated financial markets
across the globe: the tendency to exploit easy liquidity
conditions to leverage investments in areas varying
from housing and real estate to stock and derivatives
markets. According to Lehman Brothers’ bankruptcy filing,
it owes more than $600 billion to creditors worldwide.
With much of that money being invested in mortgage-backed
securities, the collapse in the value of those securities
must have increased demands for additional collateral
that Lehman was hard pressed to find. It contemplated
sale of either parts of its business or of equity, with
the state-controlled Korea Development Bank emerging
a potential suitor. When that did not work, the value
of Lehman’s shares collapsed, touching less than $10
a share as compared to $80 in May-June 2007, making
it even more difficult for it to find additional funding.
Lehman then sought a solution in a “innovative” scheme
of hiving off its real estate assets originally valued
at $30 billion into a separate public company that would
look for a suitor. That would have helped save the parent.
But when that too failed to materialise bankruptcy seemed
a real possibility.
This forced the Treasury and the Fed to bring other
private financial institutions to the table, as it did
a few years earlier with Long Term Capital Management,
to work out a takeover or at least an acquisition of
the worst bit of the firm’s assets with some help from
the Fed. The offer of marginal support from the Fed
and the Treasury proved inadequate, because the institutions
concerned were unsure whether this could stall the crisis
creeping through other firms as well. The Treasury on
the other hand, had had enough of using tax payers’
money to save firms that had erred their way into trouble.
The refusal of the state to take over the responsibility
of managing failing firms sent a strong message. Not
only was Lehman forced to file for bankruptcy, but a
giant like Merrill Lynch that had also notched up large
losses due to sub-prime related exposures decided that
it should sort matters out before there were no suitors
interested in salvaging its position as well. In a surprise
move, Bank of America that was being spoken to as a
potential buyer of Lehman was persuaded to acquire Merrill
Lynch instead, bringing down two of the major independent
investment banks on Wall Street. With Bear Stearns already
dead, that leaves only Morgan Stanley and Goldman Sachs,
whose fortunes too are being dissected on Wall Street.
Whether they too would disappear into the vaults of
some large bank is an issue being debated.
This is, however, only part of the problem that Lehman
leaves behind. The other major issue is the impact its
bankruptcy would have on its creditors. Citigroup and
Bank of New York Mellon have an exposure to the institution
that is placed at upwards of a staggering $155 billion.
A clutch of Japanese banks, led by Aozora Bank, are
owed an amount in excess of a billion. There are European
banks that have significant exposure. And all of these
are already faced with strained balance sheets. More
trouble in financial markets seems inevitable.
This, therefore, is truly the end of an era. The independent
investment banks are under threat. The state is no more
seen as an agency that can buy its way out of any crisis.
And the crisis that has dragged on for more than a year
just refuses to go away. But all this still seems inadequate
to force a rethink of the financial liberalisation that
triggered these problems.