This article was originally published in Maclean's Magazine on September 29, 2008
Disaster on Wall Street
Twenty years from now, everyone in the financial world will remember where they were on the weekend of Sept. 13-14, 2008. They'll talk about how they got the news and how they felt when they heard that the venerable brokerage firms Lehman Bros. and Merrill Lynch were swallowed up by the credit crisis they helped unleash. And, depending on how the next few months play out, they will remember these as the darkest days in a financial panic that was finally contained by painful bargains struck by the titans of global finance. Or they will remember it as the watershed moment when the forest fire in the U.S. financial system accelerated, and exposed the inability of authorities to control it.
"There's still a list of walking wounded on Wall Street that may or may not survive over the next month or two, depending on whether they can convince markets that they're worthy of financing," Avery Shenfeld, senior economist at CIBC World Markets, explained this week. Until recently, most observers had been relatively optimistic that the world ECONOMY would handle the credit crisis in stride. Now, Shenfeld and others are playing an uneasy game of wait and see. "I think that financial markets are anticipating future failures. The final chapters for many of these shaky companies are going to unfold over the next few weeks or months."
The shape of those final chapters remains very much up in the air. Lehman and Merrill are merely headline-grabbing symptoms of a much broader and deeper malaise affecting every market around the world to varying degrees. What began as a crisis of confidence in the U.S. housing market has tumbled and spiralled around the globe, exposing how interconnected, and dizzyingly complex, international markets have become. From Wall Street to Main Street, and in every big city around the world, the effects are everywhere, and affect everyone.
The problems began about a year ago, with the first signs that the soaring U.S. housing market was weakening. Modest increases in interest rates, coupled with a slowing of the economy, tipped deeply indebted homeowners into financial turmoil, sparking a rash of foreclosures and a rapid drop in house prices. The price of an average home in the U.S. has fallen more than 16 per cent in the past year, and there are an estimated 3.9 million unsold homes currently on the market, the most in at least 26 years. Foreclosures are now at a record level in the U.S. - with 2.75 per cent of all home loans now in the default process.
That housing funk, the worst since the Great Depression, sowed the seeds of a broader economic turmoil. Mounting loan losses forced lenders to tighten credit conditions, both for corporations and individuals, which only heightened the financial strain. The shrinking U.S. economy has lost 605,000 jobs since the beginning of the year, and in August, the unemployment rate hit 6.1 per cent - the highest level in five years.
While most experts had expected the world economy to remain insulated from the U.S. troubles, thanks to surging growth in Asia, it has become clear over the past few months that it won't. Even China's vaunted economic growth has run into problems of late. The Chinese stock market has fallen by 59 per cent this year, and last week the Chinese central bank, which had been fighting to control inflation, reversed course and cut interest rates in an attempt to boost growth and ease fears of a slowing economy. All that has combined to cool global prices of basic metals, materials and energy. Oil prices, which peaked at US$147 a barrel in July, fell to US$91 earlier this week - still pricey by historical standards but a stunning drop in such a short time period. Gold, which was flirting with US$1,000 per ounce this summer, is trading below US$800. That has put the Canadian stock market into a tailspin - down 19 per cent in three months, and 12 per cent in just the past two weeks. With manufacturers in Ontario and Quebec already suffering as a result of the U.S. slowdown, it now appears that the West's commodity-fuelled expansion could be imperilled as well. Last week economists at Scotiabank projected Canada's economy will grow by just 0.7 per cent this year, and that Ontario's economy will not grow at all.
So, with anxiety rising around the world, U.S. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke focused on the immediate problem - the imminent collapse of one of the industry's oldest and most venerable dealers. Paulson summoned 30 of the top executives in the U.S. financial industry to an emergency meeting at the headquarters of the U.S. Federal Reserve in lower Manhattan on the weekend. As dozens of black limousines idled for hours outside, the bankers received a stark and disheartening message: the U.S. Treasury would not pay a dime to save Lehman. Paulson had already tapped public money to take over the two largest mortgage guarantors, Fannie Mae and Freddie Mac (which essentially added US$200 billion to the national debt), and provided a US$29-billion lifeline to facilitate the acquisition of Bear Stearns by JP Morgan in May. In a modern-day re-enactment of J.P. Morgan's emergency summit to halt the market panic of 1907, he challenged the financiers to find their own solution. All weekend, executives urged Paulson to change his mind and kick in part of the US$85 billion or so needed to erase the bad debt on Lehman's balance sheet. But Paulson was adamant - the public purse was closed.
This was not just the Fed playing hardball. Paulson and Bernanke were trying to re-establish the concept of "moral hazard." Moral hazard is essential because if all major financial institutions believe that the U.S. government will, ultimately, bail them out no matter how badly they screw up, they will take more and more ill-advised risks, at huge cost to investors and the public. The government will be expected to pony up for a never-ending series of bailouts, and the line between private enterprise and public finance will be blurred forever.
After an exhausting and fruitless weekend, Lehman was abandoned to its fate. A 158-year-old brokerage that began in Alabama trading cotton and coffee, it survived the Civil War, the Great Depression, the 1987 stock market crash, the 1998 Russian debt crisis, the tech implosion and 9/11. But it could not survive its own outsized bets on the U.S. mortgage market and all the many exotic securities it spawned. Merrill CEO John Thain knew that his firm could face exactly the kind of squeeze that killed his erstwhile rival if housing prices and credit markets continue to worsen. Already having racked up more than US$40 billion in credit losses so far, it was time to join forces with a more stable benefactor, and Bank of America fit the bill. Merrill agreed to be acquired for US$50 billion in stock - a huge sum, but roughly 60 per cent less than the firm was worth less than a year ago. Thus ended Merrill's 94-year run as a titan of finance.
If there was any good news to be found, it's that the immediate fallout in the wake of Lehman's demise and Merrill's capitulation could have been far worse. Monday's 500-point decline of the Dow Jones Industrial Average was a bad day - the worst, in fact, since the 9/11 terrorist attacks - but it was nowhere near the nightmare scenario that some had feared. Rather than easing fears, however, it has created a sense of nervous anticipation, with investors and economists left wading through all the various implications of the crisis, wondering when and where the next shoe might drop.
Anyone who has ever found themselves in a tight financial spot knows about the Catch-22 of credit. Lenders like to loan money to borrowers who are already flush. The more desperate you are for money, the harder it is to get it. When that familiar dilemma plays itself out on a massive, global scale, you have the potential for disaster. Starting first thing Monday, efforts began in earnest to avert it.
Central banks around the world, including the Bank of Canada, pumped billions of dollars into the system to alleviate immediate cash shortages. The U.S. Federal Reserve loosened collateral requirements, making it easier for lenders to remain solvent in the short term. Ten of the world's biggest banks, including Deutsche Bank, UBS, and Bank of America, created a US$70 billion loan program as a lifeline for ailing banks.
But all those efforts did little to dispel the fear at the heart of the market. "The Fed has made a lot of credit available, but no one wants to use it because there's still fear that whoever you lend it to is going to go bankrupt," Dan North, chief economist of credit insurer Euler Hermes in Owings Mills, Md., told Bloomberg. Tuesday afternoon, the Fed released more bad news: it would not cut interest rates, for fear that doing so would spark inflation. And so, although there is plenty of money around to borrow, the cost of borrowing it remains high - especially for those struggling firms that need it the most.
Each day, more casualties lurch forward like victims in a horror movie. Washington Mutual, the biggest savings and loan in the U.S., had its credit ratings cut to junk-bond status over fears it will need to raise more cash in order to cope with as much as US$19 billion in debt linked to bad mortgages. All over the U.S., smaller regional banks are locked in their own life-and-death struggle to raise capital and remain solvent. But the biggest fears revolve around American International Group, one of the world's biggest insurance companies. Facing huge losses tied to the mortgage market, AIG spent this week in a desperate race to raise as much as US$70 billion to shore up its finances. When it came up empty Tuesday night, the U.S. government reversed itself and provided a US$85-billion loan to save AIG, in return for a majority stake in the company. So much for Paulson's commitment to moral hazard. It lasted roughly 48 hours. But the alternative may have been worse. "There are no buyers," said Eric Sprott, chief executive of Sprott Asset Management. "Nobody wants to buy someone else's mortgage, or someone else's loan or someone else's [investments]. Everyone is trying to de-lever at once. They've all got the same problem."
The nightmare scenario that Sprott and others describe is a sort of domino effect that continues to send pain spiralling throughout the economy and around the world. Lehman must now sell and dispose of almost US$700 billion in assets - including millions of complex investments and agreements, the value of which is extremely difficult to determine. If all those assets come pouring onto the market at once, it could devastate their value, forcing other banks, insurance companies and hedge funds to write down the value of their investments, meaning bigger losses, falling stocks and worst of all, more credit-rating downgrades. That in turn triggers the need for more asset sales, and even tougher lending conditions. If it gets even more difficult for people to borrow, recovery becomes impossible, and another domino falls. Had AIG been allowed to fail, observers say the repercussions would be far, far greater than in the case of Lehman. "Right now, we're still caught up in this vicious cycle of falling house prices, tightening credit standards, weakening demand for houses and therefore more pressure on house prices," says Sal Guatieri, senior economist at BMO Capital Markets. "That feeds back into weakening credit markets and a weakening economy. They're all reinforcing each other on the way down much like they did on the way up. We're certainly not at the bottom of that vicious cycle yet and we may not be until later this year, or early next year."
Already, many are laying the blame at the feet of government and the Federal Reserve, not just because they refused to bail out Lehman, then agreed to save AIG, but because officials seem to have misunderstood the sprawling implications of a falling real estate market. "That just leads to inadequate responses. That's why the thing just grinds on," says Brian Bethune, chief U.S. economist at Global Insight. "Even the Federal Reserve, right from the get-go, has underestimated the scale and scope of this crisis. The real worst case is you have another couple of institutions that fail and that triggers a domino effect in the financial system on a scale that's not been seen since the Great Depression. That is the worst-case scenario plain and simple."
There is another school of thought, however, and more and more observers are willing to predict that while the problems are far from over, we may now be on the long road to recovery. They say the disappearance of Lehman and Merrill, while regrettable, is good news because it allows stronger players to get on with the business of rebuilding confidence and separating the truly toxic from the merely depressed. "You have to stand back, take a deep breath, and say look, the outlook isn't great, but the financials in the U.S. had the biggest correction since the Great Depression," says Murray Leith, director of investment research at Odlum Brown in Vancouver. "Bad banks are being absorbed by good banks, or by government, so the overall health of the financial system is actually getting better. A lot of these banks have businesses that are making good money. I think you'll see more of a coordinated effort by central banks to reflate the global economy, and I think, ultimately, they'll succeed."
Indeed, that coordinated effort is already well under way. The hope is that with central banks and private lenders making tens of billions available to cover short-term cash shortages, confidence will gradually return, and any remaining failures will be relatively small and isolated. And Paulson's plans to save AIG demonstrate an extraordinary (some might say reckless) determination to stave off a market crash at almost any cost.
If those efforts pan out, then we will look back on this week as the beginning of a golden opportunity for prudent, long-term investors to buy decent assets at fire-sale prices, setting the stage for a rebound. Tighter regulation of the industry will undoubtedly follow, with restrictions on the worst forms of speculation that devastated so many. The key to recovery, observers say, is real estate. Prices need to stabilize and defaults need to slow in order for lenders to get back on their feet and put this nightmarish year behind them. There are many who are willing to bet that that stabilization is near at hand. "My personal opinion is that this is as a bad as it's going to get. I'm not going to predict the bottom to the day, but I don't think it will get much worse," Ted Rechtshaffen, president and CEO of Toronto's TriDelta Financial Planners, said last week. "I'm buying now and I'm not alone. When a crisis hits main street, and main street starts to panic, you know you're near the bottom."
If Rechtshaffen is right, then Henry Paulson may well go down as one of the shrewdest treasury secretaries in the modern era. He will have successfully defused the biggest financial panic in generations and prevented the outright collapse of the mortgage system - albeit at the expense of moral hazard.
If it goes the other way, if more failures lead to more asset sales, more foreclosures and a deepening crisis, then Paulson will have put U.S. taxpayers on the hook for hundreds of billions of dollars for nothing, and there's no telling where that rabbit hole leads. Then we will look back on last weekend with deep regret, and Paulson will be the one who let the fire spread beyond anyone's control.
Hero or Nero. The stakes could scarcely be higher.
See also BANKING.
Maclean's September 29, 2008