America on the brink
WHAT a few weeks it has been, banks and financial institutions in the US, and to a lesser degree around the globe, are falling like nine-pins. Suddenly, the whole global financial system looks shaky and crumbling. Nothing seems safe and banks, strangely but understandably, least of all.
The very institutions that are supposed to keep our money safe and make it grow are perversely doing just the opposite. The top global financial institutions, principally from the US, which include banks, investment banks, hedge funds and even boring, conservative insurance companies, have been gambling away depositors' and shareholders' money with reckless abandon.
To think, today, that these institutions are run by some of the smartest people can only sound like a bad joke. This ramifications of this disaster in the US are just too big to fathom.
What is really happening is a chain reaction that started off from assets created by bad mortgage lending of almost $1 trillion; that got bought all over the world, principally in the US, by a whole array of financial institutions because of its attractive yields and supposedly high credit quality.
When these assets became toxic (meaning they lost value) because of falling US housing prices, the market for these tradable assets seized up. The banks, who were the majority holders of these assets, were unable to offload them from their books and were left with the only recourse of marking the prices down on their balance sheet -- causing an immediate hit on their capital -- consequently making them weaker.
Financial systems all over the world, and the US is no different, function on confidence. Banks and financial institutions trust each other and, therefore, easily lend to each other without much concern -- partly because there is a general understanding that financial institutions function prudently and are policed by the regulators.
But when this confidence, which is nothing but faith in one's peer group, breaks down, banks stop lending to each other. The inter-bank market is the lifeline of the financial system and when this snaps all hell breaks loose, doubts and suspicion take over.
This is precisely what is happening now. The financial system is not sure who holds what in terms of the toxic mortgage assets and are, therefore, suspicious of lending to each other.
This is clogging up the credit market, causing a colossal liquidity crunch. The confusion is exaggerated by the market targeting on financial institutions that they think are weak, causing massive outright and short-selling (which recently has been banned) and forcing sharp falls on their share prices.
In turn, it is leading to a rush of consumer withdrawal of deposits from banks and investments from the affected financial institutions. This is nothing less than acute panic and, if allowed to carry on and have the market sort it through failures and bankruptcies, it can only lead to a total collapse of the financial system.
Fearing a cataclysmic outcome, the US government has stepped in to save the financial sector from total collapse. The Senate and the House of Representative have approved the $700 billion bailout plan by Treasury Secretary Paulson, after throwing it out on the first vote.
The bailout plan is aimed at buying out, by the government, the toxic assets of the financial institutions. Thereby, in one fell swoop, cleaning up the balance sheet, helping bring back confidence in the market, and allowing the inter-bank market to function normally. This is the theory; whether it will work or not, who knows?
There is more than one problem with this bailout plan, but the most obvious one is how to ascertain the price of the assets sold to the government. Too high a price would be viewed as a bailout of the fat cats in Wall Street, and the Main Street taxpayers are likely to go up in arms for having to foot this bill.
Then again, too low a price may not entice the financial institutions to sell at all, thereby letting the liquidity crisis to persist, which is clogging up the artery of the global financial system. There is also the scepticism that all this may not save the financial system after all.
The US government is caught between a rock and a hard place. The bailout plan is a must for confidence building but it is unpalatable politically. The ordinary taxpayers; who will ultimately pay for all this, see it as nothing more than rescuing the greedy bankers and failed regulators from their follies. But do they really have a choice?
On top of it; the US economy is not doing too well, the start of slower growth and a likely recession round the corner is the foreboding fear that dictates more fiscal prudence and not the profligacy of $700 billion.
This colossal amount has to be raised from the market at higher and higher interest rates, which is the last thing you need in a recessionary environment, to attract the investors.
As for rest of the world, we just have to see it all play out in the US. The ramifications, both economic and financial, are global and one can only speculate about them.
One likely scenario is a sea-change in how financial markets will function in the future. If we survive through this turmoil with some sanity than we may see the demise of the old system, where credit was easy and leverage was king, to a regime of tight regulation and more conservative financial institutions hopefully focused on steady growth than the go-go days of the yester-years. We have indeed seen the end of a reckless era.
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