An easy guide to the banking crisis By Nick Louth March 17 2008
The global banking crisis which began last summer is far from over.
News that a major US investment bank has been rescued over the weekend sent British bank shares plunging once again today after a few weeks in which prices seem largely to have stabilised. So what is happening, and why do we still not know which banks are safe?
What's the latest?
Investment bank Bear Stearns, a feisty 85-year-old Wall Street entity that survived the 1929 crash, has been taken over by rival JP Morgan in a $2 per share deal which values the entire firm at just $236m (£116m).
This price is almost loose change by Wall Street standards and is a measure of the difficulties the firm had got into. It compares with the $30 the shares were trading at on Friday and the $156 per share the bank was trading at a year ago. The US Federal Reserve, America's central bank, had already lent Bear Stearns $30 billion on Friday to prevent its collapse.
What was the problem?
Bear Stearns, like many banks, lends far more money than it has capital of its own. Bear Stearns was pretty aggressive, even by these standards. It had only $11.5 billion of shareholders capital, but a balance sheet total of $395 billion. Much of its depositors' money is tied up in bonds, but many of these bonds are backed by mortgages which have plunged in value along with US house prices.
Banks can deal with the problems of falling asset values, given time. They can either sell troubled assets selectively, wait until prices recover, or take a non-cash impairment charge on their accounts, or a combination of these things.
The trouble is that the first whiff of a problem causes those who lend money to it to stop, or to demand tougher conditions or higher collateral. When banks are forced to offload assets at fire-sale prices, then you know there is a real problem.
Is this just another Northern Rock, US style?
There are clear parallels. Banks are like sharks. Sharks need to keep moving in the water or die from lack of oxygen. Banks, by making long- term loans supported by short-term deposits, need liquidity on tap to keep refreshing their capital positions and meet redemptions.
Northern Rock needed funds lent by other banks to meet demand for mortgages and to roll-over its existing deposit base. Bear Stearns needed money to keep its many businesses liquid. In both cases, counter-parties (ie other banks) which had happily lent money a few months earlier got nervous and refused fresh loans.
Why does this matter?
Bear Stearns is involved in just about every type of trading undertaken on Wall Street: mortgages (sub-prime and AAA-rated), government bonds, shares, commodities, energy and a plethora of highly complex credit derivatives. It is a market-maker in credit default swaps, which are effectively the insurance policies that other banks use when they want to curtail the risk of lending.
Had Bear Stearns actually collapsed, the market would have had to unpick the complex crochet of derivative trades the bank had undertaken, and assign a value to them. Given the current mood of the market, those values would probably be very low. With the complex web of banking relationships across the globe, British banks would not be immune.
Why is the stock market so nervous?
The market is particularly nervous because of contagion: where one bad loan and demand for repayment can trigger dozens or even hundreds of others, bringing down indebted hedge funds, private equity groups and fully-fledged banks. After all, which of us could on demand repay our mortgages in full within a day or two?
Without confidence in credit default insurance, there would be an even greater wave of nervousness, with banks demanding repayment of loans from any organisation whose risk profile looked anything less than rock solid.
How will it affect me?
There are real effects for ordinary citizens on this side of the Atlantic:
Mortgages are harder to come by, especially big loans for those with small deposits or an impaired credit history. If you get an attractive offer, don't hesitate because many are being withdrawn at short notice. Expect this situation to worsen. Savings deals are getting more attractive, though it would be wise not to put more than the £30,000 covered by the Financial Services Compensation Scheme in any one bank. Ironically, Northern Rock is topping the best rates tables, and seeing as it is owned by the Treasury, it stands pretty safe. Pension schemes will once again be under pressure because of weakening share prices. Those with a heavy weighting of bonds will do better because of the recent cuts in interest rates which increase bond prices. However, in general terms, lower interest rates are bad for pensions because they decrease the rate at which the real value of future liabilities are discounted. Investors are looking at big losses. Share prices for most companies will probably recover over the coming months or years. The worry most afflicting the banking sector is that if there is another Northern Rock, investors in the new victim will never see their money back. Investors with gold are sitting pretty, with the yellow metal at record prices. Those with their money in cash aren't doing badly either.
What happens next?
The reporting season for Wall Street's banks begins this week. Normally, this would help calm nerves, but in many cases the figures reported will be completely out of date.
Traders and short sellers (speculators who buy shares they don't own in order to buy back at lower prices) are waiting to see which other banks have even the slightest hesitancy over the capital position. The fact that Bear Stearns has already had problems means attention will shift to whichever banks are owed most money by the firm.
Has the global economic slowdown made this worse?
Yes, definitely. The Federal Reserve has opted to flood the market with cheap loans, by dumping hundreds of billions of dollars of taxpayers' cash into the market. It has repeatedly cut interest rates to ease the pressure on banks and homeowners. Just this morning, the Fed cut its discount rate by a quarter point, and is expected in coming days to cut its overnight interest rate by as much as 1-1/4% to
1-3/4%.This level of largesse makes the Bank of England's rescue and nationalisation of Northern Rock seem almost modest. It has had one further, dramatic effect. Chopping interest rates has made the dollar a much less attractive currency for foreign investors to hold, and its value has plunged in recent days.
That in turn has sent the dollar price of oil and gold soaring, plus many other commodities. So American inflation is effectively being completely ignored while the Fed races to keep the banking system afloat. It is a high risk strategy, and one without parallel since the Great Depression of the 1930s.
"The current financial crisis in the U.S. is likely to be judged in retrospect as the most wrenching since the end of the second world war," That comment comes today from no less a figure than Alan Greenspan, the legendary central banker who ran the Fed from
1987-2006. Wall Street is already in agreement.