Richard AdamsMonday September 15 2008
Has Wall Street ever seen a weekend like the one it has just been through? Perhaps, in the depths of the great depression - but nothing in recent memory, not even the collapse of the hedge fund LTCM 10 years ago, comes close to the drama and crisis that the US financial system is going through.
In case you haven't been paying attention, here's what's happening. Lehman Brothers, one of the largest and oldest US investment banks, is going bust, barring an unlikely last-minute government bailout. Merrill Lynch, for years one of the titans of Wall Street, hocked itself in a firesale to a rival, Bank of America. And AIG, one of the world's largest insurance firms, is begging for a $40bn emergency loan from the US government to stave off its own destruction. In the words of the Wall Street Journal: "The American financial system was shaken to its core".
And that was just on Sunday. It doesn't pay to take the weekend off on Wall Street these days – it was just last Sunday that the US Treasury confirmed it was taking control of Fannie Mae and Freddie Mac – the vast American mortgage agencies – at a cost to the taxpayer estimated to eventually range between zero dollars and a few hundred billion.
And as the minutes ticked over from Sunday to Monday on the US east coast, Lehman Brothers finally threw in its towel and filed for bankruptcy. In one way or another it will be the end for a bank that started in Alabama back in 1844 – a sticky end considering that last year it had sales of $57bn and only a few months ago was named by Business Week magazine in its 50 top performing companies for 2008. (Business Week's citation, in hindsight, looks wise: "Still, the firm is highly leveraged. The final throes of the global credit contraction will test just how good it really is." Now we know.)
What links all these once-buoyant institutions? All of them – from Fannie Mae to AIG – have been caught up in the bonfire of the vanities that was the US housing market, the same underlying cause that six months ago saw the combined forces of Wall Street and Washington rush to prop up and then dismember another former investment banking stalwart, Bear Stearns.
As the housing market turned toxic, so the loans that Bear Stearns, Lehman Brothers, Fannie Mae et al, had cheerfully advanced, bought up, repackaged and insured, lost value. The Federal Reserve, abetted by the US Treasury, pumped cash into the financial markets to prevent them seizing up. But their efforts were hampered by the very financial instruments that the masters of Wall Street had invented. The blizzard of options and derivatives the banks have used in recent years are byzantine in their complexity, making it very difficult to value the potential losses on the books.
That's why the emergence of AIG may be the most troubling event of Wall Street's Bloody Sunday. While the fall of Lehman Brothers was no surprise – in recent weeks the bank has desperately tried to raise fresh capital and sell its most profitable arms – AIG is in a different league as (until recently) one of the largest financial institutions in the world of any type. It has (or it did have) a trillion dollars worth of assets. But despite all that, it too is suffering from the shaky mortgages it holds, as well as the mortgage insurance contracts it has underwritten. Now it needs to borrow money on the financial markets on anything other than punitive terms – and this is the root cause of its problem.
To raise funds AIG needs to show potential lenders what its assets are – and so is forced to put price tags on the swamp of mortgages and derivatives it is holding. As the New York Times reports, AIG has been valuing its mortgage junk bonds at far higher than the likes of Lehman Brothers, and so the hole in its accounts is bigger than expected.
If that's the case at AIG and Lehman Brothers, then the existential question facing Wall Street this morning – as it has on so many recent mornings – is how do you put a value on something that no one wants to buy? You can wait, and hope that something (a housing market recovery?) turns up. You can hope the government gets you out of the jam. But otherwise: when no one wants to buy something, its value diminishes towards nought. And until that problem is solved, next Sunday could be just as exciting as the last two. But we won't even have to wait that long: today is shaping up to be hectic as well, with credit rating agencies poised to downgrade AIG, and stock markets around the world opening to the sound of "sell" orders whizzing through the ethernet.
