After the "No" Vote Special Edition - Two articlesArmaggedon
I predicted a correction last July, but I did not foresee that destruction of so many institutions. As I wrote my column on Monday 29 September, I believed Congress would bail out Wall Street, and this would stabilize markets. But Congress has rejected the bill, and Armageddon has arrived.
As I file my column the wires carry news of massive assets collapses around the world. More US, British, German and Icelandic Banks have crashed, and stock markets are following. More will follow as credit markets will freeze no matter how much money central banks pour into the system. A new wave of destruction will follow: more banks, more insurers will have inadequate assets, hedge funds will lack capital, and much business will die for want of working capital.
Last week the credit crunch almost brought Wall Street crashing down. The symptoms were not only the failure of another bank, but a cession of interbank lending. There were no hysterical bank runs, but banks haemorrhaged. Seeking a safe haven, depositors drove down treasuries to an unheard of zero percent.
VIX, The Chicago Board Option Exchange, registered panic every day last week. I believe this is a record since the indexes introduction in 1993. There were other panics globally as UK banks crashed, and the mammoth Belgian-Dutch Bank Fortis fought for its life. History indicates that bail out are generally efficacious
Panic
Panic prompted a run last week by institutional investors on the $3.4 trillion US money-market mutual funds. The run began on the Reserve Primary Fund; the nation’s oldest, for the second time in 40 plus years. The Government stepped in and promised liquidity. Other money funds in the run had excellent assets. The US Mint, incidentally, has suspended sales of its 24 -carat buffalo gold coin as demand soared.
A few months ago depositors formed long queues to withdraw money form the failing Northern Rock. Britain calmed the panic by nationalizing the bank. Similar pressures were gathering around the HBOS bank last week as its share price plunged. The British assisted its shotgun marriage to Lloyds, and this week nationalized the enormous Bradford and Bingley Building Society.
There were been runs on New Zealand finance companies, some of which had good assets. No financial institution can resist a run unaided because they necessarily have illiquid assets. I believe Governments are responsible for financial order, and that it is necessary to extend credit sometimes to prevent panic. In contrast to the Reserve Bank’s inactivity, the British and American authorities have been pro-active. Greenspan’s propping up Long Term Capital management in 1998 was a good precedent.
Nineteenth Century precedents
My views on runs are supported by two particular matters. The first was witnessing a run on a small bank in Hong Kong. I will never forget the frenzy of people, out of their minds in fear, jostling and fighting to get to a bank counter to make a withdrawal. The efficient Hong Kong Government killed the rush by piling gold bars in the bank’s window, and promised to pay out any request.
My second confirming experience is history. My argument is that authorities must quickly to restore confidence in credit markets. One authority, Encyclopedia Britannica, (the priceless “thin” edition, 1911) affirms that financial crises are worldwide and “touch every home in the country”. Walter Bagehot (1826-1877) an Economist editor and the London representative of a family bank, wrote “Lombard Street”, a brilliant description of high finance. Bagehot’s thesis is that money should be available at high interest rates during runs and panics.
There have been crises in the UK in 1847, 1857, 1866, 1870, and 1890: 1847, 1857 and 1866 became panics. In 1847, a railway share boom collapsed and there was a rush for good credit or cash. The Bank of England (BOE) had set interest rates at 3% in June 1847, by October they were 8%. The public hoarded notes and cash and BOE’s reserve wilted. The Earl of Russell, PM, ordered the 1844 Bank Act to be suspended because it limited the issue of notes and coin to that covered by gold and paid up capital. New notes were issued. Money became freely available at the BOE at 8%. Treasury rubbed its hands in glee because of the extra profits. The panic subsided.
In 1857, Prime Minister Palmerston again suspended the Bank act and liberally injected liquidity. He also wrote soothing letters to bankers, and succeeded in ending a profound crisis in which, we are told, “the wildest alarm prevailed”.
In 1866, The BOE underwent “pressure more severe than anything that went before”. Even with a bank rate of 10%, reserves were so restricted that the Bank asked other banks to deposit their coin and notes overnight. The government again stepped in and saved the day. In 1890 the Government brought in ₤3 million pounds-worth gold from Paris. Gold buffs will be delighted to hear that it did the trick, thereafter “caution prevailed, not panic”. These examples indicate that Government intervention is effective because the state promises full liquidity at current prices.
Other runs
Last Friday, the shares of Fortis, a massive Belgian-Dutch Bank melted by three-quarters of their value. I thought its sheers size presented an insuperable problem: how could a state bail a bank which had assets as big as the state’s GDP? As it happens, the Benelux countries injected a mere $16.4 billion in order for each country to get 49% of the equity in their country. I had not have foreseen that a substantial stake would be ridiculously cheap.
Not all interventions succeed. It is almost impossible to remove barriers to inter-bank lending. Rates are prohibitive—when trade exists. The Reserve Bank of Australia added AU$ 2.75 bn to operations, but the Aussie banks deposited it, and much more, in the Reserve Bank. On September 26 Australian banks held a record AU$7.5 bill on deposit
Summary
There are excellent examples of the beneficial effects of state intervention to support financial institutions in distress. Admittedly, there are moral hazard implications, but when liquidity dries up, state support is efficacious.
Markets Take a Bath
This crisis is as bad as 1929. Congress’s rejection of the bail out plan has opened the sluice gates, and many markets are going to be drained of value. Some will seize up. The focus will be upon steep stock market losses, but other financial institutions will be losers, and commerce will be affected.
The drain is hard to stop because it started with an over-inflated housing market in the US, UK, parts of the EU and Australasia. Those markets are deflating and ruining the value of assets held by lenders as collateral. Some collateral is toxic, and it has poisoned some banks, some fatally. More house price declines are expected, and more assets will be compromised.
The bail-out would not have totally soothed markets. It would have staved off bankruptcy for qualifying institutions by allowing the transfer of poor assets (worth about 10c in the dollar). The aim was to remove impediments to banks being more willing to lend to stop markets going into a tail spin.
But confidence has been shaken by the collapse of Lehman’s, Goldman Sacks, Washington Mutual and Wachovia in the US, HBOS and Bradford and Bingley in the UK, Fortis in Benelux etc.
There is a crisis for institutional investors in the $3.4 trillion US money-market mutual funds. The run began on the Reserve Primary Fund; the nation’s oldest, for the second time in 40 plus years. The Government stepped in and promised liquidity. The commercial paper market is also chilled. Commerce needs these short-term money markets to function.
Banks are also reluctant to lend because the risks have escalated. In the US, they deposited their cash last week in treasuries, driving down the yield to zero. It was safety first. Even in Australia, where the Reserve Bank (RBA) tried to keep credit flowing by injecting AU$2.75 bn to operations, the Aussie Banks deposited a record $8.5bn at the Reserve Bank
The RBA also auctioned $10 billion of American currency to restart the forward exchange market... The market had seized up for several hours as Australian business tried to roll over foreign currency swap contracts. The RBA used its own money but also had $10 billion from the Federal Reserve. The Fed has advance $210 billion to keep foreign markets operating.
These examples from the Australian credit markets are a warning that the crunch could intensify here. The New Zealand stock market will be sold down by foreign investors, the Kiwi will tumble as global investors put safety first. It will be expensive to raise money overseas, even if a lender can be found.
Stock markets are accustomed to huge swings in sentiment, but credit markets are more fragile, and damage there can be significant.
The crisis will necessarily affect the real economy. Commodities have slumped the most today in 50 years as traders feel the crisis will reduce demand for oil and metals. Food prices will also fall, reducing demand for New Zealand’s exports.
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