Tuesday, September 16, 2008

Financial crisis primer

With Lehman Brothers and Merrill Lynch following Bear Stearns into the pages of Wall Street history, of the big five investments banks, only two remain - Morgan Stanley and Goldman Sachs. And of these two, the former may soon follow suit and the crisis is taking a heavy toll on the later.

Worldwide, financial companies have reported more than $500 billion in charges and losses stemming from the credit crisis — a figure some experts say could eventually exceed $1 trillion. NYT has this primer on the financial crisis.

The marriage of an investment bank, Merrill Lynch, and a commercial bank, Bank of America would be throwback to the pre-depression era. During the Depression, Congress separated commercial banks, which take deposits and make loans, from investment banks, which underwrite and trade securities. The investment banks were allowed to do business with less oversight, while commercial banks operated with tighter supervision. But after Congress repealed those Depression-era laws in 1999, commercial banks began muscling in on Wall Street’s turf.

As the new competition whittled down profit margins, investment banks used more of their capital to trade securities and also began developing financial derivatives to fuel profits. The low interest rates, real estate boom, and the proliferation of mortgage-backed securities aided this process. The finance industry’s credit market instruments increased more than one and a half times in the last decade, to $15 trillion last year, according to Moody’s Economy.com, and climbed at a pace that was two times faster than the growth of the broad economy.

All this has brought about a fundamental change in the global banking system. As Paul Krugman says "the old world of banking, in which institutions housed in big marble buildings accepted deposits and lent the money out to long-term clients, has largely vanished, replaced by what is widely called the "shadow banking system". (These) depository banks now play only a minor role in channeling funds from savers to borrowers; most of the business of finance is carried out through complex deals arranged by "nondepository" institutions, institutions like the late lamented Bear Stearns — and Lehman."

The good thing about the Lehman bankruptcy is the reluctance of the Fed (unlike in case of Bear Stearns when the Fed guaranteed JP Morgan with tax payers money to engineer a bailout) to use public funds to prop up failing financial institutions. But the Fed's decision to accept lower-quality assets, such as equities, as collateral for its credit lines, so as to cushion the markets against the shock will surely further moral hazard. On the other hand, the Bank of America may have bitten off more than it can chew by taking over Merrill with all its toxicity. Given what has happened so far, Kenneth Lewis, CEO of Bank of America, may be celebrating too soon!

Update 1
Banks have been forced to take big losses as the value of their holdings — mainly complex securities tied to home mortgages — has declined. Bank share prices have fallen precipitously as well. Since banks borrow against their assets — shareholders’ equity and holdings — and lend to customers, fall in their asset values reduces their leeway to lend, and increases the risk of insolvency. So it becomes necessary to inject fresh capital in the banks to add financial ballast and halt a downward spiral in asset values and lending activity.

NYT has this summary of the crisis and the bailout.

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