Drowning in a sea of debt

Published on Saturday 27 September 2008 17:09

AMERICAN politics is used to high drama. But few events compare with the developments of last week as the President and Congress battled to keep the economy afloat. While critics of the proposed $700bn bailout indulged in their own hyperbole, revelling in what they saw as the crumbling of US capitalism, even the most seasoned observers were left speechless by events at the White House on Thursday night.

If the nationalisation of two financial institutions and the sale or collapse of others wasn't enough, reports from the Cabinet Room suggested that Hank Paulson, the investment banker turned Treasury Secretary, was literally reduced to begging on one knee for his rescue package for the US economy to be approved.

As the seven-hour meeting collapsed in what observers described as a "verbal brawl", the President issued a warning about the dire consequences if the bill was not passed: "If money isn't loosened up, this sucker could go down."

Just a week earlier, Wall Street was silenced when Ben Bernanke, the chairman of the Federal Reserve, warned that the American economy's arteries and its financial system were clogged.

"If we don't act," Bernanke said, "the patient will surely suffer a heart attack; maybe next week, maybe in six months, but it will happen."

For many, the warning was clear: fail to act and America will plunge into a long and painful recession affecting everything from student loans to car loans.

Bernanke's speech was made in the wake of the most turbulent month in Wall Street since the 1930s. Some of the world's biggest names in investment banking have closed their doors, with Lehman Brothers collapsing, Merrill Lynch being bought by Bank of America, and the insurance company American International Group (AIG) being effectively nationalised.

By last weekend Bernanke and Paulson had made up their minds. Enough was enough. Ad hoc responses such as the rescue of AIG would no longer suffice. A long-term solution had to be found. Paulson published his plans in just two and a half pages. The package was big, entitled TARP (Troubled Asset Relief Program) and it would authorise him to purchase any "residential or commercial mortgages and any securities, obligations or other instruments that are based on or related to such mortgages".

In short, under Paulson's plan, the US Treasury would be given virtually unchecked authority to spend up to $700bn (379bn) on debt-based mortgages to stabilise the system. As one commentator said: "It was the mother of all bailouts."

But as markets closed on Monday evening it became clear that TARP wasn't going to get an easy ride through Congress. By Tuesday morning stock markets were tumbling across the globe as financiers fretted that the "toxic bailout", as it became known, would not be enough.

India's BSE index fell 1.95%, Hong Kong's HSI shed 2.7%, while both the FTSE 100 Index and US Dow Jones took another tumble. By the end of the week, 222.8 points had been wiped off the FTSE 100 and similar falls affected stock markets worldwide. In Frankfurt the DAX index saw 126.03 points wiped off, while in Paris the CAC 40 index closed 161.49 down. In Hong Kong, the Hang Seng Index dropped 654.64 points.

Paulson defended the plan, arguing that the cost of the programme should fall well below $700bn since some of the mortgages would be repaid. In an increasingly fractious atmosphere on Capitol Hill it fell on deaf ears.

Detractors argued that bailing out the financial system would sow the seeds for a future economic and political crisis. They also pointed out that the plan would allow the use of taxpayers' money to generate massive profits for the likes of Citigroup, Morgan Stanley and Merrill Lynch, by buying their poisonous assets at far above what the market said these assets are worth. Most analysts agreed that it would be unlikely that the US Treasury would turn a profit.

"The strength of the plan is that in theory it should do what it says on the tin and take away a lot of the bad debt, complex credit derivatives and illiquid assets from the banking and insurance sector and relieve a considerable amount of the burden," says Andrew Milligan, head of global strategy at Standard Life.

But will it work? There have been numerous false dawns since the credit crisis started in August last year. The underlying problem is that while TARP may address the root cause, within the banking system it is only part of the answer.

Bad debt aside, the immediate problem haunting the banks is the availability of capital. With commercial banks hoarding cash and increasingly unwilling to lend to one another, there has been a surge in demand for short-term lending from central banks. Mario Draghi, governor of the Bank of Italy and chairman of the Financial Stability Forum, estimates that up to $350bn is needed to ease the worsening credit markets.

"Vehicles like TARP are only part of the answer," says Milligan. "You also need recapitalisation, liquidity facilities and easier monetary policies. The other problem is that the wholesale money markets are becoming log-jammed and inactive. TARP is excellent. Is it sufficient? No."

By Thursday night, news emerged that another bank had hit the wall, Washington Mutual, shut by the federal Office of Thrift Supervision and sold to JPMorgan Chase for $1.9bn (1bn). The sale happened after customers withdrew an eye-watering $16.7bn from accounts in just under two weeks. It was the biggest bank failure in US history.

"What we are talking about in the United States is the entire US investment banking community in effect disappearing," says Milligan. "The largest insurance company over there has had to be nationalised. The two lynchpins of the US housing market, Freddie Mac and Fannie Mae, have had to be saved. In the last two weeks we have been talking about the highest echelons of the financial services industry in America having to be nationalised or kept on a life support system. The next step is not so much what happens in the banking system but what happens in the real economy. I am not particularly concerned with the UK. This is a US problem. The situation there is very much more complex and dangerous than the UK. "

As Congress prepared for a long weekend of heated discussions, the House of Representatives Speaker Nancy Pelosi said progress was being made. "We will not leave until legislation is passed," said Pelosi. "We will be working through the weekend to achieve that end."

George W Bush insisted that despite differences over the plan, "there is no disagreement that something substantial must be done". He said: "The legislative process is sometimes not very pretty, but we're going to get a package passed. Republicans and Democrats will come together and pass a substantial rescue plan. Our proposal is a big proposal because we have a big problem. We need to move quickly."

Meanwhile, the Bank of England moved to pump an additional 55bn into the banking system in a fresh effort to ease worsening credit markets as hopes for a US bailout receded. "These operations are intended to address funding pressures," the Bank said, adding that it formed part of a coordinated series of actions with other central banks including the US Federal Reserve, the European Central Bank and the Swiss National Bank.

"It is quite likely that something along the lines of Paulson's package will be approved over the weekend," says Colin McLean, managing director of SVM Asset Management. "As it stands, it's all to do with brinkmanship and stage management. The problem it will have is having an impact. To get stuff moving again you have to pay up over the market prices, and of course that implies losses for taxpayers.

"But it's hard to see it solving all the problems. The stock market seems increasingly jaundiced, it needs to see some action in the UK and Europe. Perhaps in the UK we do need some sort of mortgage guarantee scheme like Freddie or Fannie that would perhaps help the process of underwriting new business."

Whatever the short-term outcome, the unprecedented events of the last few weeks have caused a tectonic shift in power. Milligan says: "One of the fascinating things about this last week is that some of the banks have raised capital – those banks with a convincing proposition that they are able to take advantage of some of the value opportunities. JPMorgan has raised capital, Barclays raised capital, Lloyds TSB and Deutsche raised capital. Where has the capital come from? Japan."