Globe and Mail Update
The year-old credit crunch has become a full-scale financial crisis that this week alone has seen the collapse of a major Wall Street investment bank, the sale of another and a move by the U.S. Federal Reserve to bail out a private insurer to the tune of $85-billion (U.S.). Four Report on Business reporters explain what's behind the global shockwaves.
Why are credit markets frozen, and why won't banks lend to each other?
Credit markets have dried up because lenders fear they won't be paid back.
Fear of the unknown has caused banks and other institutions to hoard their money. Worry that more financial institutions will fail has made banks reluctant to lend to one another, exacerbating the situation and raising the chance that another bank will find itself without enough funds.
It's unclear to what extent individual financial institutions are exposed to the toxic assets that caused the crisis. For that reason, they are only willing to lend to each other at sky-high rates to compensate for the perceived risk, if they are willing to lend at all. This jams the flow of money around the world, a serious problem for banks and other lenders that need to balance their daily accounts. This starts a chain reaction that makes borrowing more expensive for companies and consumers.
Merrill Lynch & Co. chief executive John Thain reportedly told employees that Bank of America Corp. “cut our trading lines” in the days before it bought the firm, a signal that it had lost confidence in Merrill's ability to meet its financial obligations.
When banks won't lend to each other, the market freezes, prompting central banks to pump in cash.
Why do central banks flood markets with injections? Are these measures working, and are they more effective than interest rate cuts?
The credit crunch has forced central banks to rethink how they protect the financial system.
They remain the lenders of last resort, as the U.S. Federal Reserve's rescue of AIG shows in dramatic fashion.
Central banks are still trying to control the temperature of the economy by adjusting benchmark lending rates. They also now are plumbers.
When banks won't lend to each other and the market freezes, the plumbers come in. The U.S. Federal Reserve, the Bank of Canada and others for much of the past year have taken various measures to flood pockets of the financial system with cash, accepting as collateral the riskier assets that private lenders refuse. The co-ordinated action by the central banks Thursday to make available another $180-billion (U.S.) provides a vivid example of the plumbers in action.
The cost of borrowing U.S. dollars overnight – when banks settle their accounts – surged on Wednesday. To make dollars available in Asia and Europe, the Federal Reserve and several central banks agreed to swap dollars for yen, euros, sterling, Canadian dollars and Swiss francs.
This gave the Bank of Japan, European Central Bank, Bank of England, Bank of Canada and Swiss Central Bank access to dollars to dole out in their markets through short-term loans. (The Bank of Canada set up a swap arrangement with the Fed, but said it didn't actually need to use it at this time.) For the most part, experts laud the central banks for seeking creative ways to keep money flowing. Lowering the benchmark lending rate is effective, but it is a blunt instrument that risks stoking inflation, a risk most central bankers have been unwilling to take during a period of record commodity prices. These liquidity injections are more laser-like, and aren't inflationary. At least that's the hope.
Why does the situation appear different in Canada?
Bank of Canada Governor Mark Carney joined in Thursday's mass liquidity injection by the world's biggest central banks, but in many ways, it was only to show moral support.
While Mr. Carney arranged to receive $10-billion (U.S.) in exchange for an equivalent amount of loonies, the Bank of Canada said it did so only as a precaution. Unlike his counterparts, Mr. Carney didn't actually feel the need to circulate those dollars in the Canadian market. Separately, though, the Bank of Canada said it would inject a total $2-billion into Canadian markets through an auction for 28-day loans.
While the leaves are rustling and the surrounding seas are a little rough, Canada remains a relative oasis of calm amid the financial storm roiling the rest of the world.
The reason starts with the country's banks, which, for the most part, avoided the mortgage-backed securities that got so many of their American and European cousins in trouble. Also, the investment banks in Canada are arms of the big deposit takers. That's different than the Unites States, which allowed investment banks such as Lehman Brothers Holdings Inc. to get huge without hard capital to back up their operations.
The evidence of Canada's exceptionalism is in the markets: The cost of credit is about half as much in Canada as it is in the United States and Europe, and Canadian financial stocks are faring much better than most others around the world.
It's also easier for Canadian lenders to access U.S. dollars, either because they have enough of their own or because their U.S. subsidiaries can access low-cost lending from the Federal Reserve.
And there's one last reason: Canadian bankers keep the same hours as the Federal Reserve. One of the reasons for Thursday's co-ordinated action was that Asian and European lenders couldn't get the dollars they needed because no one at the Fed was awake to lend the cash. The swap facilities set up Thursday make cash available when international central banks need it.
Why are Canadian banks faring better than their global counterparts?
Over all, Canadian banks have maintained a much stronger position than their U.S. and U.K. counterparts over the past year.
At the heart of the current crisis are risky U.S. mortgage lending practices that enabled borrowers with few documents and little money to obtain large home loans. These mortgages were packaged into complex securities and sold to investors.
Canada's regulations minimized this country's so-called subprime mortgage market. The Wall Street titans that have teetered in the past week have been standalone investment banks.
While there have been problems prompting huge writedowns among Canada's big banks, the Canadian financial institutions have large consumer banking operations that rake in deposits and give them a solid cash base that helps protect them from blowups in their investment banking operations.
Why was Lehman allowed to fail, but not AIG? And what does that mean for Morgan Stanley?
U.S. policy makers were faced with the reality that they don't have a blank cheque to bail out every foundering financial institution, and must choose. There's also a fundamental belief in Washington that the market should clean up its own mess, lest investors begin to believe that every time someone gets in trouble the government will be there as a saviour. The danger in that so-called moral hazard is that people will take crazy risks, betting that there will always be a governmental net to save them from any fall.
Faced with the Lehman situation, the government bet that the markets were prepared for an investment bank to go down, in no small part because it has been almost six months since Bear Stearns was in the same spot and everybody should have learned a lesson.
In the case of AIG, the government tried to avoid any involvement, telling the insurer repeatedly it had to find money on its own and prodding other Wall Street institutions to help. But as AIG desperately sought cash, it became clear that the private sector couldn't come up with the funds. The Fed and the U.S. Treasury Department were faced with the failure of an institution they judged much more integrated into financial markets and the everyday economy. At the last minute, they stepped in with a rescue loan package, but even there they tried to dispel any notion of moral hazard.
The message is clear: Shareholders will pay for the mistakes of the companies they own. That means that Morgan Stanley is likely on its own.
Where does the fault lie?
There's plenty of blame to spread around, from the greed and irresponsibility of lenders, the failings of regulators and the decline of old-fashioned banking values to the complete lack of transparency in the multitrillion-dollar derivatives market. People were lulled into becoming more speculative in their mortgages and other investments, because the risks of doing so seemed to carry so little cost.
Underlying this was a decision by the Federal Reserve and other major central banks to maintain historically low interest rates for far longer than could be justified by economic conditions.
Former Fed chairman Alan Greenspan has been cited by numerous critics as the father of the credit disaster, because of the Fed's easy money policies in the wake of the tech bubble collapse in 2000 and the 9/11 terror attacks the following year. That may be overstating things a bit, but he was definitely complicit.
Mr. Greenspan, who was fearful of a return to the recessionary economy of 2000-2001, played an important role in encouraging people to accumulate mountains of debt that would prove to be unsustainable once the prices of houses and other assets began to tumble.
When the key lending rate was at 1 per cent and inflation was running above 2 per cent, it didn't take a rocket scientist to figure out that the Fed was effectively paying bankers to borrow, which they most certainly did. Then they looked around for places to deploy the money at a profit, whether it was for home refinancings, complex securities or other speculative investments.
Mostly, Mr. Greenspan deserves blame for what he chose not to do. Besides raising rates, he could have used his position as bully pulpit to challenge the headlong rush into rampant speculation.
Did the removal in 1999 of the Glass-Steagall restrictions on certain U.S. banking activities play a part?
The rules that prevented commercial and investment banks from stepping into each other's turf were long outdated and increasingly irrelevant, as banks increasingly found ways to get around the legislation.
The real problem is that some big financial organizations decided to play at being investment bankers without the experience in managing risk.
A bigger problem stems from the decision by big Wall Street firms to go public.
As a result, the principals no longer were putting their own capital at risk.
It's much easier to make extremely risky wagers — which is the best way to goose profits and hence the share price and bonuses — when you're playing with other people's money.
What's behind Russia's crisis?
Like every other market, Russia and its banks have been caught in the global credit crunch and the Wall Street mess, which has sparked worries about all financial institutions, raised their costs of capital and sent investors scurrying to the safety of triple-A-rated foreign government bonds.
Like other major commodity producers, Russia, which is more of a triple-B-plus credit, has also been hit by a slowing world economy and falling prices that have hammered the ruble as well as once high-flying resource stocks. The stock market is down nearly 60 per cent from its peak in May, but oil stocks are down as much as 70 per cent or more.
Russia has its own peculiar set of problems that have turned a loss of confidence into a market rout. These include a poor record of corporate governance, failure to enact promised market reforms, a relatively weak banking system, heavy-handed interference in key sectors of the economy and a feeling among investors, fostered by Russia's invasion of Georgia in August, that the government is putting politics ahead economics.
If you want to encourage foreign investment, it's not a good idea to attack your neighbour, pressure western partners in Russian joint ventures to give up their rights or lean on publicly traded coal producers to reduce prices. As a result, the Russian market has taken a much greater pummelling than it otherwise might have from falling oil and crumbling Wall Street banking giants alone.
B y Kevin Carmichael, Boyd Erman, Brian Milner and Tara Perkins
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