In a dramatic turn of events, the Federal Reserve Board extended a $85bn secured credit line at LIBOR+850bp to AIG, the biggest insurer in the world, in exchange for a 79.9 percent stake in the company. As Lehman, AIG is a large player in the off-balance sheet credit derivatives and structured finance market, but with much stronger ties to the real economy, to consumers, to pension funds, mutual funds, to municipalities in its quality as bond guarantor, not to mention its international interlinkages in over 100 countries worldwide. “The Federal Reserve Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.”
Lehman’s demise over the September 13/14 weekend, on the other hand, did not come as a complete surprise. Treasury Secretary Paulson stuck to his word given at the July 10 full committee hearing where he clearly stated that – after receiving extraordinary access to Fed liquidity – “the trigger for invoking government’s emergency authorities should be very high, such as filing for bankruptcy.”
The big unknown is whether Lehman’s unsecured creditors and bondholders will be able to weather their losses – current indicators set the likely recovery value for Lehman’s bonds at 30 cents on the dollar. The second question is whether the financial system will bring up the funds or the guarantees to compensate for the disappearance of one of the top ten counterparties in the highly concentrated $62 trillion OTC credit derivatives (CDS) market. The remaining peer banks were proactive in establishing a $70bn liquidity pool for this purpose. Furthermore, still unresolved is the fate of large amounts of off-balance sheet toxic waste that will keep weighing on banks’ balance sheets barring a holistic approach. See some solution outlines in: “Lessons From Past Banking Crises: How To Avoid a Japan-Like Experience”
The authorities’ immediate response was to widen the volume of and the collateral base for its lender of last resort facilities to include “collateral that can be pledged in the tri-party repo systems of the two major clearing banks.” This can basically include anything the parties agree on, including equities. Could central banks suffer any collateral damages in the long run? See: “Lending Against Shaky Structured Collateral: Can Central Banks Go Broke?”
Whether these precautionary measures prevent ripple effects from occurring remains to be seen. We are now closer to a financial meltdown as described in Nouriel Roubini’s February paper “12 Steps to a Financial Disaster”. Stock prices are sharply down and there is a risk of a market crack. Interbank spreads and credit spreads are wider than ever since the beginning of this crisis. Lehman and Merrill are gone and the fear is that soon enough Morgan Stanley and Goldman Sachs might also need to find a larger partner with deep pockets.
Moreover, the biggest U.S. S&L – WaMu – might be close to a bust. Dozens of other banks could be near bankruptcy and the beginning of a silent bank run is looming as depositors are nervous about their assets. Indeed, panic is mounting in financial markets: the CDS market is frozen because of the collapse of Lehman and fears of the collapse of AIG, WaMu and other financial institutions. At the same time, many hedge funds are now teetering as their losses are mounting. Investors in fixed income – including preferred stocks – have also experienced massive losses. Importantly, as a sign that the Fed lost control of the Fed Funds rate, overnight LIBOR spiked over 300bps to over 6% as panicky investors sought the safety of cash.
In the first fully unified vote since last September, FOMC voted to leave the Fed Funds Rate and Discount Rate unchanged. While according to the FOMC “the inflation outlook remains uncertain”, “strains in financial markets have increased significantly and labor markets have weakened further” and after the events of the past weekend – with government rescues apparently off the table, the possibility of a rate cut came back to the table – even intermeeting if needed – although rate cuts in this environment might have a limited effect.
The fallout of the financial turmoil in the U.S. is becoming global with stock markets all over the world plunging. The effects of contagion are being felt in Russia, China, Emerging Asia, Emerging Europe and in the European banking sector. Equities in Russia, India and Brazil – three of the BRICs – fell sharply. Commodity countries, such as Russia and Brazil, and those with high external financing needs, such as Turkey, came under particular pressure. The MSCI emerging-markets index has lost a quarter of its value over the last three months and outflows from emerging equity and bond fund reached levels not seen for more than a decade while emerging-market currencies have taken a battering over the last week or so as risk aversion rose.