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Bank of America is buying Merrill Lynch for $45 billion, AIG needs an emergency $40 billion bail-out from Uncle Sam to stay afloat, and Lehman Bros is kaput. Whew! The financial world has been turned upside-down overnight. It'll be a rough day of trading ahead.
The news of Wall Street's Sunday night massacre sent foreign stock markets into a deep swoon. Shares tumbled in Asia and dropped more than 4 per cent in Europe. The dollar is steadily losing ground to the euro and gold is on the rise. The question is not whether the Dow will fall, but "how far" and what affect that will have on increasingly fragile financial institutions.
Lehman Brothers, the 158-year-old Wall Street warhorse, announced Sunday that it will file for bankruptcy after weekend rescue plans broke down without finding a buyer. Fears of credit contagion and a global recession have resurfaced and become more widespread. Lehman's failure suggests that that the other Wall Street giants will soon be following the same path to extinction. Economist Nouriel Roubini put it like this:
All of the independent broker dealers are going to disappear. In March it was Bear Stearns. Tonight it was Lehman and Merrill Lynch. Morgan Stanley and Goldman Sachs should go find a buyer tomorrow. The business model of broker dealers is fundamentally flawed. They cannot survive.
Roubini may be right. The funny thing about capitalism is that you need capital to play. When the bank-vault is full of nothing but worthless mortgage-backed securities (MBS) and overvalued junk bonds, the whole thing goes belly-up fast. That appears to be the case with Lehman Bros, the century-old Wall Street warhorse that has joined the long procession of underwater banking establishments now hurtling towards the cliff. Lehman had a great go of it during the boom times when all it took to make oodles of money was a predictable flood of low interest credit from the Fed and a compliant ratings agency that would stamp every crappy securitized pool of mortgages with a big Triple A before hawking it to some gullible investor in Shanghai or Heidelberg.
Lehman travails are not much different from anyone else in the banking fraternity. The problem is that the entire system is under-capitalized and over-leveraged. When Bear Stearns went down last year, it was levered at a ratio of 26 to 1. When Hedgie Carlyle Capital blew up, it was levered at 32 to 1. And when Fannie and Freddie were finally taken over by the U.S. Treasury the two behemoths were levered at 80 to 1, which is to say that they had a one dollar capital cushion for every $80 they had loaned out. They would have continued on the same erratic path -- buying up toxic mortgages and MBS from people who had no chance of ever repaying their loans -- had they not been taken into federal "conservatorship", which is a fancy way of saying they were insolvent. Treasury Secretary Henry Paulson unwisely attached a 6 inch-wide money-hose from the bowels of the Treasury to Fannie's front office so the two mortgage giants could continue to teeter-along at taxpayer expense regardless of the fact that the securitization business model has completely broken down and foreign investors -- including China -- have already started cutting back on their purchases of GSE debt. This is no laughing matter. The $700 billion U.S. current account deficit is financed through foreign investors who are getting increasingly jittery about sinking money into a system that looks more like casino-poker all the time. Here's a clip from China daily on Friday:
China, which holds a fifth of its currency reserves in Fannie Mae and Freddie Mac debt, may cut the portion held in U.S. dollars, according to China International Capital Corp (CICC), one of the nation's biggest investment banks.
The crisis has made Chinese officials realize it's a bad idea to put all their eggs in one basket,' wrote CICC Chief Economist Ha Jiming. 'This will likely lead to greater diversification of foreign exchange reserve investments.' China held $447.5 billion of U.S. agency bonds as of June 2008, according to the CICC calculations using disclosures by the U.S. Treasury. It is likely to reduce the portion of reserves in dollar assets from the current 60 percent by purchasing more non-dollar assets with new reserves, he said."(China Daily)
Naturally, foreign investors and central banks will curtail their purchases of U.S. securities and Treasuries until there's some indication that U.S. markets have stabilized and will be able to withstand the ferocious headwinds of the biggest housing crash in history, a frozen corporate bond market, a paralyzed banking system, and steadily waning consumer demand. But Americans still seem breezily unaware of what all this means for the country's future. They'd rather savor every new bit of gossip about the Bible beating, Grizzly-hunting Alaska governor who wants to lead the country back to Frontierland lips rather than learn about the about the firestorm raging through the financial markets.
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