What has unleashed this new financial storm? I thought the banks’ turmoil ended earlier this year.
Well, yes, until recently many bankers did hope that the worst of the credit storm had passed. They thought that the sale of Bear Stearns to JPMorgan in March had marked the nadir of the crisis.
But the turmoil this month is worse than anything seen in March: two mortgage behemoths have been quasinationalised, Lehman Brothers collapsed, Merrill Lynch was forced into a merger, AIG was nationalised and markets were rocked.
But why?
There are broadly two factors behind the credit storm. The first is a set of tangible economic losses from US mortgage defaults.
The second factor is psychological. As subprime defaults have emerged, investors have lost confidence in the techniques that have underpinned 21st century finance, such as the practice of taking loans and turning them into complex bonds. Worse still, they have also lost confidence in their ability to value debt.
But if the defaults started a year ago, why is there a crisis now?
By the middle of this year, banks had made about $500bn (€357bn, £280bn) in writedowns and raised $200bn of capital. But recently, new credit losses have started to emerge as debt values have fallen. That has left investors shunning groups that hold toxic assets, such as Lehman Brothers.
This week fullblown panic erupted after Lehman filed for bankruptcy. This was a shock since investors had thought the US government would protect big banks, because it prevented a bankruptcy at Bear Stearns.
As a result, investors started to worry about other weak groups, such as AIG.
Why AIG? It is not even a bank.
AIG moved into the world of complex finance this decade and now holds a vast pile of securities linked to mortgage bonds. These assets have tumbled in value over the last year, tipping AIG into crisis - until the US Federal Reserve extended an $85bn loan on Tuesday night.
But if the Fed rescued AIG and Bear, why did it let Lehman collapse?
An unhappy mixture of ideology and practicality.
When the crisis erupted at Bear, the Fed feared a bankruptcy would devastate the financial system, since other institutions were unprepared for the challenge of unwinding derivatives and funding contracts linked to Bear. However, with Lehman, the Fed believed the system was better prepared for the shock and wanted to show it would not always prop up brokers.
However, AIG was different again. The insurance group is not just bigger than Lehman, but has insured numerous other banks against defaults on securities they hold. Thus AIG's collapse could have created new losses at banks, which they can ill afford.
Where does that leave other banks in the US and Europe?
No one knows - hence the panic. Most analysts assume that governments will continue to protect big retail banks. However, some weaker groups are now being removed from the system, via mergers, and the fate of others is unclear.
So when will this all stop? Surely the credit losses cannot keep getting bigger?
Hard to say, because there is a risk of two negative feedback loops. First, the longer the banking woes last the greater the damage to the real economy - which could produce more credit losses. Second, as more financial institutions tip into crisis they are selling their assets, such as mortgagelinked bonds.
These fire sales are dragging down asset prices, creating more credit losses - and fresh uncertainty about what anything is worth.
Can governments stop this?
That is the $64 trillion question. Western central banks have already flooded the system with liquidity to ensure banks can get shortterm funds. However, that cannot address the root cause of investor fear: the rising credit losses and uncertainty. Nor can they allay fear about the nonbank parts of the system, such as money market funds.
Hence, some analysts think the US government will eventually nationalise parts of the financial system, as it has started to do with AIG.
Another idea is that the government could purchase troubled securities.
However, that will cost money. Thus Washington has preferred to wait and hope that this storm will blow itself out.
Financial Times Service