No Such Nonsense

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Thursday, September 18, 2008

A Seismic Shift

Wall Street, and Bay Street by extension, are having a rough go of it.

It's almost unprecedented. In 1929, shares fell, people panicked and, oh, by the way, a massive drought swept the continent, throwing scores of farmers off their land. Bankruptcies rose. Unemployment soared. Back then, the crash was a signal of an economic crisis, not the sole cause of it. The Great Depression followed.

Today, we've seen some of the most important financial firms in the world brought low by their own hubris:

Fannie Mae and Freddy Mac have been taken over by the federal government after it became clear that the biggest secondary mortgage firms in the US would fail without drastic measures. And failure would have meant unprecedented economic chaos, affecting every bank and financial company in the country. What happened? Overzealous investment in sub-prime mortgages during the housing bubble - when the real estate market softened and defaults rose, these firms were so overexposed they couldn't recover.

Bear Stearns, one of the biggest investment banks in the world, was heavily exposed to the sub-prime mortgage market too, through investments in asset-backed securities (a kind of investment vehicle tied to those sub-prime mortgages). One of Fortune's Most Admired Firms in 2007 was sold to JP Morgan for just $1 billion in 2008. Two years earlier, the company had assets in excess of $300 billion. That $299 billion - totally gone.

Lehman Brothers wasn't even that lucky. Hot on the heels of the government bailout of Freddy Mac and Fanny Mae, this 150-year old investment firm filed for bankruptcy after it became clear that a bailout wasn't going to happen for them. A storied investment bank that generated $59 billion in revenue last year, gone.

Then there's AIG, an insurance company in so deep that the government had to loan them $85 billion to prevent collapse. So much for the minimally regulated free market system.

Mortgages, investment banks, insurance and more. All aspects of the American financial market are now exposed and reeling. The government has stepped in, realizing that their own lack of oversight is part of the problem. Expect to see tighter regulation and a score of new rules, now that the Fed recognizes just how far things can fall.

The questions now are: Is the worst over? Looks like it may not be, given the rumblings about Morgan Stanley and Goldman Sachs. Plus, the spillover effects for international banks and investment houses will continue to trickle out with losses and reduced earnings over the next few quarters. The bad news will keep coming. So, will people panic? That's harder to say. Right now, the nature of the problem is pretty complex, and the scope may not be clear to the average American, distracted by a big election. But if it keeps going, and the market keeps falling, everyone will be affected - not just laid off investment bankers and traders facing no million-dollar bonus this year.

For an excellent analysis of the crisis, check out Andrew Willis in the Globe. He rightly points out that the very firms being destroyed in this crisis paid their executives, bankers and traders obscene rewards when times were good. Problem is, it isn't just the masters of the universe who take a hit when things go downhill.

1 Comments:

  • At 1:29 PM, Blogger the2scoops said…

    I can't recall the name of the commentator on CBC mornings, but they were saying the bailout is a bit of a last minute solution. They envisioned a "woulda, should, coulda" bailout: if it had been done when the initial wave of the Credit Crisis happened, the government could have imposed more conditions on the bailout: rate of payback, approval of all executive salaries and bonus structure, limit shorting. Basically the government bailout needs to be mananged like a Debt Collection agency.

    There's an excellent podcast of This American Life which explains the Housing Credit Crisis and how it got there. Very slimy of these guys to give out loans to people who had no business taking on that debt load, to profit from something that in no concievable way could be sustainable. Very educational for the common lay-person.

    TAL #355: The Giant Pool of Money

     

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