Though it has been more than a year since the sub-prime crisis in the US mortgage sector came to light, the meltdown in global financial markets, especially its Wall Street frontage, persists. Just days after the Treasury and the Federal chose to nationalise Fannie Mae and Freddie Mac and pump in as much a $200 billion to keep them solvent, troubled Lehman Brothers Holdings Inc., the fourth largest investment bank on Wall Street came to the table with requests for support. This was to be expected, not just because of the nationalisation of the government sponsored enterprises (GSEs) in the mortgage market, but because of the role that the Federal Reserve and the Treasury had taken on to inject liquidity into the market and support and part finance the merger of Bear Stearns with J.P. Morgan Chase. Even when the Treasury Secretary declared that the government was unwilling to bail out Lehman, and tried arm twisting the big banks to buy into the company, the effort failed because it was not willing to underwrite the process with tax payers’ money.

What followed is the beginning of a tale still being told. The 158-year old Lehman filed for bankruptcy and Merrill Lynch, one more Wall Street icon, chose to pre-empt a similar fate befalling it by deciding to sell out to Bank of America in a $50 billion all stock deal. That may appear a good price relative to its then prevalent market capitalisation of $26 billion, but was way below the $80 billion high it had reached during the previous 52 weeks. Meanwhile, the insurance and investment management major AIG (American International Group) has been struck by a major ratings downgrade and is in Fed mediated talks to secure a $75 billion line of credit that would help cover the additional collateral it would have to provide it derivatives trading partners because of that downgrade. If that line of credit does not materialise (or perhaps even if it does) AIG too is heading towards bankruptcy.

What accounts for the recent spate of problems? All of them are related to the now-not-so-new sub-prime crisis and the unwillingness of both the institutions concerned and the regulators to properly assess the effects of that crisis on their financial viability. On the contrary, they have been strenuously engaged in concealing those effects. Consider for example Fannie Mae and Freddie Mac which acquire mortgages from banks, housing finance companies or other financial institutions, so as to keep lending for housing acquisitions going. According to reports, just before they were placed under conservatorship, they together held or backed $5.3 trillion in mortgages. What is more with the mortgage markets facing a credit squeeze over the last year, they were providing 70-80 per cent of new mortgage loans. To undertake these activities, these firms were indebted to a range of creditors, credit from many of whom would freeze up if these GSEs defaulted on their commitments. Any effort on the part of these creditors to sell their debt would result in a decline in value that would threaten the financial viability of many of them.

Thus, there were two important reasons, among many, why these institutions could not be allowed to close. First, mortgage credit would dry up resulting in a collapse of the already declining prices in the housing market. Second, the fall out for the viability of other financial firms and the stability of financial markets could be dire. An implication was that institutions such as these should exercise caution in their operations and be subject to stringent supervision, neither of which seems to have been the case. Managers who paid themselves fat salaries and bonuses backed suspect mortgage loans and bought into suspect mortgage-backed securities on the presumption that defaults would be low. And regulators not merely turned a blind eye to such activities but missed the use of accounting practices, which though not in violation of rules, overestimated the capital resources and financial strength of these firms. At the time of the nationalisation, losses on mortgage related securities were estimated at $34.3 billion in the case of Freddie and $11.2 billion in the case of Fannie, both of which were kept out of calculations of regulatory capital by treating them as temporary losses. On the other hand, these losses were used to generate deferred tax assets on their balance sheets on the assumption that they would make large enough profits in future, so that these losses can be offset against the tax to be paid on those profits. The fact of the matter, however, was that these firms were on the verge of insolvency, and ended up needing huge taxpayer-financed, bail-out packages to survive.

The Fannie and Freddie experience illustrated a larger feature of the increasingly deregulated financial markets across the globe: the tendency to exploit easy liquidity conditions to leverage investments in areas varying from housing and real estate to stock and derivatives markets. According to Lehman Brothers’ bankruptcy filing, it owes more than $600 billion to creditors worldwide. With much of that money being invested in mortgage-backed securities, the collapse in the value of those securities must have increased demands for additional collateral that Lehman was hard pressed to find. It contemplated sale of either parts of its business or of equity, with the state-controlled Korea Development Bank emerging a potential suitor. When that did not work, the value of Lehman’s shares collapsed, touching less than $10 a share as compared to $80 in May-June 2007, making it even more difficult for it to find additional funding. Lehman then sought a solution in a “innovative” scheme of hiving off its real estate assets originally valued at $30 billion into a separate public company that would look for a suitor. That would have helped save the parent. But when that too failed to materialise bankruptcy seemed a real possibility.

This forced the Treasury and the Fed to bring other private financial institutions to the table, as it did a few years earlier with Long Term Capital Management, to work out a takeover or at least an acquisition of the worst bit of the firm’s assets with some help from the Fed. The offer of marginal support from the Fed and the Treasury proved inadequate, because the institutions concerned were unsure whether this could stall the crisis creeping through other firms as well. The Treasury on the other hand, had had enough of using tax payers’ money to save firms that had erred their way into trouble. The refusal of the state to take over the responsibility of managing failing firms sent a strong message. Not only was Lehman forced to file for bankruptcy, but a giant like Merrill Lynch that had also notched up large losses due to sub-prime related exposures decided that it should sort matters out before there were no suitors interested in salvaging its position as well. In a surprise move, Bank of America that was being spoken to as a potential buyer of Lehman was persuaded to acquire Merrill Lynch instead, bringing down two of the major independent investment banks on Wall Street. With Bear Stearns already dead, that leaves only Morgan Stanley and Goldman Sachs, whose fortunes too are being dissected on Wall Street. Whether they too would disappear into the vaults of some large bank is an issue being debated.

This is, however, only part of the problem that Lehman leaves behind. The other major issue is the impact its bankruptcy would have on its creditors. Citigroup and Bank of New York Mellon have an exposure to the institution that is placed at upwards of a staggering $155 billion. A clutch of Japanese banks, led by Aozora Bank, are owed an amount in excess of a billion. There are European banks that have significant exposure. And all of these are already faced with strained balance sheets. More trouble in financial markets seems inevitable.

This, therefore, is truly the end of an era. The independent investment banks are under threat. The state is no more seen as an agency that can buy its way out of any crisis. And the crisis that has dragged on for more than a year just refuses to go away. But all this still seems inadequate to force a rethink of the financial liberalisation that triggered these problems.

September 15 , 2008.