x Abu Dhabi, UAETuesday 25 July 2017

After Lehman's fall: a nuclear market rescue plan

The Bush administration, Congress and the Federal Reserve have moved extremely quickly to expedite a "comprehensive solution".

The Bush administration, Congress and the Federal Reserve have moved extremely quickly to expedite a "comprehensive solution" of nuclear proportions to cut right to the heart of the credit crunch with a package of measures to relieve banks of distressed assets. The plan has two main parts. The first would involve a programme of up to US$700 billion (Dh2.57 trillion) to buy failed assets from banks. The second is a backstop of up to $400bn to create a federal insurance programme for money market funds.

The first part may involve several components. The purchase of mortgage-backed securities could be deployed rapidly under existing authorities without new legislation or the creation of a new independent agency akin to the Resolution Trust Corporation. There would be no limits on the size of repurchases under that authorisation, but the legislation does limit the Treasury to the purchase of newly issued agency paper, rather than impaired assets already on bank balance sheets. The Federal Housing Administration's newly created refinancing programme is another existing vehicle that could be rapidly expanded for large-scale purchases of mortgages. But other distressed assets would require a new vehicle, as would the money market insurance programme.

While there are qualms on the part of Republicans, especially in the Senate, over the political liability of "bailing out Wall Street" in an election year, congressional leaders of both parties have expressed support for the plan, arguing that the urgency of the crisis calls for bipartisan politics. Many details have to be nailed down, and officials say there is a tension between the need to "hoover up" bad assets from the banks and paying prices for distressed loans that have a substantial enough value in them to protect taxpayer interests. The valuation of distressed assets also remains a crucial issue.

Such draconian measures could signal that this must be the turning point in the global financial crisis, for if there are greater financial collapses in the coming weeks, the world economy would be threatened. Financial crises do usually end with a big bang. The rescue of Freddie Mac and Fanny Mae, the pillars of US mortgage lending guarantees, was the significant event that signalled the need to think big to cut to the heart of the crisis. However it was the collapse, without government support, of Lehman Brothers that set off the avalanche of financial global panic. The judgment by the US authorities that letting Lehman go did not pose a systemic risk for the financial sector looks possibly just right, assuming no more surprises lurk.

The consequences of the unravelling of the financial markets have already begun to have an impact on the structure of the financial system, especially in investment banking. Whatever glamour surrounds it, investment banking is quite a small segment of the financial system. Other, more traditional parts of the business such as fund management and commercial banking will continue to thrive. Investment banking, with its stratospheric bonuses, aroused jealousy among peers, and so perhaps there was a bit of comeuppance for the sector when the US administration and regulators rejected a Lehman Brothers bailout.

For the financial services industry, the effects will last for a long time. Mindsets will have to change. First, how business is done in the financial sector will be recalibrated to take account of risk. Investors will be much more cautious about buying investment banking products. Second, the industry will move back to basics - no one will want to do anything that looks too sophisticated. Everyone will want to know where risk lies: who actually loses if the borrower cannot pay.

For those left in investment banking, the lessons have not been lost and that could be the silver lining in the catastrophic breakdown. It came as no surprise that the remaining two US investment banking giants - Goldman Sachs and Morgan Stanley - decided to give up their investment banking structures and have successfully applied to become bank holding companies, enabling them to take deposits and regular Fed discount window support. It is an end of an era in financial innovation, until the next cycle or our memories dull.

What are the long-term effects on us then? For the Gulf, awash with liquidity, things might not look so bad because banks have not yet delved deeply into exotic investment products and the growth in Islamic finance and banking has shielded Gulf institutions from some leveraging excesses. Islamic financing will boom. Tighter credit to quality names will become more prevalent, however, and Gulf corporations will have to get accustomed to more accounting scrutiny and transparency than they have been accustomed to.

For the rest of the world, it might be different. It will be harder to borrow. We have already seen that happen in residential mortgages and it seems to be starting for corporate borrowers. There is plenty of money around. Many of the people who have large cash balances will still look to invest them, to buy assets at depressed prices, and there will be a self-correcting mechanism at work. Some businesses, however, will find they have to cut back their investments, not because their core businesses are unsound, but rather because they can't get the money. If, however, there were a general loss of confidence in the world banking system, regardless of huge rescue packages, the whole engine of world trade and investment would be threatened.

This is giving politicians sleepless nights, as voters will never forgive them from taking their eyes off the regulatory ball. Dr Ramady is a former banker and visiting associate professor, King Fahd University of Petroleum and Minerals, Saudi Arabia