Thursday, September 18, 2008

US Economic Crisis Bulletin: Stock Market Whipsaw; No End in Sight; Central Banks Pledge Another $180 Billion, etc.

Rally Sputters as Banks Suffer Again

Wall Street Journal

The stock market took a whipsaw turn Thursday as lingering fears about the survival of Wall Street investment houses overshadowed reassuring action by major central banks to keep money flowing through the global financial system.

Major indexes opened higher but traded in the red in recent action. The Dow Jones Industrial Average, which posted a 215-point rise at its morning high, was recently off 34 points points, or 0.3%, at 10575.63.

Markets on the Move

Early Thursday, the Federal Reserve authorized a $180 billion expansion of its swap lines with other world central banks. The funds, which will be provided by the U.S. central bank, can be injected into money markets. The Fed also pumped another $55 billion directly into U.S. markets.

The move provided some relief to investors, especially anyone looking to use money funds as a safe haven – a strategy that looked surprisingly dicey after a money fund posted a loss on Wednesday. The central-bank moves were also designed to free up short-term lending between banks that had seized up over the last two days.

However, traders and analysts said it remained unclear Thursday how much the financial firms that have so far weathered this week's tumult – especially the surviving investment-banking giants Morgan Stanley and Goldman Sachs – will suffer from soured credit bets that remain difficult to value or unload.

"This Fed action is nice to see, but it doesn't directly address the issue at hand right now. It skirts around it," said strategist Marc Pado, of the brokerage Cantor Fitzgerald.

The Dow's financial components rallied across the board following the opening bell, but they were a mixed bag in recent action. J.P. Morgan Chase gained 4%. Bank of America rose 4.2%. But Citigroup fell 3.5%.

The blue-chip average's losses were limited by a 7% rise in American International Group, which will be replaced by Kraft Foods in the Dow on Monday. Kraft shares rose 2.4%.

Dow Jones & Co., publisher of the Wall Street Journal, announced the change in the wake of Wednesday's $85 billion government bailout of AIG, which was first added to the Dow in April 2004. It is the quickest exit from the average in 75 years.

While the stock market fell another 450 points on Wednesday, personal finance columnist Brett Arends has a few good reasons to stay in the market. (Sept. 17)

Other stock indicators traded down. The technology-focused Nasdaq Composite Index was off 0.5% at 2088.53. The S&P 500 slipped 0.6% to 1149.37, hurt by a 2.1% decline in its financial sector. The only S&P category to trade higher was the consumer-staples sector, a traditional investor safe haven that managed a 0.4% gain.

Shares of the two remaining big independent brokerages led the financials lower. Goldman slid 19%, while Morgan Stanley was off nearly 40%.

Gold futures continued to strengthen after Wednesday's $70 spike, with the lead contract up $30.20 to $880.70 an ounce. Oil futures slipped 25 cents to $96.91 a barrel in New York.

Treasury prices rose. The two-year note gained 14/32 to yield 1.424%. The benchmark 10-year note rose 10/32 to yield 3.388%.

Write to Peter A. McKay at

SEPTEMBER 18, 2008

Worst Crisis Since '30s, With No End Yet in Sight

Wall Street Journal

The financial crisis that began 13 months ago has entered a new, far more serious phase.

Lingering hopes that the damage could be contained to a handful of financial institutions that made bad bets on mortgages have evaporated. New fault lines are emerging beyond the original problem--troubled subprime mortgages-- in areas like credit-default swaps, the credit insurance contracts sold by American International Group Inc. and others. There's also a growing sense of wariness about the health of trading partners.

The consequences for companies and chief executives who tarry -- hoping for better times in which to raise capital, sell assets or acknowledge losses -- are now clear and brutal, as falling share prices and fearful lenders send troubled companies into ever-deeper holes.

This weekend, such a realization led John Thain to sell the century-old Merrill Lynch & Co. to Bank of America Corp. Each episode seems to bring government intervention that is more extensive and expensive than the previous one, and carries greater risk of unintended consequences.

Expectations for a quick end to the crisis are fading fast. "I think it's going to last a lot longer than perhaps we would have anticipated," Anne Mulcahy, chief executive of Xerox Corp., said Wednesday.

"This has been the worst financial crisis since the Great Depression. There is no question about it," said Mark Gertler, a New York University economist who worked with fellow academic Ben Bernanke, now the Federal Reserve chairman, to explain how financial turmoil can infect the overall economy. "But at the same time we have the policy mechanisms in place fighting it, which is something we didn't have during the Great Depression."

Spreading Disease

The U.S. financial system resembles a patient in intensive care. The body is trying to fight off a disease that is spreading, and as it does so, the body convulses, settles for a time and then convulses again. The illness seems to be overwhelming the self-healing tendencies of markets.

The doctors in charge are resorting to ever-more invasive treatment, and are now experimenting with remedies that have never before been applied. Fed Chairman Bernanke and Treasury Secretary Henry Paulson, walking into a hastily arranged meeting with congressional leaders Tuesday night to brief them on the government's unprecedented rescue of AIG, looked like exhausted surgeons delivering grim news to the family.

Fed and Treasury officials have identified the disease. It's called deleveraging, or the unwinding of debt. During the credit boom, financial institutions and American households took on too much debt. Between 2002 and 2006, household borrowing grew at an average annual rate of 11%, far outpacing overall economic growth.

Borrowing by financial institutions grew by a 10% annualized rate. Now many of those borrowers can't pay back the loans, a problem that is exacerbated by the collapse in housing prices. They need to reduce their dependence on borrowed money, a painful and drawn-out process that can choke off credit and economic growth.

At least three things need to happen to bring the deleveraging process to an end, and they're hard to do at once. Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets.

But many of the distressed assets are hard to value and there are few if any buyers. Deleveraging also feeds on itself in a way that can create a downward spiral: Trying to sell assets pushes down the assets' prices, which makes them harder to sell and leads firms to try to sell more assets.

That, in turn, suppresses these firms' share prices and makes it harder for them to sell new shares to raise capital. Mr. Bernanke, as an academic, dubbed this self-feeding loop a "financial accelerator."

"Many of the CEO types weren't take these losses, and say, 'I accept the fact that I'm selling these way below fundamental value,'" said Anil Kashyap, a University of Chicago Business School economics professor. "The ones that had the biggest exposure, they've all died."

Deleveraging started with securities tied to subprime mortgages, where defaults started rising rapidly in 2006. But the deleveraging process has now spread well beyond, to commercial real estate and auto loans to the short-term commitments on which investment banks rely to fund themselves. In the first quarter, financial-sector borrowing slowed to a 5.1% growth rate, about half of the average from 2002 to 2007. Household borrowing has slowed even more, to a 3.5% pace.

Not Enough

Goldman Sachs Group Inc. economist Jan Hatzius estimates that in the past year, financial institutions around the world have already written down $408 billion worth of assets and raised $367 billion worth of capital.

But that doesn't appear to be enough. Every time financial firms and investors suggest that they've written assets down enough and raised enough new capital, a new wave of selling triggers a reevaluation, propelling the crisis into new territory.

Residential mortgage losses alone could hit $636 billion by 2012, Goldman estimates, triggering widespread retrenchment in bank lending. That could shave 1.8 percentage points a year off economic growth in 2008 and 2009 -- the equivalent of $250 billion in lost goods and services each year.

"This is a deleveraging like nothing we've ever seen before," said Robert Glauber, now a professor of Harvard's government and law schools who came to Washington in 1989 to help organize the savings and loan cleanup of the early 1990s. "The S&L losses to the government were small compared to this."

Hedge funds could be among the next problem areas. Many rely on borrowed money to amplify their returns. With banks under pressure, many hedge funds are less able to borrow this money now, pressuring returns.

Meanwhile, there are growing indications that fewer investors are shifting into hedge funds while others are pulling out. Fund investors are dealing with their own problems: Many have taken out loans to make their investments and are finding it more difficult now to borrow.

That all makes it likely that more hedge funds will shutter in the months ahead, forcing them to sell their investments, further weighing on the market.

Debt-driven financial traumas have a long history, from the Great Depression to the S&L crisis to the Asian financial crisis of the late 1990s. Neither economists nor policymakers have easy solutions. Cutting interest rates and writing stimulus checks to families can help -- and may have prevented or delayed a deep recession. But, at least in this instance, they don't suffice.

In such circumstances, governments almost invariably experiment with solutions with varying degrees of success. President Franklin Delano Roosevelt unleashed an alphabet soup of new agencies and a host of new regulations in the aftermath of the market crash of 1929. In the 1990s, Japan embarked on a decade of often-wasteful government spending to counter the aftereffects of a bursting bubble.

President George H.W. Bush and Congress created the Resolution Trust Corp. to take and sell the assets of failed thrifts. Hong Kong's free-market government went on a massive stock-buying spree in 1998, buying up shares of every company listed in the benchmark Hang Seng index. It ended up packaging them into an exchange-traded fund and making money.

Taking Out the Playbook

Today, Mr. Bernanke is taking out his playbook, said NYU economist Mr. Gertler, "and rewriting it as we go."

Merrill Lynch & Co.'s emergency sale to Bank of America Corp. last weekend was an example of the perniciousness and unpredictability of deleveraging. In the past year, Merrill had hired a new chief executive, written off $41.4 billion in assets and raised $21 billion in equity capital.

But Merrill couldn't keep up. The more it raised, the more it was forced to write off. When Merrill CEO John Thain attended a meeting with the New York Fed and other Wall Street executives last week, he saw that Merrill was the next most vulnerable brokerage firm. "We watched Bear and Lehman. We knew we could be next," said one Merrill executive. Fearful that its lenders would shut the firm off, he sold to Bank of America.

This crisis is complicated by innovative financial instruments that Wall Street created and distributed. They're making it harder for officials and Wall Street executives to know where the next set of risks is hiding and also contributing to the crisis's spreading impact.

Swaps Game

The latest trouble spot is an area called credit-default swaps, which are private contracts that let firms trade bets on whether a borrower is going to default. When a default occurs, one party pays off the other. The value of the swaps rise and fall as the market reassesses the risk that a company won't be able to honor its obligations. Firms use these instruments both as insurance -- to hedge their exposures to risk -- and to wager on the health of other companies. There are now credit-default swaps on more than $62 trillion in debt, up from about $144 billion a decade ago.

One of the big new players in the swaps game was AIG, the world's largest insurer and a major seller of credit-default swaps to financial institutions and companies. When the credit markets were booming, many firms bought these instruments from AIG, believing the insurance giant's strong credit ratings and large balance sheet could provide a shield against bond and loan defaults. AIG believed the risk of default was low on many securities it insured.

As of June 30, an AIG unit had written credit-default swaps on more than $446 billion in credit assets, including mortgage securities, corporate loans and complex structured products. Last year, when rising subprime-mortgage delinquencies damaged the value of many securities AIG had insured, the firm was forced to book large write-downs on its derivative positions. That spooked investors, who reacted by dumping its shares, making it harder for AIG to raise the capital it increasingly needed.

More on the Crisis

Mounting Fears Shake World Markets Morgan Stanley in Talks With WachoviaUnheard Pleas, Lost Chances for AIG Complete Coverage: Wall Street in CrisisCredit default swaps "didn't cause the problem, but they certainly exacerbated the financial crisis," said Leslie Rahl, president of Capital Market Risk Advisors, a consulting firm in New York. The sheer volume of CDS contracts outstanding -- and the fact that they trade directly between institutions, without centralized clearing -- intertwined the fates of many large banks and brokerages.

Few financial crises have been sorted out in modern times without massive government intervention. Increasingly, officials are coming to the conclusion that even more might be needed. A big problem: The Fed can and has provided short-term money to sound, but struggling, institutions that are out of favor. It can, and has, reduced the interest rates it influences to attempt to reduce borrowing costs through the economy and encourage investment and spending.

But it is ill-equipped to provide the capital that financial institutions now desperately need to shore up their finances and expand lending.

Resolution Trust Scenario

In normal times, capital-starved companies usually can raise money on their own. In the current crisis, a number of big Wall Street firms, including Citigroup Inc., have turned to sovereign-wealth funds, the government-controlled pools of money.

But both on Wall Street and in Washington, there is increasing expectation that U.S. taxpayers will either take the bad assets off the hands of financial institutions so they can raise capital, or put taxpayer capital into the companies, as the Treasury has agreed to do with mortgage giants Fannie Mae and Freddie Mac.

One proposal was raised by Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee. Rep. Frank is looking at whether to create an analog to the Resolution Trust Corp., which took assets from failed banks and thrifts and found buyers over several years.

"When you have a big loss in the marketplace, there are only three people that can take the loss -- the bondholders, the shareholders and the government," said William Seidman, who led the RTC from 1989 to 1991. "That's the dance we're seeing right now. Are we going to shove this loss into the hands of the taxpayers?"

The RTC seemed controversial and ambitious at the time. Any version today would be even more complex. The RTC dispensed mostly of commercial real estate. Today's troubled assets are complex debt securities -- many of which include pieces of other instruments, which in turn include pieces of others, many steps removed from the actual mortgages or consumer loans on which they are based. Unraveling these strands will be tedious and getting at the underlying collateral, difficult.

In the early stages of this crisis, regulators saw that their rules didn't fit the rapidly changing financial system they were asked to oversee. Investment banks, at the core of the crisis, weren't as closely monitored by the Securities and Exchange Commission as commercial banks were by their regulators.

The government has a system to close failed banks, created after the Great Depression in part to avoid sudden runs by depositors. Now, runs happen in spheres regulators may not fully understand, such as the repurchase agreement, or repo, market, in which investment banks fund their day-to-day operations. And regulators have no process for handling the failure of an investment bank like Lehman Brothers Holdings Inc. Insurers like AIG aren't even federally regulated.

Regulators have all but promised that more banks will fail in the coming months. The Federal Deposit Insurance Corp. is drawing up a plan to raise the premiums it charges banks so that it can rebuild the fund it uses to back deposits. Examiners are tightening their leash on banks across the country.

Pleasant Mystery

One pleasant mystery is why the crisis hasn't hit the economy harder -- at least so far. "This financial crisis hasn't yet translated into fewer...companies starting up, less research and development, less marketing," Ivan Seidenberg, chief executive of Verizon Communications, said Wednesday. "We haven't seen that yet. I'm sure every company is keeping their eyes on it."

At 6.1%, the unemployment rate remains well below the peak of 7.8% in 1992, amid the S&L crisis.

In part, that's because government has reacted aggressively. The Fed's classic mistake that led to the Great Depression was that it tightened monetary policy when it should have eased. Mr. Bernanke didn't repeat that error. And Congress moved more swiftly to approve fiscal stimulus than most Washington veterans thought possible.

In part, the broader economy has held mostly steady because exports have been so strong at just the right moment, a reminder of the global economy's importance to the U.S. And in part, it's because the U.S. economy is demonstrating impressive resilience, as information technology allows executives to react more quickly to emerging problems and -- to the discomfort of workers -- companies are quicker to adjust wages, hiring and work hours when the economy softens.

But the risk remains that Wall Street's woes will spread to Main Street, as credit tightens for consumers and business. Already, U.S. auto makers have been forced to tighten the terms on their leasing programs, or abandon writing leases themselves altogether, because of problems in their finance units. Goldman Sachs economists' optimistic scenario is a couple years of mild recession or painfully slow economy growth.

—Aaron Lucchetti, Mark Whitehouse, Gregory Zuckerman and Sudeep Reddy contributed to this article.Write to Jon Hilsenrath at, Serena Ng at and Damian Paletta at

Morgan Stanley in talks with CIC

By Francesco Guerrera and Henny Sender in New York
September 18 2008 16:35

Morgan Stanley is in talks to sell a stake of up to 49 per cent to China Investment Corp, the state-owned investment fund, as part of the Wall Street firm’s efforts to ensure its survival and reverse a slump in investor confidence.

People close to the discussions said the investment bank was exploring the stake sale to CIC as an alternative to a merger with Wachovia, the troubled US lender that approached Morgan Stanley on Wednesday.

Morgan Stanley’s frantic effort to find a partner comes as its shares have been hammered by heavy selling amid concerns over its ability to survive as one of the last two large investment banks. They were trading down 20 per cent at $17.39 in midday trading in New York on Thursday.

Morgan Stanley executives believe that a tie-up with the cash-rich CIC, which bought a 9.9 per cent stake in the investment bank in December, could help it to restore investors’ faith in its business. They argue that the backing of CIC, which can draw from the deep pockets of the Chinese government, would reassure the market that Morgan Stanley has adequate resources to survive the current turmoil.

However, the sale of a large stake in a blue-chip Wall Street firm to a Chinese state owned entity could cause a political backlash in Washington, especially if the alternative of an all-American merger with Wachovia was on the table.

Morgan Stanley declined to comment and CIC could not be reached.

Copyright The Financial Times Limited 2008

FSA to ban short-selling of financial stocks

By Peter Thal Larsen, Banking Editor
September 18 2008 18:09

Short-selling of financial stocks is to be banned in the United Kingdom from midnight on Thursday night under rules drawn up by the Financial Services Authority.

The ban, which has been approved by the watchdog’s board of directors, will prevent investors from creating or adding to short positions in all publicly quoted financial companies. The ban will remain in force until January 19, 2009, when the FSA plans to publish a comprehensive review of short-selling rules.

The ban comes after a week in which the shares of leading financial institutions have come under intense pressure as a result of turmoil in the financial markets. Short-sellers have been blamed for driving down the share price of HBOS, the banking group that on Thursday unveiled it was being rescued through a takeover by Lloyds, its UK rival.

Hector Sants, chief executive of the FSA, said: “While we still regard short-selling as a legitimate investment technique in normal market conditions, the current extreme circumstances have given rise to disorderly markets. As a result, we have taken this decisive action, after careful consideration, to protect the fundamental integrity and quality of markets and to guard against further instability in the financial sector.”

In addition, the FSA is also tightening up its disclosure rules, forcing investors to disclose all net short positions in excess of 0.25 per cent of a company’s share capital.

Though the ban currently applies only to an unspecified list of financial stocks, the FSA said it “stands ready to extend this approach to other sectors if it judges it to be necessary.”

The change in the rules is the FSA’s second attempt to curb short-selling. The regulator has already prevented short-selling of shares in companies that are in the midst of raising cash from investors through a rights issue.

News of the ban comes amid growing political backlash against short-selling, which has been blamed for exacerbating the woes of the country’s banks, and for contributing to the crisis of confidence in some of the country’s largest financial institutions.

Copyright The Financial Times Limited 2008

Central banks act to calm markets

By Ralph Atkins in Frankfurt and Norma Cohen in London
September 18 2008 16:07

The world’s main central banks on Thursday unveiled an emergency $180bn injection of dollar liquidity in the latest attempt to halt the escalating global financial market crisis.

The US Federal Reserve announced it was making available the extra funding to overnight and longer-term money markets in swaps with other leading central banks. In a joint statement, the European Central Bank, the Bank of Japan, the Bank of England, the Bank of Canada and Swiss National Bank pledged they would “continue to work closely together and will take appropriate steps to address the ongoing pressures.”

Their action followed the dramatic escalation of financial market tensions following the collapse of Lehman Brothers, the rescue of the insurer AIG and the continuing crisis on Wall Street. By Wednesday, lending between banks in Europe and in the US had in effect halted.

The intervention had an immediate impact on overnight interbank lending rates. The overnight Libor dollar rate was fixed at 3.84 per cent on Thursday down from 5.03 per cent the previous day.

However, longer term interbank lending rates continued to rise in a sign that banks remain nervous about the liquidity of their peers.

“The timing, so early in the trading day, shows both the severity of the strains in the interbank market and as well the authorities’ determination to resuscitate orderly functioning of the money markets,” said Julian Callow, European economist at Barclays Capital.

President George W. Bush also moved to reassure investors. ”The American people can be sure we will continue to act to strengthen and stabilise our financial markets and improve investor confidence,” he said.

The liquidity boost, accompanied by a swirl of bid talk in the embattled banking sector, helped Wall Street stocks rebound on Thursday after the previous session’s rout. By mid-morning in New York, the S&P 500 index was up 1.9 per cent at 1178.07, while the Dow Jones Industrial Average was up 1.4 per cent at 10,762.49. The Nasdaq was up 1.7 per cent at 2133.60.

The news also had an immediate impact earlier on Asian equity markets. In Hong Kong, the Hang Seng rose as much as 0.4 per cent higher after earlier falling as much as 7.7 per cent on the back of Wednesday’s Wall Street sell-off.

In Europe, stocks also responded positively, with the FTSE Eurofirst 300 climbing 0.6 per cent and London’s FTSE 100 up 1.4 per cent to 4,982.6.

”These measures address funding difficulties, but do not address the primary risk of further bank writedowns,” said Chris Turner at ING.

Yields on two-year Treasury bills rose to 1.76 per cent as risk appetite returned. On Wednesday, yields on short-term US Treasuries fell to their lowest levels since 1941.

The gap between the two-year yield and US interest rate swaps dropped to around 110 basis points, from a record high of around 133bps before the liquidity action was announced.

The collective intervention by some of the world’s largest central banks pushed the yen lower against the dollar and the euro as risk appetite improved. The dollar, which has also widely been used as a funding currency, also suffered.

But gold added to Wednesday’s record gains, rising more than 1.5 per cent to $876.30, after gaining more than 11 per cent or $33.50 the previous session as investors continued to worry about the outlook for the global economy.

Under the latest action plan drawn up by central bankers, the ECB said it would expand its armoury by offering “for as long as needed” $40bn in overnight funds to eurozone banks.

The ECB is also expanding its reciprocal arrangements with the US Fed to increase to $25bn the amount it provides in the market for 28-day funds and $15bn over 84 days. Under the expanded plans, the amount of outstanding dollar liquidity provided by the ECB could reach as much as $110bn– compared with $50bn previously.

The Bank of England moved to add additional funds into the stressed sterling markets, announcing that it would renew the £25bn it loaned the banking sector earlier this week for another seven days and expanded the ability of banks to borrow from their own funds kept on deposit at the central bank.

The Bank of Japan has agreed make available $60bn of dollar liquidity, and the Bank of Canada $10bn.

After the collapse of Lehman Brothers, commercial banks found themselves short of cash and overnight bank borrowing costs soared around the world.

Additional reporting by Peter Garnham in London

Copyright The Financial Times Limited 2008

Wary companies halt M&A deals

By Lina Saigol and Martin Arnold in London
September 17 2008 22:32

Companies across the globe are putting deals on ice as they struggle to value acquisitions amid the worst financial crisis seen on Wall Street and the City of London in decades.

The collapse of Lehman Brothers and wider financial turmoil has dealt a heavy blow to the confidence of strategic and financial buyers.

Henrik Aslaksen, co-head of global M&A at Deutsche Bank, said the pipeline of deals has not shrunk but the current market volatility made it harder to execute deals.

“Financing is also more challenging. However, this is not stopping some companies from approaching target boards with lower offers when the deal’s logic is still sound,” he said.

Last month, Royal Bank of Scotland decided against selling its insurance divisions after failing to attract a high enough price; while Commonwealth Bank of Australia walked away from buying ABN Amro’s investment banking units in Australia and New Zealand citing turmoil.

“Companies are putting many deals on hold at the moment because share prices are so volatile that they cannot decide the market clearing price,” Gavin MacDonald, global head of M&A at Morgan Stanley, said.

However, bankers expect to continue to see deals struck among financial institutions, as better capitalised banks take advantage of the credit crisis to acquire their weaker counterparts, and opportunistic buyers in other sectors. On Monday, BASF made a SFr3.4bn ($3bn) bid for chemicals producer Ciba.

There have been 27,536 deals worth a total $2,725bn so far this year, Dealogic said. That compares with 27,567 deals worth $3,597bn for the same period last year.

Private equity groups have been working on potential bids for a number of companies, including Informa, the UK business information group; Tandberg, the Norwegian video conferencing group; BSN Medical, the German bandages maker, and Reed Business Information, the publishing house. “Private equity broadly expects it to be very challenging to finance medium-sized deals this side of Christmas,” Mr MacDonald said.

Copyright The Financial Times Limited 2008

Wachovia tumbles 22% on capital fears

By Saskia Scholtes in New York
September 17 2008 22:46

Wachovia’s shares plunged 22 per cent on Wednesday after the fourth largest US bank said it would prop up its money market funds to prevent losses on their $494m of debt issued by Lehman Brothers.

The blow to Wachovia’s capital reserves helped reignite speculation the bank may have to seek a buyer to weather the turbulence in financial markets, potentially with an investment bank seeking the stability of a retail deposit base.

The bank joins Washington Mutual on the list of depository institutions needing a deal. WaMu and private equity firm TPG on Wednesday agreed to waive a clause that would have forced the savings and loan institution to pay TPG for any dilution it suffered from a future capital infusion or buy-out. TPG led a group of investors in a $7bn (€5bn, £3.9bn) capital-raising for the bank in April. Eliminating the clause makes a potential acquisition or capital infusion cheaper and clears the way for a deal.

Wachovia is cutting $1.5bn in expenses and reducing risk to cope with mounting losses from the bank’s $122bn of option adjustable-rate mortgages. However, Wachovia’s dominant franchise on the US east coast has long been seen as a promising takeover target. The rout in the bank’s shares – which have lost more than 75 per cent of their value this year – makes that prospect increasingly attractive, say analysts.

Talk of a potential merger for Wachovia has simmered since Stan O’Neal, Merrill Lynch’s former chief executive, made an unauthorised approach to the bank in October last year.

The appointment of Robert Steel as chief executive in July rekindled the possibility of a deal with other financial groups such as Goldman Sachs or Wells Fargo. Mr Steel is a former Goldman executive, and Goldman has been hired to analyse the bank’s loans.

Following Lehman’s bankruptcy and Merrill Lynch’s sale to Bank of America in a hastily engineered deal on Monday, the list of potential suitors for Wachovia could include Morgan Stanley, one of the last remaining independent investment banks, or JPMorgan, which has been interested in growing its retail banking franchise.

However, analysts say any deal will be complicated by the same factors that have dogged other potential deals amid the credit turmoil. Not least of these are purchase accounting rules that require buyers to mark their target’s portfolios to market, which can result in the need to raise costly capital in unstable markets. Potential buyers are also now reluctant to assume such losses without government help.

Copyright The Financial Times Limited 2008

Money markets fund sector shocked

By Michael Mackenzie and Paul J Davies
September 17 2008 20:39

In the culture of US money market funds, whose shares are supposed to be as safe as cash, “breaking the buck” is seen as reputational and commercial suicide.

So news that a fund run by the Reserve Management Corporation had become the first large top-rated retail fund to see its net asset values drop below the sacred $1 mark came as a shock to industry experts. Among even unrated funds, not since 1994 has any fund suffered this fate.

RMC is the oldest of all managers in the industry, which as a whole has more than $3,500bn in assets, but crucially it is rare in not having a large financial company parent.

When it decided that the bankruptcy filing by Lehman Brothers meant that it should write down the value of $785m of the bank’s debt it held to zero, there was no institution with deep pockets to make good the losses.

Standard & Poor’s, which downgraded the fund’s specialist ratings to the lowest mark possible, said the Lehman exposure combined with the enormous redemptions over the past two days resulted in an NAV payout of 97 cents.

More than $27.3bn was pulled out Monday and Tuesday, leaving it with $35.3bn.

Peter Rizzo, primary credit analyst for money market funds at Standard & Poor’s in New York, said that it was impossible to assess what would happen with the Reserve Funds. “I’m not able to prognosticate on where this company is going, we’re in uncharted territory here.”

Analysts and other money fund professionals were left hoping that RMC would remain singular event.

Kevin Flanagan, fixed income strategist at Morgan Stanley, said: “Hopefully this is an isolated case, but if we see further trouble then the problems on Wall Street will show up on Main Street”.

Alex Roever, analyst at JP Morgan, said other funds did not have such exposures to Lehman, but there could still be knock-on effects.

He said: “The impact of The Reserve’s breaking the buck may serve as a catalyst for investors to shift assets to larger, deeper pocketed managers that are more likely to provide support to money funds”.

Large parent companies have had to provide somewhere between $8bn and $10bn worth of cash to stop their companies’ funds breaking the buck since the onset of the credit crunch, according to analysts.

Problems have mostly been caused by the collapse of the complex structured investment vehicles and conduits that issued highly-rated short-term asset backed paper, but were decimated by the collapse in mortgage-related securities.

According to Crane Data, a fund industry newsletter, 21 money funds have supported shareholders in the past 13 months. Bank of America, Federated and State Street are among the large institutions to pump cash into their businesses.

As Lehman’s filing has reverberated, Evergreen Funds, Columbia Cash Reserves and Russell Money Market Fund are among those to disclose exposure.

S&P’s Mr Rizzo said that the majority of rated funds had stopped investing in Lehman before its bankruptcy filing, and many others were rolling overnight repos that were paid in full on Monday, September 15.

He said: “The remaining rated funds that held Lehman paper either had their exposures purchased out by their parent companies or are in the process of obtaining credit support agreements”.

Paul Schott Stevens, president of Investment Company Institute, the national association of US investment companies, said that the fundamental structure of money funds was sound.

He said: “While not obligated to do so, fund sponsors have voluntarily lent support to their money market funds with credit lines or cash infusions in a number of recent instances. These funds are subject to strict regulation governing credit quality, liquidity, diversification and transparency.”

In recent years, retail investors have pulled away from stocks and pumped their savings into money funds boosting the level of assets to record levels – they have grown by about $500bn this year alone.

But the collapse of many ABCP issuers and the fierce competition for Treasury related holdings means financial company debt is now the main investment for these funds because they have to hold investment grade paper.

A widespread loss of confidence in financial debt could have severe repercussions, but that does not appear to be happening yet.

Mr Rizzo said there had been no discernable rush for exits by money fund investors as a result of the Reserve Fund problems, but added: “This will be a good test for the money fund industry. We have seen funds switching from prime commercial paper funds into Treasury funds, but no flood out of the industry.”

Peter Crane, of Crane Data, said: “Whether a run develops or whether investors lose confidence remains to be seen. But fund companies have been very proactive, trying to assuage investors’ concerns. . . they are talking each investors off the ledge one at a time.

“Investors have stayed put in money market funds throughout the crisis so I wouldn’t expect to bail now.”

RMC did not return calls seeking comment.

Additional reporting by Deborah Brewster

Copyright The Financial Times Limited 2008

Q&A: Forces behind the financial storm

By Gillian Tett, capital markets editor
September 18 2008 03:00

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 the government 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.

Copyright The Financial Times Limited 2008

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