Wall Street turning the American dream into a nightmare!

James Truslow Adams (1878-1949), the American writer and historian, in his book The Epic of America stated: “The American Dream is that dream of a land in which life should be better and richer and fuller for everyone, with opportunity for each according to ability or achievement. It is a difficult dream for the European upper classes to interpret adequately and too many of us ourselves have grown weary and mistrustful of it. It is not merely a dream of motor cars and high wages, but a dream of social order in which each man and each woman shall be able to attain to the fullest stature of which they are innately capable and be recognised by others for what they are, regardless of the fortuitous circumstances of birth or position.”

The American Dream is gradually evaporating before the majority of Americans, if it has not already turned into a nightmare. The financial turmoil that befell America from the sub-prime mortgage crisis to the Wall Street turmoil is indicative of the absence of prudence in the conduct of those entrusted with financial affairs of millions of investors, borrowers and depositors, and it is a present and immediate threat to the stability and soundness of the financial system.

There is a natural expectation that the lessons of history would inform and shape the present order of things and the destiny we are to embark towards. Financial gurus and regulators should have drawn instructive lessons from the global financial turmoil of 1998 triggered by the collapse of Long-Term Capital Management (LTCM) and the Asian financial crisis. I have naively expected that necessary safeguards would have been put in place by regulators to prevent the possibility of recurrence of a similar crisis; that the financial industry would have enhanced their risk management practices. But recent events prove otherwise.

The role that central banks play, particularly when such events pose an immeasurable threat to the soundness and stability of the financial system, is crucial. Central banks are known to be the “lenders of last resort” – meaning the central bank would avail funds to rescue institutions that do not have any other means of borrowing and whose failure to obtain credit would dramatically affect the soundness of the economy. As lender of last resort, central banks are specifically concerned with protection of investor/depositor’s funds and to prevent a run on a bank experiencing limited liquidity, particularly if such run on a bank would have a domino effect and cause havoc (systemic risk).

There has been a theory that some financial institutions are too big to fail; that should they find themselves in a financial predicament, the central bank would be readily waiting with a rescue package. This is a problematic theory in that it gives rise to a moral hazard – that if some protection exists for an institution against systemic risk, that institution is likely to conduct its business affairs irresponsibly or recklessly. The sub-prime crisis may arguably fall within the category of reckless conduct by banks, perhaps in the knowledge that given their size, failure is improbable, or as an indicator of desperate attempts by authorities to turn the American Dream into reality.

In September 1998 the Federal Reserve Bank organised a rescue package for LTCM, which was on the brink of going belly-up and taking with it a multitude of casualties. The Fed intervened because it was concerned about possible dire consequences for world financial markets if it allowed the hedge fund to fail. Numerous commentators argued that the Fed’s intervention was “misguided and unnecessary because LTCM would not have failed anyway”. IMF also provided rescue packages during the Asian financial crisis to affected countries to avoid further defaults.

When the Fed helped engineer the takeover of Bear Stearns by JP Morgan Chase in March 2008 and agreed to guarantee $29 billion of potential losses, it was accused of setting a dangerous precedent; but the precedent had already be set in 1998. The assumption was that Bear Stearns was too big to fail, hence the Fed’s intervention.

Ben Bernake, the Fed chairman, explained their action by saying, “… Bear Stearns was deeply involved in a number of critical markets, including (as I have noted) markets for short-term secured funding as well as those for over-the-counter (OTC) derivatives.

“One of our concerns was that the infrastructures of those markets and the risk- and liquidity-management practices of market participants would not be adequate to deal in an orderly way with the collapse of a major counterparty. With financial conditions already quite fragile, the sudden, unanticipated failure of Bear Stearns would have led to a sharp unwinding of positions in those markets that could have severely shaken the confidence of market participants.

“The company’s failure could also have cast doubt on the financial conditions of some of Bear Stearns’s many counterparties or of companies with similar businesses and funding practices, impairing the ability of those firms to meet their funding needs or to carry out normal transactions. As more firms lost access to funding, the vicious circle of forced selling, increased volatility, and higher haircuts and margin calls that was already well advanced at the time would likely have intensified. The broader economy could hardly have remained immune from such severe financial disruptions.”

Since then economic and market conditions having been sliding precipitously, and more and more financial institutions have found themselves staring imminent death in the face. Rescue packages have been extended to Fannie Mae and Freddie Mac; a decision that would have further raised reasonable expectation that such assistance would be made available to others who find themselves in a financial pooh-pooh.

The bankruptcy of Lehman Brothers caused financial panic around the world; financial stocks in all major exchanges plummeted on the uncertainty of banks exposures to this old investment bank. Interestingly the Fed and US National Treasury decided to let the Lehman Brothers die a painful and undignified death; almost debunking the myth that certain institutions are too big to fail. Merrill Lynch, to avoid the same demise, swiftly arranged its distressed sale to Bank of America.

Now the biggest bailout of AIG with an $85 billion loan came as a surprise, as many expected this largest insurer to go the same path as Lehman Brothers. The Herald Tribune reports that, “If AIG had collapsed — and been unable to pay all of its insurance claims — institutional investors around the world would have been instantly forced to reappraise the value of billions of dollars in debt securities, which in turn would have reduced their own capital and the value of their own debt.”

These collapses, bailouts or distressed sales may be an indictment of the regulators who appear to have been caught asleep; and further indictment on the executives of these institutions who appear to have exposed the financial system to undue risks. While the continued bailouts by the Fed of some of these institutions are not ideal, it is necessary to prevent a total collapse of the markets and implosion of the financial system. The risk of banks behaving badly is ever present, but hopefully the demise of Lehman Brothers is a clear message that no institution is too big to fail.

The intervention by the Feds to bail out Lehman Brothers and acquiring an 80% stake in the ailing investment bank is an indication that nationalisation is not restricted to the vilified socialist countries; even proponents of capitalism succumb to the dreaded socialist imperatives in order to contain systemic risk. Current financial turmoil is full realisation of the failures of market regulation and ineffective predictive measures employed by risk managers. This crisis also speaks to the issue of disclosure by these financial institutions to the regulators. Regulators can only effectively perform their functions when there is full disclosure by regulated institutions. In the absence of transparency there can be no proactive measures put in place to curb the potential collapse of the financial system.

Stock markets around the world have plummeted; the Russian stock market was forced to suspend business after the worst plunge of share prices since the 1998 financial crisis. The JSE Securities Exchange has not been immune to the turmoil rippling across global exchange as investors continue to abandon financial stocks — a nervous move by people you would expect to make informed decisions. Perhaps they act on the assumption of adequately dispersed risk across exchanges; but if that is true such dispersion of risk should mean that shocks to the overall economic system would be better absorbed and less likely to create cascading failures that could threaten financial stability.

Jittery traders should be acting responsibly and refrain from unnecessarily liquidating their positions due to their paranoia. Local banks listed on the JSE had been unaffected by sub-prime and are insignificantly exposed to financial institutions going belly-up. We should not be seeing financial stocks being hammered as they are.

The chickens have certainly come home to roost! Morgan Stanley and Goldman Sachs, the last standing US investment banks, are the latest casualties. Their stocks have taken a severe beating after the announcement of a rescue package for AIG. The two investment banks are now preparing themselves for the inevitable and already other commercial banks are sniffing around to swallow these prominent names. How deep are the pockets of the Fed and National Treasury? We may be witnessing the end of stand-alone investment banks.