Are Markets Headed For BIGGER TROUBLE?

Source : The Electric New Paper, 18 March 2008

Major crisis averted by US Fed last Friday but...

What is happening to the world's financial markets?

US shares dropped like a rock on Friday. Today, Asian markets are expected to follow.

The story began last Tuesday when the US central bank (the Fed) said it would help commercial banks by loaning them money.

Large withdrawals by depositors could have been a disaster. It was a relief that problem was resolved.

Then, on Friday, the Fed said it would do the same for investment banks like Goldman Sachs, Merrill Lynch, Lehman Brothers and Bear Stearns.

Wow. The Fed hasn't used such drastic medicine since the 1960s. The time before that was in the great depression of the 1930s. Are things really so serious?

LEVERAGE CAN BACKFIRE

Investment banks make riskier deals than commercial banks. They sell re-packaged home loans. They also set up funds to trade stocks and bonds, mostly with borrowed money.

Borrowing is called 'leverage'. It boosts risks as well as returns. Indeclining markets, like now, the losses get magnified.

Some funds and investment banks may have taken on too much risk. There are reports of 30 and 40 times leverage. It means they used $1 of investors' money to borrow $40 from banks and invest it.

True, leverage can earn a fortune. But it can also turn around and bite you.

Consider this: If a $40 investment declines by one per cent, the loss is 40 cents.

But that small decline of 40 cents translates into a 40 per cent loss of the initial $1 investment.

When it happens, the bank which loaned the $40 would make a 'margin call'.

It would say, 'We are very sorry but the $1 you invested is no longer sufficient.

'Markets are falling and your $1 will be wiped out soon. You have 24 hours to put up more money. If you don't, we will sell off your investments at a loss.'

The fifth largest investment bank, Bear Stearns, owned funds which ran into this kind of problem. That was the root of its cash crisis.

Last week, Bear Stearns said it had US$17 billion ($23.4b) in cash so no one should worry.

It didn't work. Traders reasoned if Bear Stearns declared bankruptcy, their money would be stuck for months, as legal proceeding dragged on. They withdrew billions of dollars on Wednesday and Thursday.

On Friday, Bear Stearns had insufficient cash to meet further redemptions. So, it called the US Central Bank (Fed) and said, 'We are sorry but withdrawals are so heavy that if we open for business, we will run out of money. So, we will not open tomorrow.'

BIG TROUBLE

It was a shock. The Fed knew it had to do something. Selling of Bear Stearns' assets would have decreased the value of securities across the board. Losses could be enormous.

So, the Fed arranged to loan the firm all the money it needed. The irony is the Fed offered the same credit facility to commercial banks on Tuesday. Then, markets celebrated, thinking the credit crisis had been solved. The US Dow index rose 416 points.

On Friday, when the identical deal was extended to investment banks, the Dow index fell 195 points. Shares of Bear Stearns dropped 50 per cent.

This time, markets feared that financial institutions were failing. An unending series of bailouts might be needed.

Should we expect a downward spiral of collapse, rescue, collapse, and rescue? We haven't seen that since the great depression in the 1930s.

Everyone says such a possibility is unlikely.

True, but one year ago, everyone considered it impossible.

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When will it end?

THE futures market indicates a 90 per cent chance of a 1 per cent cut in US interest rates when the Central Bank meets tomorrow.

Will it be enough to turn the US economy around?

Who knows? Our best predictor is the stock market, and it is a far from perfect.