Ten days that shook the world

The 7 September rescue of half of the American mortgage industry in the form of Fannie Mae and Freddie Mac might have looked like the biggest single catastrophe to hit the financial markets, against which any subsequent collapse would pale in comparison.

Not quite true. In terms of sheer dollar weight propping them up, the $300bn of US Treasury money is certainly the largest bailout in the history of pretty much everything. But what happened next still created huge shock waves.

Lehman Brothers had been fighting a rearguard action for weeks, trying to shore up a balance sheet that was holed below the waterline. Things weren’t helped by the highly-respected think tank, the Brookings Institution, saying, “If I were at the Fed I would be hoping for an opportunity to show the world that the Fed will not rescue every ailing institution, but will let some go.”

On Sunday 14 September, Barclays turned its back on an opportunity to rescue Lehmans, seemingly preferring to pick up just the bits it really wanted once the 158-year-old firm went belly-up. And Bank of America, according to the Wall Street Journal Europe, didn’t want anything to do with Lehmans unless the US government was prepared to provide assistance. Deal or no deal?

Don’t like Mondays
No deal. As credit derivatives dealers and everyone else scrambled on Monday morning to unwind their positions with the firm, it went into Chapter 11 bankruptancy protection. Newspapers showed photographs of sullen bankers carrying out their personal belongings in boxes.

Later that day, an almost equally momentous event was overlooked by the non-financial press as the revered investment bank Merrill Lynch was forced into the arms of Bank of America. The loss of independence at Merrills, self-styled as “The thundering herd”, shocked many, even more than the wholesale collapse of Lehmans.

But it was at least a dignified market-originated solution, with BofA of fering $29 a share for the investment bank whose shares had closed on Friday at just over $17. There was “always the possibility of someone else making a strategic investment,” said BofA chief executive Ken Lewis in defence of his $50bn offer.

On this side of the Atlantic, HBoS watched its share price slide and slide. The combination of what was once Britain’s biggest building society, the Halifax, and the conservative Bank of Scotland, was “securitised up to the hilt”, as one commentator put it. On 17 September HBoS confirmed it was in merger talks with Lloyds TSB. The government seems content to wave away any competition objections.

The reluctance of US authorities to prop up the market didn’t last long. Also on the 17th, insurance group AIG received $85bn in emergency funding from the Federal Reserve in return for giving the government a 79.9% stake. AIG was stymied by its exposure to products that pay out to lenders who find themselves with dud mortgages.

It also had huge exposure to credit default swaps. What seems to have killed it was a downgrading by credit rating agencies that resulted in a need for further capital ­ and even allowed customers to cancel their policies and reclaim unearned premiums. The worse things got, the worse that made things.

It’s not over yet. As we write on 18 September, Morgan Stanley is in merger talks with US Wachovia ­ which has its own troubles. Overnight, dollar interbank rates soared to 6% above the Fed Funds rate of 2% while the scramble for some US bonds sent yields below 0%. The Fed is pumping $180bn into money markets while all five other major central banks around the world are also working together and taking “appropriate steps to address the ongoing pressures” ­ to the tune of almost $100bn. But despite the funding, those pressures seem unlikely to disappear overnight.

See out blog, Shareholder Values, at http://shareho ldervalues.financialdirector.co.uk