from Follow the Money

On the precipice

October 12, 2008

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Words no Managing Director of the International Monetary Fund ever wants to utter:

“Intensifying solvency concerns about a number of the largest US-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.”

(source: FT)

Lehman’s default – and the resulting $400 billion run on money market and "prime" funds – precipitated the current, intense crisis. Van Duyn, Brewster and Tett of the FT report:

As word of the Reserve Fund’s predicament spread, investors fled. By that weekend, more than $200bn had been pulled from money market funds, by both retail and institutional investors. When other short-term funds, such as prime funds, are included, the amount that was taken out of short-term investments quickly reached $400bn. That shift brought the funds under heavy pressure to sell into an illiquid market, simply to ensure they had enough cash to pay investors withdrawing their money. For banks, heavily reliant on these investors for their funding needs, it created a spiral of liquidity crises. “It was the straw that broke the camel’s back,” says Joe Lynagh, a portfolio manager at T. Rowe Price, an investment company. …

The run on money markets created problems for a host of institutions that relied on the money markets rather than deposits for dollar financing. Think European banks – and the large former investment banks. It turns out that American money market funds were financing the large European purchases of US corporate debt. That explains why less risk was dispersed than the regulators thought – and why Europe was providing less financing to the US than the TIC data indicated. Van Duyn, Brewster and Tett:

The impact of the investor pullback is borne most heavily by banks that are predominantly reliant on wholesale funding, a group that includes many European banks,” says Alex Roever, analyst at JPMorgan. “This investor pullback from the secured dollar bank commercial paper market is a contributing factor in the recent wave of liquidity issues at European banks.”

Lehman’s default clearly triggered the run. But the ultimate cause of the crisis is more troubling: a large number of large commercial and investment banks seem to have been borrowing not on the strength of their own balance sheets but rather on the expectation that they were too big and too systematically important to fail.

“Prior to Lehman, there was an almost unshakable faith that the senior creditors and counterparties of large, systemically important financial institutions would not face the risk of outright default,” notes Neil McLeish, analyst at Morgan Stanley.”

Much of the infrastructure of modern finance in effect rested on an expectation of a government backstop for the creditors of large financial institutions – a backstop that allowed a broad set of institutions to borrow short-term at low rates despite holding large quantities opaque and hard to value assets on their balance sheets.

That observation has a number of implications, not the least that the leverage – and resulting capacity for outsized profits -- of some parts of the financial sector was made possible by the expectation that the government would protect the key creditors of the financial system from losses.

Lehman’s default shattered this implicit guarantee. The end result likely will be a series of explicit guarantees – and a rather significant government recapitalization of the financial sector.

The G-7 didn’t agree on a detailed action plan, only general principles. But by tomorrow morning, national governments will likely have extended guarantees to an enormous share of the liabilities of the world’s "private" financial system. And other parts of the "private" financial system will no longer be in private hands.


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