Trust is vanishing. On Wall Street they are not sticking their money under the bed as they did in the aftermath of the 1929 Crash. They are hiding it with a computer and a mouse.
Banks are asking themselves, do we want to risk lending money to someone who could be exposed to Lehman Brothers? Or AIG from that matter? The huge American insurer is tottering: its obligations and its counterparties are unknown.
Its risks are unknown.
The implications of the present crisis for any company with high debt levels or a large derivatives exposure are unpalatable. These will be shorted by the hedge funds, again. There is now a "flight to quality". Until confidence is restored in the banking system, anything with the smell of leverage will get smacked hard.
You can say goodbye to Babcock & Brown, whose stock price has just been cut in half again this morning. Other heroes of the bull-market Allco, Centro, Rubicon, MFS - all gone now if they weren't before. Anything too highly-leveraged is at risk. Too much can go wrong. Too much is unknown.
The purest indicator of confidence in the global financial system is the TED spread. The TED spread is the difference between the interest rate on a three-month US Treasury bill and the three-month LIBOR rate (London Interbank Offered Rate).
LIBOR is the rate at which the banks are willing to lend to each other. The T-bill rate is considered to be risk free. Overnight, the TED spread rose to 200 basis points, or two per cent. In the first six months of 2007, the TED spread averaged 39 basis points.
Money market operators all reported that banks were reluctant to lend out their money. The US Federal Reserve injected $US70 billion into the system last night. Today, the Reserve Bank of Australia will be throwing the cash around.
There is at least one bank in Australia with a derivatives exposure of more than $1 trillion. Yes, one thousand billion dollars. This exposure is notional in the sense that it reflects the underlying value of all the derivatives contracts. It is not the net position. Still, the potential for large sums to be lost, or called on, when some counterparty hits the wall on the other side of the world is significant.
What an irony it is that Alan Greenspan, the former chairman of the US Federal Reserve, came out on Sunday - as salvage talks were proceeding for Lehman Brothers - and said this US credit squeeze had brought on a "once-in-a-century" financial crisis that was likely to claim more big firms before it was over.
It was "is in the process of outstripping anything I've seen, and it still is not resolved and it still has a way to go."
"Indeed, it will continue to be a corrosive force until the price of homes in the United States stabilises," Greenspan said. That would not happen till early next year.
This "once-in-a-century" financial crisis could be put down, at least in part, to the Greenspan policy of drilling down the cash rate to one per cent - and keeping it there for too long.
This had the effect of bringing out every huckster on the planet - including most of the bankers on Wall Street - to get their hands on this virtually free money: to lend it and spend it. When money is virtually free you can get away with a lot. So it was that an entire generation of financial engineers and structured-finance charlatans was spawned to exploit this temporarily free money.
The greed and paper shuffling reached absurd levels. The CDO for instance (collateralised debt obligation) - which is now unsaleable and triggering billions in losses - gave rise to the CDO squared ( a CDO of CDOs) and even a CDO cubed (a CDO of CDO squareds). In one case there were 11 levels of paper before the underlying "referenced" assets.
Most often (see BNB, Allco etc) they borrowed this money short-term and lent it long-term. Over the past year there has been a scramble to refinance, to lock in longer rates but the cost of debt has risen.
The consequent process of assets sales, unwinding of complex structures and corporate deleveraging will take time. Markets will be depressed until that process is well and truly underway - and it has only just begun.
In the meantime, the greatest risk lies in derivatives quite simply because their consequences are unknown and cannot be easily measured.
mwest@fairfax.com.au
BusinessDay
