US regulators appear to believe a purge is needed for the market's long-term health.
LEHMAN Brothers' bankruptcy and Bank of America's rescue of Merrill Lynch could mean that the financial markets have begun a cathartic purge that was postponed last March, when US regulators decided to shield investors from the full consequences of the Bear Stearns meltdown.
The purge has not been induced by US regulators, but they have created the circumstances for it to occur, by refusing to partially underwrite a Lehman rescue, as they did with Bear Stearns.
It has already produced changes in the landscape that were unthinkable before the crisis began, and a significant re-ordering of global financial power structures is likely before it is over.
Merrill at least negotiated a deal before it was too weak and its share price too vulnerable, and will live on as a separate division inside Bank of America, with top Merrill executives still in place at the merged asset management and broking businesses.
Merrill in Australia is primarily a wholesale broker and funds manager, and should not miss a beat, because Bank of America has a very small footprint here. Bank of America has added Merrill's investment banking, broking and funds management businesses at a takeover value of just $US29 a share, less than a third of Merrill's price of $US97.53 in January last year, and the deal heads off a probable selling attack on Merrill this week after Lehman's capitulation.
Shares in Bank of America and Merrill should both rally strongly on the news, as short-sellers cover their positions.
BA's swift move could be one of the great vulture swoops in this crisis, and it will be an important confidence boost for the market as it handles the Lehman shock — Lehman's operating subsidiaries will remain open to try to prevent counterparty contamination — and concerns about the US insurer America International Group (AIG), and Washington Mutual that gathered pace last week.
There could also be new selling attacks, and the market will be monitoring Morgan Stanley, an independent blue-blood broker-dealer investment bank that like Merrill does not have a full bank balance sheet, and is, with the stronger Goldman Sachs, the last of the big independent investment banks standing.
One of the implicit messages in the decisions not to bail out Lehman and usher in the Bank of America-Merrill merger may be that there is no longer official support for the independent investment banking model: the Fed has widened direct access to its funding window from banks to broker-dealers during the crisis, but would not want to make that arrangement permanent, and the elimination of broker-dealers through bank takeovers is one solution.
The paradox at play now is that the world markets face significant short-term pain from a purge that US regulators appear to now believe is necessary for the market's long-term health.
AIG, for example, is reported to be seeking a $US40 billion ($A49 billion) capital injection from the US Government to avoid credit rating downgrades that would create big new losses. It is America's biggest insurer, with $US1.06 trillion of assets and liabilities of $US954 billion at the end of 2007 — and a taste of the economy-wide repercussions of its collapse came here in 2005, when HIH imploded. Whether that means it should be rescued by the Government is far from clear, however.
Washington Mutual runs a $US300 billion balance sheet that is skewed more than 50% by value to US mortgage debt, and its shares are also down 80% in a year.
Will the US Government continue to stand by? That probably depends on how far it goes, and how quickly. AIG in particular is a litmus test of the Government's rediscovered sense of laissez faire.
But the intent is clear. The March rescue of Bear Stearns is now viewed as a tactical mistake — an intervention that created a precedent that was not only impossible to honour given the magnitude of the losses being racked on Wall Street, but one that should not be honoured anyway.
Credit and capital is available in this crisis — Bank of America, Barclays, Citibank, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan, Merrill, Morgan Stanley and UBS yesterday created what was in effect a jointly funded $US70 billion finance industry overdraft, for example.
The key is to get funds circulating through the global financial system again however, and that will not happen until lenders and borrowers are confident about collateral value.
Balance sheet and share price adjustments that are not masked by government intervention are a critical part of the process, but if the purge continues, credit is going to be rationed even more, and asset sale programs launched by debt-strapped groups are going to struggle.
Centro's conditional $US714 million sale of 29 US shopping centres, for example, fell through after the US buyer emerged from due diligence and attempted to reduce the purchase price. Most of Centro's lenders agreed that the sale should be halted, and they dragged the others across the line. It is not a death blow for Centro, because a hoped-for extension of its debts from September 30 to mid-December and, Centro hopes, into 2009 is not tied to a time-line for specific asset sales.
But the US deal was the only major sale Centro had announced. At some point it must sell major properties to stand a chance of getting out from under its $US6 billion debt load — and the reality is that sales are grinding to a halt as the crisis endures, and credit is hoarded. The purge can free the system up: but the market pain will be intense while that is occurring.
