The rotten state of finance


Following government attempts at stability, Theresa Cummins investigates the dire global economic panorama.

Although he would now be perfectly vindicated in his “I told you so”, even Polonius, with this sage wisdom and worldly advice, could not have claimed to have foreseen the financial turmoil that has evolved over the last past few months.

Last Friday saw the full extent of the effects of lending, with the financial system losing far more than its friends. Stock markets plummeted to their lowest level in five years amidst fears of a recession. Investor confidence was practically non-existent with a remarkable sell-off in shares around the world. This bleak outlook reinforced the sentiment in the market that a global recession is on the horizon, despite the attempts of governments worldwide guaranteeing deposits in banks.

Before “subprime” and “leverage” became the latest swear words, banks did extremely well from lending and borrowing. After the Federal Reserve cut interest rates in 2001, mortgage payments became cheaper; demand grew for houses which caused house prices to increase dramatically.

Profits in banks soared and they lent more and more money to people who couldn’t afford it. Banks hedged their risks through complex financial instruments such as Credit Default Swaps and Collateralised Debt Obligations.

When people started to default on their loans, these instruments turned out to be rotten and the credit crisis surfaced, leaving a lack of liquidity and frozen credit markets in its wake. Fearing one another’s exposure to subprime mortgages, banks stopped lending to each other, significantly reducing the credit available in the economy.

The past few weeks have seen huge sell-offs in global equity markets; financial stocks among those being hit the hardest with investors rushing to divest themselves of additional risk.

Governer of the Bank of England, Mervyn King commented on the sentiment reflected in the markets. “Not since the First World War has our banking system been so close to collapse. The long march to boredom and stability starts tonight.”

His outlook was resonated in the opinions of the former Federal Reserve chairman, Alan Greenspan, who described the current turmoil as “a once-in-a-century credit tsumani.” Market confidence is linchpin to the value and health of a financial system. Over the past few months, a number of measures have been taken to restore investor confidence.

Market confidence is linchpin to the value and health of a financial system

The Federal Reserve cut interest rates, bailed out mortgage entities Fannie Mae and Freddie Mac, and insurance giant American International Group, and more recently guaranteed deposits in banks to the tune of $700 billion.

Western governments followed, with the leaders of Britain, France, Germany and other European countries offering more than a trillion euros in credit supports for banks and the Irish government guaranteed €400 billion deposits in banks.

Despite these efforts to re-establish confidence in the financial system, by attempting to enhance liquidity and improve credit conditions in the markets, the threat of a global recession has since becoming much more significant.

Reports of the possibility of a recession in Britain intensified last Friday week as data emerged on the negative growth rate in the economy. According to figures published by the Office for National Statistics, output fell by 0.5 per cent, causing the value of UK shares and sterling to fall substantially.

The British Prime Minister clarified that other countries would be intrinsic in the attempt to fighting the downturn. “This is a global financial recession and we’re fighting it every way we know how,” Gordon Brown declared. “But we need other countries to work with us and that’s why I’m also spending my time making sure other countries take the action that we’re taking to stop this becoming worse.”

The fall in output is reported to be the direct consequence of the credit crunch, increasing energy prices and a fall in house prices. Despite the recent UK bank bailouts of the Royal Bank of Scotland, HBOS and Lloyds TSB to the value of £37 billion, the British economy is tethering on the brink of a recession.

The unexpected 0.5 per cent shrink in economic output caused UK shares to drop. This negative economic growth was larger than what had been predicted and had a detrimental impact on investor sentiment.

Last Friday also saw Dublin’s ISEQ reach a twelve year low, as investors got rid of shares in an effort to lessen their exposure to the possibility of a global financial recession. Large hedge funds and institutional investors have complimented this downward strain in equity markets as they too dumped their shares and ran for safety.

News of the possibility of a recession in Britain coincides with the publication of the Bank of England’s Financial Stability Report, which investigates the financial turmoil over recent months.

Remarking on the report, Sir John Gieve, Bank Deputy Governor said that “the instability of the global financial system in recent weeks has been the most severe in living memory. And with a global economic downturn underway, the financial system remains under strain.”

Commenting on the possible solution to the financial turmoil, Gieve went on to say “we need a fundamental re-think of how to manage systemic risk internationally. We need to establish stronger relationships on the build-up of risks in the financial system over the cycle with the dangers they bring to the wider economy.”
Such solutions may include reducing the leverage ratio (that is the debt to equity ratio a bank has) and enforcing stronger capital and liquidity requirements.

If the billion dollar bailouts observed globally are futile in restoring market confidence, you have to question what, if anything can stop, or at the very least curb, this financial downturn. The US Federal Reserve cut interest rates last Wednesday down to 1 per cent, their lowest level since 2004.

The Fed hopes that this latest interest rate will help improve credit conditions and stimulate economic growth. A similar response of a reduction of interest rates in the eurozone is forecasted. This mounting speculation of interest rates cuts by the European Central Bank and the Bank of England, combined with the belief that such reductions could alleviate a global recession, have already helped shares rebound from their dramatic fall last week.

This recovery of shares could signal that the credit crisis has reached its nadir, and mark a positive step towards improving financial conditions, however it could just be another symptom of the highly volatile equity markets, merely prolonging the inevitable.