Financial Crisis threatens to become the Perfect Storm

According to the NYT, when the Bush administration brought out its $700 billion bailout two weeks ago, its sheer size was meant to restore confidence nationally and globally. But only three days after the plan became law, “it looks like a pebble tossed into a churning sea.”

Originating in America as a storm caused by subprime lending abuses, the financial crisis has raced across the globe wreaking havoc in Japan and Europe and returned to its point of origin to buffet the NYSE on Monday. The next day (Tuesday) the Dow Jones average went down by 5%. Japanese stocks plunged 9.4 percent Wednesday (Toyota down 10%) as Asian markets reinforced the trend on Wall Street. The Nikkei 225 suffered its biggest single-day loss since October 1987 adding to Tuesday’s drop of more than 3 percent. Unless something is done to break the vicious cycle, a perfect storm appears to be brewing.

US treasury secretary Henry Paulson had hoped that the American bailout, which entails buying securities from banks at more than their current market value, would make available credit for banks and investors.

Instead, credit has become more costly as investors are unwilling to back short-term loans to companies. Banks, already hard-pressed, were forced to provide short-term corporate loans. To address the problem of non-availability of credit, the Federal Reserve announced Tuesday that it would buy lots of short-term debt in order to stimulate the credit markets. This would make it easier for companies to finance their day-to-day activities.

Investors in Europe have apparently not been reassured by the American bailout package, which includes provisions to help foreign banks. Though Europe is supposed to be integrated economically with a single predominant currency, it is not able to respond in a unified manner at the political level, unlike the United States. It’s not a federation and it does not have a federal budget. Result: piecemeal action, panicky withdrawals and bank failures.

On Tuesday panic spread to stock markets in Russia, Brazil, Indonesia and the Middle East. The basic cause for the global slide is non-availability of credit. Economists fear that the $700 billion plan might end up being a stopgap for the United States alone. Unless European governments act in concert to launch a massively funded rescue operation a severe global recession might be around the corner.

As observers are beginning to realize, the decision not to help the old firm of Lehman Brothers started the rot in the USA. In Europe the key firms under siege were Hypo and Fortis. Fortis, a Belgian concern, became insolvent even after it received 11.2 billion euro from the Benelux countries. Hypo, a German concern, was to get a transfusion of 35 billion euro but that had to be increased to 50 billion euro or $65 billion.

Bad loans made in Europe, poor business decisions and transactions with institutions in the United States are being blamed for the problems of the European banks. For example, Hypo had given guarantees to back the American municipal bonds that it had sold to investors.

Apart from non-availability of credit, fear that Europe and the United States are undergoing recessions has made investors shy.

In addition to the $700 billion bailout for banks, the United States has also decided to guarantee $25 billion in loans for America’s troubled automakers. European automakers said Sunday they would seek similar aid from the European Commission.

The BBC reports that the European Union finance ministers at an emergency meeting in Luxembourg have decided to increase the guarantee for customers' bank savings accounts to at least 50,000 euro ($68,250). They also agreed to support big banks in trouble in order to protect the financial system.

In dealing with the European banking crisis, the FT warns Europe’s leaders not to “float rescue plans and then abandon them at the first whiff of controversy.” They should be firm, consistent and prudent, avoid beggar-thy-neighbor and beggar the taxpayer policies. "Admittedly," acknowledges FT, "there has been some nimble footwork to save individual banks, but overall it is perhaps best to draw a veil across the European response over the past seven days."

In a separate development, the UK government has announced a rescue package to make extra capital available to eight of the UK's largest banks and building societies totaling £50bn ($88bn). In return for the money, the government would receive preferential shares in those institutions.